Lowe’s Faces A Tough FY 2018 Despite Favorable Conditions
Lowe’s (NYSE:LOW) reported its third quarter results on November 20, and despite beating consensus expectations on both revenues and earnings, the quarter isn’t as impressive as it first seems when we delve deeper into the financials. The revenue growth of nearly 4% beat anticipated sales by roughly $75 million; however, this was helped by the adoption of the new revenue recognition standard, which provided a 143 basis point benefit to sales growth. Meanwhile, the comps growth came in at 1.5%, falling behind expectations. The earnings growth was primarily a result of the reduction in the tax rate, since the gross and operating margins of the company continue to slide. Lowe’s has been unable to match the performance posted by its closest competitor, Home Depot (NYSE:HD), continuing the recent trend of the former playing catch-up to the latter. The home improvement retailer is faced with significant organizational changes, including a new CEO and CFO, along with certain disruptions and inventory issues which have pressured sales, despite favorable macroeconomic conditions. Although the industry outlook remains bright, the company has reduced its guidance for the year given the number of strategic initiatives being undertaken. Sales and comps growth is now expected to be 4% and 2.5% (versus 4.5% and 3% earlier), the operating margin is anticipated to decline by 240 to 255 basis points (versus a fall of 180 basis points earlier), including 135 to 150 basis points from charges associated with its strategic reassessment, and the diluted EPS is projected to be in the $4.08 to $4.24 range (versus $4.50 to $4.60 earlier). Meanwhile, the adjusted diluted EPS is expected to be in the range of $5.08 to $5.13.
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. The charts have been made using our new, interactive platform. You can click here for the interactive dashboard on Lowe’s Performance in Q3 And Estimating 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 soft 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. Furthermore, the home price appreciation also continues to encourage homeowners to engage in discretionary projects. Moreover, consumer confidence is high, 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 12% on the company’s website in Q3, which accounts for roughly 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, once the company sorts out its inventory problems.
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. Declining Margins: The gross margin declined 157 basis points compared to last year despite a 170 basis points benefit from the adoption of the new revenue recognition standard. This was primarily a result of the steps undertaken to rationalize inventory and to eliminate slow-moving or underperforming SKUs, which negatively impacted the metric by 180 basis points. Other factors that pressured the margins included its clearance activity, closure of its Orchard Supply Hardware operation, and increased transportation costs.
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 24%, 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. This could be one of the reasons for the decline in the earnings guidance provided by the company.
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