EUR 850.00 For Business Accounts Only

Morningstar | Lowe's Evolution Begins Under New Leadership Team; Shares Modestly Overvalued

With Marvin Ellison taking the helm at the beginning of July and a massive overhaul of the C-suite, we aren’t surprised that changes are underway at Lowe's. Taking his first step to alter the business, CEO Ellison announced the wind-down of the Orchard Supply brand, which was acquired in 2013 and has troubled the wide-moat company, generating a $76 million impairment in 2016. He also announced an inventory rationalization plan; both are set for execution over the remainder of the year. Given that Lowe’s inventory days (92) were around 30% higher than Home Depot’s (70) at the end of 2017, there should be ample opportunity to improve working capital efficiency, and with an executive team with extensive retail experience at topnotch category leaders, execution should be seamless.

Expenses of $230 million from the wind-down cost Lowe’s $0.21 per share in the second quarter, and another $390 million-$475 million is expected in the second half of 2018, leading to one-time charges around $0.60-$0.65 per share for the full year, by our estimate. The remainder of Lowe’s GAAP earnings guidance downgrade (to $4.50-$4.60 per share from $5.40-$5.50) comes from inventory management initiatives. These two efforts should better streamline the business and lead to improved operating metrics over time as a focus on faster inventory and cash conversion metrics could generate meaningfully better cash flow. We expect Lowe's will lay out a more detailed road map of changes ahead and the potential benefit these efforts could have on the longer-term operating margin profile at the company's investor day later this year.

We don’t plan any immediate change to our five-year outlook, which calls for comparable-store sales growth that averages 3%, a top line that rises slightly faster than comps, and low-double-digit operating margins. As a result, we don’t plan to materially alter our $94 fair value estimate and view the shares as modestly overvalued.

Overall, second-quarter performance was solid, with 5.2% same-store sales growth benefiting from the recovery of the spring selling season, allowing for positive comps in all 14 geographic regions and 8 of the 11 product categories. The comp comprised 0.6% transaction growth and a 4.5% increase in ticket value, as tickets over $500 increased 7.1% (low-value growth of tickets less than $50 was up just 1%). The comp gain was slightly slower than the 5.5% we had forecast and trailed the 8% Home Depot posted over the same time. Gross margin was 20 basis points lower than we anticipated, increasing 25 basis points year over year to 34.5%, bolstered mostly by the accounting standard changes and hindered by mix and transportation costs. Selling, general, and administrative expense as a percentage of sales was about 50 basis points worse than we forecast, at 22.5%, with Orchard Supply offering 110 basis points, or about half, of the year-over-year deleverage. Changes to accounting standards added more than 60 basis points on incremental deleverage on the SG&A metric.

Over the past year, Lowe’s has hired a new chief digital officer (from Amazon) and CEO (J.C. Penney, Home Depot) as well as heads of merchandising (Chevron), stores (J.C. Penney, Home Depot), and supply chain (Walmart) and a CFO (CVS Health, slated to join later this year). With a bevy of competent retail experience, we don’t anticipate policies regarding return of capital to shareholders will change, and we expect rising dividends and ongoing share repurchases will continue to be a focus for the company after reinvesting in the business. As evidence, Lowe’s has already planned to reduce capital expenditures by $500 million in 2018 (canceling projects that were not centered on improving the core business or that didn’t increase productivity), reallocating that cash to incremental share repurchases, driving around $3 billion in repurchases for 2018 versus a $2.5 billion forecast prior. We plan to maintain our Exemplary stewardship rating for Lowe’s.