Bruce Bennett
A Macro Company
Home improvement retailer Lowe’s (NYSE:LOW), the occupier of second place in the home-improvement world behind Home Depot (HD), has experienced quite the turnaround. CEO Marvin Ellison came to the company in 2018 and over the past five years has done what can only be described as a stellar job despite macro headwinds in the form of a worldwide pandemic, inflation, and subsequent rising interest rates.
The market has taken notice as well.
Koyfin
Since the start of 2018, Lowe’s has handily outperformed the broader market, delivering 150% in total returns versus the S&P 500’s (SPY) return of 67%.
And yet, the story of whether or not Lowe’s can continue to perform is still being written. The home improvement and residential construction sectors are quite sensitive to interest rates, and it remains to be seen what impact they and a potential recession in 2023 will have on the industry and the company as a whole.
In this article we will explore what we think of Lowe’s current position and outlook within the market, as well as what we think the future may hold for the company. Let’s dive in.
Tough Times Ahead For Pros?
As the economic debate rages on about whether or not the United States is in for a hard landing, soft landing, or no landing, life and economic activity must press on. To this end, 2023 was expected by most contractors to be a year in which survival was a priority. As inflation threatened to reduce consumer’s average spending and make home and business owners more hesitant about embarking on new building projects, the outlook for home improvement industry darkened.
Recently, however, bright spots have begun to emerge. Contractor Supply Magazine recently reported that a broad based survey conducted by Wells Faro in Q1 of 2023 showed a surprisingly high level of confidence by contractors.
If this sentiment bears out, then it will likely mean a boost for Lowe’s as one of the company’s Total Home strategy is greater penetration of the professional contractor (referred to simply as pro) market. In an effort to gain market share with this highly lucrative segment, the company launched its first pro-only fulfillment center last year, which is meant to hold more items that pros more frequently need and accommodate larger vehicles for equipment pickups.
The attraction of pro-business to Lowe’s isn’t difficult to understand–professional contractors bring steady, repeat business, whereas a retail shopper is far more intermittent in their home improvement buying habits.
Further, this improvement in professional sentiment (if it lasts) could make it easier for the company to hit their 2023 targets. In 2022, Lowe’s reported revenues of $97 billion and operating income of $12.2 billion. The company guided down, estimating that it would do $80-$90 billion in sales for 2023. We believe that if professional sentiment remains even slightly elevated from its 2022 levels, this could translate to a better year than anticipated.
Koyfin
Analysts on average have not adjusted their estimates to reflect any potential growth of optimism in the market–the average estimate for the company’s FY2024 performance sits at $88 billion, the low end of the company’s guidance.
Value
With 1,738 stores and household brand, Lowe’s operates in a what is basically a duopoly with Home Depot for the dominant spot in the home improvement space. (Yes, there are smaller retailers and Home Depot is quite a bit larger than Lowe’s, but the two companies remain each other’s largest competition in the space.)
As such, Lowe’s trades at a discount to Home Depot.
Koyfin
On a forward price to earnings basis, Lowe’s trades at 11.5x projected earnings, while Home Depot trades at 13.5x. On a forward EV/EBITDA basis, Lowe’s sits at 15x while Home Depot trades at 18.6x.
One might look at this and think that there really isn’t much meat on the bone when comparing these two companies–the disparity just doesn’t seem wide enough.
And we agree. However, there are other factors that we think will drive Lowe’s to close and potentially even surpass the valuation gap with its rival.
First, the two company’s outlooks for 2023 were not initially the same. As we saw, Lowe’s predicted a down year to start, and analyst estimates followed suit. Home Depot, meanwhile, set the bar slightly higher for itself by predicting a flat year of overall sales (sales for Home Depot in FY22 were $157 billion).
In what might seem like a bit of financial reporting gamesmanship, Lowe’s has created an expectation among investors that its sales will dip this year, setting itself up for a potential inflow of investor interest should sales remain even from 2022, the market is very likely to react positively.
Further, Lowe’s just jettisoned a business in February 2023 which had been a drag on its overall results–its Canadian operations and the 232 stores there. The cost associated with this was set into the 2022 results, and the company addressed the sale and its impact on earnings as such on page 22 of its 10K:
Included in the fiscal 2022 results is $2.5 billion of pre-tax costs associated with the sale of the Canadian retail business consisting of long-lived asset impairment, loss on sale, and additional closing costs, which decreased diluted earnings per share by $3.64.
This is exactly the sort of one-time charge that hits the bottom line of earnings which tends to slip by investors.
Lowe’s reported diluted EPS of $10.24 for 2022. Adding back the divestment charge of the company’s Canadian operations would put EPS at $13.88–which is what we could theorize earnings would be if the sale hadn’t taken place. Analyst GAAP EPS expectations for 2023 (where revenues are expected to be down 8%) are $13.85.
Part of what’s driving the disparity in estimates is Lowe’s projection that it can boost operating margins to 13.6% for the year as it cuts costs (operating margin for 2022 was 12.5% for reference). Again, any boost in revenue combined with cost-cutting measures is likely to bring up the bottom line as well.
The Bottom Line
While the macro picture remains unclear overall, we believe that Lowe’s has positioned themselves well for any sort of upside surprise which, according to contractor sentiment, may be in the works to start 2023. Risks to our thesis include a sudden slowing of the economy or contraction of overall building activity.
For now, though, we like where Lowe’s is at and how the company has situated itself for the coming year.
