A Tough Third Quarter Expected For Lowe’s
Lowe’s (NYSE:LOW) is slated to report its third quarter earnings on November 20, wherein a 3.4% gain in revenues and a 6.7% drop in earnings per share is expected. The home improvement retailer has had a tricky FY 2018, with unseasonably cold weather dampening its first quarter results. Although it posted a recovery in the second quarter, beating consensus expectations on both revenues and earnings, the company was unable to match the astounding performance posted by its closest competitor, Home Depot (NYSE:HD), continuing the recent trend of the former playing catch-up to the latter. Lowe’s is faced with significant organizational changes, including a new CEO and CFO, along with certain disruptions and inventory issues which have pressured sales. In the third quarter, while its sales growth is expected to be led by the digital segment, the earnings decline is primarily a result of its recent decision to shut down 20 underperforming stores in the U.S., and 31 such locations in Canada. Moreover, the exit from its Orchard Supply Hardware business will result in $390 to $475 million in additional costs in the second half of the financial year, pressuring the operating margin.
We have a $118 price estimate for Lowe’s, which is higher than the current market price. We will be updating our model based on the revised guidance expected with the third quarter results. The charts have been made using our new, interactive platform. You can click here for the interactive dashboard on Estimating Lowe’s Performance in Q3 And Its Fair Price, to modify our driver assumptions to see what impact it will have on the company’s revenues, earnings, and price estimate.
Factors That May Impact Performance
1. Focus On Pro-Customers: Professional customers place larger orders compared to the do-it-yourself segment, and better serving these customers can boost revenues for Lowe’s in the long term. While the recovery in the housing segment has benefited players such as Home Depot and Lowe’s, the latter’s growth has not been as stellar, primarily due to its focus on the do-it-yourself consumer segment. While the do-it-yourself segment is lucrative and accounts for the bulk of Lowe’s revenues, these customers are small ticket buyers and many are just one-time customers. On the other hand, pro-customers account for only 30% of Lowe’s revenues, but they enter into big-ticket transactions and are usually repeat customers. Keeping this in mind, the company has been focused on these customers by introducing pro-focused brands such as Mapei and Zoeller.
2. Housing Market: Despite news regarding a weak housing market, reflected in the declining home sales figures, the company feels positive about the strength in the home improvement sector. The housing stock in the country seems to be old and in need of repair and renovation, which should help Lowe’s. Moreover, unemployment is at its lowest level since 2000, and wages are improving. Although interest rate hikes make mortgages more expensive, on the whole, it is indicative of a strong economy. Strong macroeconomic conditions bode well for a company like Lowe’s that is heavily reliant on the improvement of the economy.
3. Digital Growth: Comps improved 18% on the company’s website in Q2, which now accounts for 5% of the total sales. Lowe’s intends to continue upgrading the shopping experience, with features such as optimized search capability, expanded assortment, faster site speed, improved checkout, and next day delivery. Lowe’s also provides flexible fulfillment options of buy online, pick up in store, and buy online, deliver from store, besides making it easier for customers to engage with its in-home project specialists to request services. We expect strong growth from this segment to continue.
4. Onset Of Hurricane Season: As hurricanes are expected to devastate many houses, there will be a greater need to fix these after the storms. Such a scenario will boost the demand for products of home improvement companies such as Home Depot and Lowe’s, which cater to not only the do-it-yourself (DIY) segment, but also professionals in the home improvement/remodeling and construction space. Home owners face the likelihood of severely damaged properties, necessitating the demand for home improvement equipment and materials. Moreover, since some of the properties in the flood-affected areas may be without insurance, people will be forced to pay out of their pockets for the repair work. Hence, a significant portion of the work can be expected to be conducted by the DIY segment, which is a core customer base for both Home Depot and Lowe’s. Even prior to the storms, the companies can be expected to have been selling large volumes of small-ticket items such as bottled water, tarps, and straps, as well as larger ticket times like fans, blowers, air conditioning units, and generators.
5. Stabilizing Gross Margins: Lowe’s has implemented new pricing and promotion analytics tools to ensure that the company is “competitive on highly elastic traffic driving products while increasing profitability across less elastic items.” This factor played a role in the slight improvement in gross margins witnessed in the second quarter. The metric also benefited from the adoption of the new revenue recognition standard. On the other hand, increased transportation costs had a negative impact on the gross margin. The company has guided for a gross margin expansion of 60 basis points for this year, along with 180 basis points of decline in the operating margin, as mentioned earlier.
6. Exiting Orchard Supply Hardware Operations: The main reason for exiting these operations is to concentrate on the core home improvement business. The management expects to close all 99 stores which are located in California, Oregon, and Florida, as well as one distribution facility by the end of FY 2018, which is one of the factors driving a larger than intended decline in operating margins. In FY 2017, Orchard generated $600 million in sales, but was a $65 million drag on the EBIT, and hence, our expectation is that the closure should positively impact the margins from the next financial year.
7. Reduced Tax Rate: Given the fact that Lowe’s operates primarily in the U.S., its effective tax rate has been 35% or higher in the past few years. As a result of the decline in the corporate tax rate from 35% to 21%, effective January 2018, the company is expected to have a tax rate of 25%, which should be a key driver in the substantial improvement in the net income margin this year.
8. Shuttering 51 Stores: Earlier this month, the company announced its decision to exit 20 underperforming stores in the U.S. and 31 in Canada, as mentioned earlier, as part of its strategic reassessment. These closures are expected to be completed by the end of the financial year. The expected financial impact of $0.28 to $0.34 per diluted share was not accounted for in the business outlook for fiscal 2018 which the company provided when it released its second quarter earnings. Consequently, additional details regarding this can be expected in the third quarter earnings release.
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