Lowe's: Will This Turnaround Turn?

Lowe's has 90% of Home Depot's store count but only 40% of Home Depot's market value. This discrepancy isn't due to store size or capital structure. Lowe's has 87% of Home Depot's the selling square footage but only 41% of Home Depot's enterprise value. What gives? Why is a Lowe's store worth 40 cents on the dollar of a Home Depot store?

The short answer: Lowe's is less efficient than Home Depot. Lowe's sales per square foot are $347, 75% of Home Depot's $455. Gross margins are 230 basis points worse while SG&A is 160 basis points higher. As a result, Lowe's EBIT margins are only 58% of Home Depot's (7.8% vs 13.3%).

Retail is tough because you have to earn the customer every day. Technology has only increased expectations and price transparency. Retail is also tough because you can walk into a competitor's store and copy what's working.

That's why there may be opportunity in Lowe's today. Lowe's need only copy Home Depot's playbook to close much of the gap. D.E. Shaw brought in new management to do this. Marvin Ellison, Home Depot's former VP of US stores, is now at the helm. Lowe's new managers have already done everything Lowe's needs at their prior jobs. They're not reinventing the wheel, just re-executing.

Buffett councils that turnarounds rarely turn, and he's right. But certain turnarounds do interest us. We like companies that are:

• profitable to begin with,

• have a creditable path to improvement, and

• a price which isn't anticipating any improvement.

Lowe's checks all these boxes.  

Culture Drives Long-term Returns

Home Depot is fanatical about serving its customers. They empower associates and store managers to do what it takes to delight customers. Home Depot even refers to their corporate head quarters are a "store support center." This led Home Depot invested in IT and supply chain ahead of demand. Now its omni-channel capabilities are the envy of all retailers in the pandemic.

Lowe's did the opposite. Rather than focusing on its core US stores, it diversified into Mexico and Canada. They also bought Orchard Supply Co, a smaller format retailer and dropped the national brands Pros rely on to juice gross margins. This cost them their lead over Home Depot in Pro. They tried to save their way to prosperity by foregoing investments in IT and supply chain. Lowe's point-of-sale devices are still terminals with green and black screens.

The good news is that Lowe's problems are all under its control. The company is actually doing well considering these issues. Traffic and same store sales were still rising under prior management. Under Ellison same store sales (SSS) have risen faster than Home Depot's.

Lowe's has a remarkable long-term record. It's raised its dividend for 57 straight years, which puts it in rare company. Its business model survived the stagflation of the 1970s and the housing bust of 2008.  And it is thriving (SSS +12% y/o/y in Q1) in the current pandemic.

Opportunities For Improvement

Lowe's has no shortage of opportunities for improvement.

Sales per square foot is a key metric in retailing that measures how well a store can leverage its fixed costs. But Lowe's  never tracked it on a granular level, so it was never maximized. What gets measured gets managed.

Ellison aims to reach $370 sales/sqft, 7% greater than 2019's $347. That would still trail Home Depot's $455 by 21%. Some of the discrepancy is structural. Home Depots tend to be more urban, with 79,000 homes within a 5-mile radius versus Lowe's more suburban 51,000.

To improve, Lowe's is going back to basics. That begins with having merchandise in stock. Customers, especially pros, who see out-of-stock SKUs on a Monday won't return on a Thursday. Time is money, and they need a one-stop solution. Lowe's failure to capitalize on its traffic is its biggest failure and greatest opportunity.

The root of Lowe's out-of-stock problem is how they managed inventory. They managed inventory by dollar volume rather than turnover. High velocity SKUs were perpetually out of stock while slow-moving items tied up capital. Compounding the problem, store managers weren't authorized to re-order out-of-stock items.

Lowe's centralized its merchandizing to headquarters. As a result, inventory wasn't customized to each store's market. For example, stores carried deck stain in areas where the houses didn't have decks. Ellison is reversing this, putting merchandising authority closer to the front lines.

New technology will help make store employees more productive and better informed. New point-of-sale devices will speed up checkout and make training new hires easier. Handheld computers will give employees walking the isles up-to-date info on inventory. Digital dashboards will replace reams of hard copy reports, freeing store managers to focus on the KPIs that really matter.

