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Morningstar | Lowe's Delivers Solid Comps but Weak Pricing, Leading to Reduced Profit Outlook for 2019

Wide-moat Lowe’s bucked its long-term trend, outperforming Home Depot on first-quarter comps; it delivered 3.5% same-store sales growth in the period, ahead of our 3% estimate. However, Lowe’s struggled with profitability, with higher costs, ineffective legacy pricing tools, and changes to the merchandising group hindering the gross margin, which contracted 165 basis points to 31.5%. While operating expenses were a bit better than we anticipated at 23% of sales (versus 25% in the year-ago period), this wasn’t enough to support operating margin expansion, with Lowe’s marking about 40 basis points of compression to 8%. With updated guidance reaffirming sales and comps at 2% and 3%, respectively (in line with our 1.5% and 3% estimates), we don’t plan much change to our top-line forecast. However, with Lowe's reduced outlook for adjusted operating margin expansion of 20-50 basis points (from 85-95 basis points prior), we plan to compress our 9.4% operating margin forecast to around 9% in 2019. This will lower our $103 fair value estimate by a low-single-digit rate as we expect gross margin pressure to alleviate in 2020. We view the shares as fairly valued after their low-double-digit decline post-report.

As with many turnarounds, hiccups are inevitable as a new leadership team implements its own operating plan. The updated 2019 outlook doesn’t sway our long-term prognosis for Lowe’s, which calls for average comps of 2.4%, sales growth of 2.5%, and an operating margin that climbs to 11% in 2025 (Lowe’s long-term goal is for a 12% operating margin). Our modest growth outlook is tamed by cyclical factors, including the recent slowing in existing-home sales and slower home pricing growth. However, we contend that Lowe’s should remain a market share leader in the home improvement industry thanks to its scale and improving merchandising prowess, supporting our wide moat rating and returns on invested capital that average 25% over the next five years.

While merchandising issues were the headline of the quarter, this was a factor already highlighted at the company’s most recent investor day in December 2018, and we suspect efforts underway to rectify prior mispositioning should largely be completed over the remainder of the year, supporting material gross margin expansion next year (which we had rising to more than 34% terminally from 33.3% in 2018).

On the positive front, we were pleased to see the cadence of one-time items slow in the quarter, with the sale of the Mexico business assets adding $0.09 to GAAP earnings and no write-downs after a massive $1.6 billion write-down in the company’s fourth quarter, which included a nearly $1 billion charge to the Canadian business (RONA), one-time charges for the shuttering of Orchard Supply, and further fees for the closure of underperforming boxes. It would appear we are largely out of the woods with regards to material changes to the structure of the business, and with new CEO Marvin Ellison at the helm for just 10 months, we think the company has acted swiftly and thoughtfully to strategically realign the business for operating margin expansion. We still believe the stewardship of the company is exemplary, given the solid returns on invested capital that Lowe’s has been able to generate even in periods of duress (9% in 2009 versus our weighted average cost of capital estimate of 8%). This conveys the business model’s ability to capture excess economic rents thanks to solid capital-allocation tactics.