|Shares Out. (in M):||830||P/E||0||0|
|Market Cap (in $M):||86,200||P/FCF||0||0|
|Net Debt (in $M):||15,210||EBIT||0||0|
Since the last recession, LOW has significantly underperformed HD in terms of operating margin expansion. In 2008, LOW actually had a higher operating margin than HD (7.8% vs. 7.4%). However, HD has significantly outperformed LOW coming out of the downturn on SG&A margin (LOW continues to generate a slightly better gross margin than HD). This has led to a ~480 bps higher 2017E operating margin for HD relative to LOW. We do not believe that this drastic of an operating margin gap should exist between the two leading home improvement retailers that hold nearly 50% combined U.S. market share. While there are some structural differences that explain some of this margin differential such as higher SSF for HD ($423 vs. $319), a more urban store base for HD and HD stores in some wealthier neighborhoods, we don’t believe that these factors fully explain this substantial of an SG&A margin gap between the two largest home improvement retailers.
LOW’s operational underperformance relative to HD since the last recession led to recent activist involvement from DE Shaw. Management appears to have been receptive to DE Shaw and recently added three new board members. We believe the new board members along with DE Shaw will help management to deliver operational and margin improvement as well as hold management accountable to the long-term targets. In particular, David Batchelder was added to the LOW board and he served on HD’s board from 2007 to 2011. His home improvement industry experience and knowledge of HD’s operations should be beneficial for LOW shareholders. Going forward, there will be three new directors with a total board size of 13.
We believe that the bulk of the LOW margin opportunity lies in SG&A. LOW has only been able to achieve 200 bps of SG&A margin improvement since 2008, despite same store sales in the +4% range in recent years and limited new store openings. HD has been able to achieve ~650 bps of SG&A margin improvement over the same time period. DE Shaw has mentioned some of the margin opportunities that they envision including shipping appliances directly from the manufacturer (like HD) vs. from LOW shipping from stores and utilizing more part time labor (40% part time for LOW vs. 60% part time for HD). We believe that the bulk of the SG&A margin gap to HD is due to differences within “payroll & other expense”, which accounts for 75% to 80% of total SG&A for LOW and HD. Over time, we believe that some of the gap to HD can be closed given that the “payroll and other expense” margin spread did not exist from 2009 to 2011. Coming out the recession, LOW’s management seems to have lost its focus on this area of the expense structure.
LOW has also underperformed HD on same store sales by an average of about 180 bps annually since the recession. We believe that HD has some structural advantages including positioning in larger metro markets. However, some of LOW’s underperformance gap should be able to be closed over time. We believe expanding growth with high volume Pro customers could be an area of opportunity for LOW. The company generates 30% of its sales from Pro customers, below HD at ~40% and the broader home improvement market at 50%. Closing the Pro customer gap is an attractive opportunity for LOW given that Pro customers spend is about five times greater, Pro customers visit three stores times more often and generate an average ticket roughly 75% higher than the typical DIY customer. We assume ~4% LOW same store sales going forward and a sustained comp gap to HD in our model, but improvement relative to HD could drive some upside to our same store sales estimates.
In our assessment, the macro backdrop for the home improvement industry continues to be favorable. U.S. unemployment remains at historically low levels, interest rates are still relatively low, home prices are rising across the country, household formation is improving, the U.S. housing base is aging, U.S. tax reform is a benefit for many homeowners and residential fixed investment as a percentage of GDP is expanding. We believe these trends support same store sales growth for LOW at least in line with recent business trends. Acceleration in U.S. economic growth could be a tailwind but is not included in our estimates.
We think there could be several hundred basis points of operating margin upside over time as well as potential revenue upside with every 50 bps of operating margin driving ~6% EPS growth. However, we don’t think significant operational improvement (or significant same store sales growth acceleration) is necessary for LOW shares to work from here given the current valuation.
Based on ~4% 2018 same store sales, 30 bps of margin expansion, a 25% tax rate and share repurchases of ~$3.5 bil. (in line with recent trends), LOW should deliver 2018 EPS of over $6. LOW shares are trading at just ~17x this estimate, well below the market and HD. Of note, LOW is trading at a ~3.5 turn P/E multiple discount to HD, near its most significant discount to HD over the past 10 years. We don’t believe that that a business with a solid competitive position, favorable top line trends, strong FCF generation with consistent returns to shareholders and high visibility to into DD EPS growth over the next several years should trade a discount to the market. In addition, just 30 bps of operating margin expansion in 2019 with 4% same store sales suggests ~12% EPS growth and we think this should be achievable with potential upside from operational improvements.
We believe that management has a poor track record of achieving long-term margin targets, including the 11.2% 2019 operating margin target (9.8% in 2017E). If operational improvement does not accelerate, we believe pressure from activist involvement and new board members will build. We commend management for aggressively returning capital to shareholders over the past several years (rather than aggressively open new stores). Annual compensation is driven by adjusted EBIT (60%), adjusted sales (25%) and leadership effectiveness metrics (15%).
Chairman, President, and CEO, Robert Niblock joined LOW in 1993 and progressed through the finance organization serving in a variety of roles including Chief Financial Officer. He was named Chairman in 2004 and elected as CEO in January 2005. In 2011, he reassumed the title of president, after having served in that role from 2003 to 2006. Before Lowe’s, Niblock had a nine-year career with accounting firm Ernst & Young. Niblock was elected to the board of directors of ConocoPhillips in 2010 and serves on its audit and finance committee. Niblock holds a bachelor’s degree in accounting from the University of North Carolina at Charlotte.
Marshall Croom was promoted to chief financial officer in 2017. Croom joined Lowe’s in 1997 after an 11-year career with Ernst & Young. He was promoted to chief risk officer in 2009 and also has served as senior vice president of finance, treasurer, assistant treasurer and senior vice president of merchandising and store operations support. Croom has served on the board of directors of the Lowe’s Charitable and Educational Foundation since 2003. He received a bachelor’s degree in accounting from Appalachian State University.
Slowing economic growth or weakness in the housing market could be a headwind for LOW.
LOW is sensitive to macro-economic trends and same store sales would likely slow if economic growth stagnated.
LOW competes with a variety of strong retailers within the home improvement space and more broadly.
The project nature of home improvement, immediate need for home improvement items and shipping challenges for big and bulky products have led to limited e-commerce penetration of the home improvement category. However, the risk form e-commerce competitors and Amazon is something that we plan to watch closely and should not be dismissed.
Activist involvement and new board members leading to improving operational performance.