Outside of the store, Lowe's is upgrading its IT systems to support omni-channel retailing. In March, Lowe's was able to roll out curb-side pick-up in 3 days because it had migrated its system to Google's cloud.

Lowe's also has a large opportunity to improve its supply chain. Lowe's continues to lead Home Depot in appliances, which are each's largest sales category. Appliances, however, are tricky. They're big and bulky and are often bought in store but delivered to a customer's home.

Formerly when a customer bought an appliance, it was shipped to the store that sold it. Then it was loaded onto another truck for last-mile delivery. Going forward, appliances will be delivered directly to customers from a distribution center. This will free up store space, save store labor, and reduce the potential for product damage.

Labor is Lowe's biggest expense behind cost of goods. Previous management threw labor at problems instead of solving the root problem with better technology and processes. As a result, only about 40% of associate's hours are spent with customers. Ellison is changing this to 60%.

Ellison's plan is to copy Home Depot's culture of customer service and decentralized operations. The 80/20 principal seems applicable. Lowe's looks poised to achieve 80% of Home Depot's results, but the last 20% will require cultural buy-in from employees at every level. This is extraordinarily difficult to achieve and doesn't happen over night.

Lowes insists that it isn't going toe-to-toe with Home Depot. A zero-sum game like that would probably be a losing proposition for them. The US home improvement market is estimated at $900 billion. Lowe's and Home Depot each only control about 10%. Lowe's aims to win a larger piece of the 80% the duopoly doesn't already control.

To do this, Lowe's aims to leverage the stores it already has. New store growth is expected to be modest over the coming years. One of the keys will be attracting more pros. Pros represent 50% of the home improvement market and produce dramatically higher tickets than DIY customers.

Pros are brand loyal and require one-stop shopping with quick turnarounds. To attract pros, Lowe's built them their own website, LowesForPros.com. They are increasing staffing at each store's Pro Desk and helping to load bulky merchandise. Improving in-stocks on national brand merchandise will be a big help in regaining pro's trust.

Investment Opportunity

Ellison is targeting $370 sales/sqft, a 12% EBIT margin, and 35% ROIC over the coming years. This would tighten the gap with Home Depot 80-90% of the way, but not entirely. Ellison feels that these aren't the business's ceiling, just realistic intermediate term targets.

If Lowe's hits these targets, normalized net income should rise about 50% from 2019's levels. If this takes three years, Lowe's earnings could compound at 15% annually before factoring in any same store sales (SSS) growth. SSS grew an unprecedented 12% last quarter. This is an anomaly of the pandemic, and unlikely to reoccur. 2-4% SSS growth is more likely, and the pace Lowe's tracked at before the pandemic.

If the market believed Lowe's was going to close the gap with Home Depot, Lowe's would trade at a premium valuation to the Home Depot. It actually trades at a slight discount. Lowe's trades at 25x PE versus Home Depot's 27x and 19x EV/EBIT versus the Home Depot's 20x.

While Lowe's relative valuation is attractive, its absolute valuation is rich. The stock bottomed out at around 10x earnings in March, a 50% year-to-date loss. As it became apparent that Lowe's was going to be one of the pandemic's big winners, shares more than doubled and are now up 22% year-to-date. Most of this year-to-date gain has been multiple expansion.

If Lowe's hits its targets in three years, it will be able to return about 6% of today's market cap as dividends and buybacks. SSS growth of 2-4% would bring the stock's total return to about 8-10% annually. This is good but not great. As Buffett says, you pay a high price for certainty on Wall Street. The market's certainty that Lowe's is a pandemic winner has priced me out of the market for now.

Lowe's will be one to watch, however. The home improvement industry benefits from a tailwind of rising home prices. When homes appreciate, owners tend to think of improvements as investments. When homes depreciate, they tend think of improvements as expenses. The Fed's commitment to ultra-low interest rates for the foreseeable future should keep the housing market humming and provide a tailwind.

Lowe's also benefits as part of a duopoly with Home Depot. The 80% of the US home improvement market outside of Lowes and Home Depot is highly fragmented. The duopoly has a high relative share, which means they benefit from scale economies smaller players can't easily replicate. So long as Home Depot and Lowe's continue to share their scale benefits with customers via lower prices, they should be able to undercut competitors. At the same time, Lowe's 10% share means there's a large addressable market to grow without stepping on Home Depot's toes. 

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