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Morningstar | Lowe's Continues to Clean House With $1.6 Billion Charge on Weak Businesses; Shares Fairly Valued

Wide-moat Lowe’s management team continues to reassess its overall business, with a less-than-year-old C-suite attempting to extract increasing efficiencies from the second-place home improvement retailer in the domestic market. This in turn provided write-downs in the fourth quarter totaling $1.6 billion, including nearly $1 billion from a goodwill impairment associated with the Rona Canada business and another $208 million from the closing of Orchard Supply locations. Rona was acquired for $2.4 billion in 2016, while Orchard Supply was purchased for $205 million in 2013. While we don’t view such developments as favorable, we see them as necessary for the company to recenter its focus on the namesake Lowe’s locations, with the goal of increasing productivity and profitability at the core business.

With cleanup noise largely out of the way and fewer distractions from struggling business lines (helped by the exit of Mexico and Iris), we think Lowe's is setting the stage to enter 2019 with the ability to more easily expand operating margins. The company hasn’t strayed from the 2019 outlook it provided at its December investor day for $6.00-$6.10 in earnings per share (in line with our $6.07 forecast), and with sales and comps of 2% and 3%, respectively (in line with our 1.7% and 2.7% estimates), we don’t anticipate any material change to our $98 fair value estimate. We view shares as fairly valued, trading at 17 times 2019 EPS versus our 13% five-year EPS growth estimate. Our intrinsic value is contingent on 2.6% average sales over 2019-23 and an operating margin that rises to 10.7% in 2023.

We don’t think Lowe’s is immune to slowing home improvement growth; it reported just 1.7% comp growth (largely in line with our 1.9% forecast), its slowest fourth-quarter rise since 2010. Additionally, the company’s 3% comp forecast for 2019 is the most tepid initial outlook for comps since 2012, although we note some of the comp outlooks since 2012 were revised downward after the first look. The fourth-quarter gross margin was more than 200 basis points worse than we anticipated, at 31.5%, hurt by inventory shortages, clearance of holiday merchandise, supply chain costs, tariffs, and mix shift, which more than offset the 110-basis-point improvement the metric received from a change in accounting. The selling, general, and administrative expense ratio was lower than our estimate, at 23%, with operational expenses more than offsetting pressure from revenue recognition changes.

While many of the efforts Lowe’s is focusing on seem obvious at first glance, including merchandising, labor staffing, e-commerce, and customer satisfaction, these are areas that were historically underinvested in and had failed to keep up with evolving consumer demands under the prior management team. We think a more streamlined model across the enterprise in these efforts will help to smooth financial performance and create consistency across the business, leading to rising free cash flow. This in turn should support the company’s 35% dividend payout ratio ahead while still permitting opportunistic share repurchases, driving low-double-digit EPS growth over the next five years.