Near-Term Macro Headwinds Fail to Dampen Lowe's Leading Position in Home Improvement

Senior Analyst

Jaime M Katz

Associate Equity Analyst

Grace Na

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Lowe's is the second-largest home improvement retailer globally, set to capture around $87 billion in sales in fiscal 2023. With continued focus on retail fundamentals (merchandising excellence, operational efficiency, supply chain improvements, omnichannel shopping experience, and customer engagement), Lowe's has been able to better leverage costs while maintaining its low-cost position. The firm retains some of the cost savings and passes the rest on to its customers through everyday low prices. These competitive advantages support our wide economic moat rating.

Since Marvin Ellison took the helm in 2018, a full overhaul of Lowe's C-suite, board, and merchandising team has ensued. With an perpetual productivity plan now bearing fruit, incremental profit margin gains should continue. Thanks to the institutionalization of processes that were inefficient (including labor management, reset efforts, and inventory controls), and the divestiture of underperforming lines, the operating margin is now forecast to reach 13.3% in 2023, up from 9.1% in 2019. Additionally, demand in home improvements stemming from an aging housing market, along with still robust home prices supporting a positive wealth effect (despite higher interest rates), positions the firm for further cost leverage. With structural changes that have included the closure of the Orchard Supply brand and the sale of its Mexican and Canadian assets, capital expenditures (estimated at $2 billion in 2023) are likely to focus on efforts that should lead to working capital efficiency gains ahead.

Lowe's updated its long-term financial goals in December 2022, which target a long-term operating margin of 14.5% and returns on invested capital of 45%. With the firm expected to reach a 13.3% operating margin and 33% ROICs in 2023 (by our math), we think a progression toward both operating margin and ROICs goals is reasonable given structural changes that have occurred. Lowe's still has opportunities in underserved domestic markets (city, rural) and via wider professional penetration, bolstered by past tie-ups of Maintenance Supply Headquarters and Central Wholesalers (now Lowe's Pro Supply, or LPS).

Business Strategy & Outlook

We assign Lowe’s a wide economic moat. As the second-largest global home improvement retailer, we believe Lowe’s will continue to gain incremental share in the North American home improvement retail segment (which Lowe's has estimated at around a $1 trillion market), given its extensive distribution network and economies of scale as well as the brand awareness it has built with consumers and professionals. Dissecting the components of its competitive prowess, Lowe's has been able to capture economic rents from its brand, offering an important intangible asset. This is evidenced in consistent same-store sales growth, which has averaged 7.7% over the past five years (just 90 basis points below its peer Home Depot). Furthermore, continued improvements in merchandising strategy, the supply chain, and a focus on meeting pro consumer demands should support the brand, driving both additional same-store sales growth (3% on average beyond fiscal 2023) and operating margin expansion over the next decade (to 14.5%, near wide-moat Home Depot and up roughly 500 basis points relative to the average margin chalked up in the five years preceding the pandemic). 

Historically, the business was built on topnotch customer service, knowledge, and innovation, which has let the firm amass around 10% share of the highly fragmented $1 trillion home improvement market (with around $87 billion in 2023 expected sales). The reliability of information that consumers can draw upon from associates is unlikely to be replicated easily; Home Depot is the sole competitor that offers a similar level of knowledge, although Tractor Supply offers consistent service levels in its respective categories. In addition, Lowe’s has worked hard to ensure that the appropriate staff is on hand to solve any problems that its customers may encounter. Labor has been a core focus of the management team in recent years, with efforts to reallocate 60% of workers to service (40% prior to the change in 2018) rather than stocking hours as a means to increase productivity, which the prior management team had struggled to execute successfully. Leveraging technology has allowed Lowe's to reduce duplicative tasks, perform faster cross-functional training across departments, and strategically deploy its team to eliminate non-productive hours and extract productivity in its stores. The company’s strategies have helped it deliver average adjusted returns on invested capital, including goodwill, of 28% over the past five years, significantly higher than our 8% weighted average cost of capital estimate. In our view, ROICs should remain north of our cost of capital over the next 20 years (with ROICs ultimately reaching 41% in 2032), supporting our wide-moat rating. 

From the brand portfolio perspective, Lowe’s continues to find new ways to innovate through product launches, private-label and exclusive offerings, and services. Apart from approximately 30 trusted national brands (including Whirlpool, Samsung, GE, DeWalt, and more), Lowe’s houses 12 private-label brands (including allen+roth, Kobalt, Origin21, among others) that foster consumer loyalty, brand positioning, and margin gain opportunities. This is a particularly lucrative opportunity as we estimate private-label sales boast higher gross margins for Lowe’s that are a few hundred basis points above national brands (in line with other consumer retail industries). Lowe’s is pursuing a balanced growth approach, targeting national brand expansion for professional customers (as this cohort tends to rely on national brands for projects), while primarily extending private brands for do-it-yourself and do-it-for-me customers, who tend to be brand agnostic. We contend the familiarity and quality of the brands offered as well as the robust knowledge of the employee base keep the business in the forefront of consumers' minds as the premier choice for home improvement needs, and we believe the specialized nature of Lowe's offerings provides some protection from mass merchants and large online retailers (which could find it difficult to capture better pricing). Evidence of recent brand strength stems from outstanding average ticket growth of 7% on average over the past five fiscal years. 

Apart from its brand intangible asset, we think the company's size (operating more than 1,700 stores throughout the United States) has allowed for significant bargaining power with vendors when sourcing products, crafting advertisements, and arranging logistics (among other things). As a low cost one-stop shop for any home improvement need, Lowe's provides value and instills customer loyalty by passing along a portion of these savings in the form of everyday low pricing, EDLP. The ability to apply EDLP tactics is a result of negotiating clout due to scale as savings from bulk purchases allow for this pricing mechanism. And we think EDLP drives a positive flywheel effect, keeping customers more likely to return as they understand the value proposition offered by the company driving further scale gains. As evidence, Lowe’s recorded total transactions of 937 million in 2022, from 878 million in 2015 (up 6.7%) and average ticket has risen to $103.64 from $67.26 over the same time frame (up 54%). Additionally, we assess the pricing strategy as successful given the stability of gross margins, which have clocked in the 33% range since 2018—a level we believe should persist as any scale benefits gained are likely to pass directly to consumers given the EDLP strategy. 

Furthermore, we think the company can build on its cost advantage through increasing speed in the supply chain, leveraging payroll, lowering operating expenses by improving inventory management (turns), and consolidating the procurement of some goods and services across the corporate and store channels. These efforts should compress selling, general, and administrative, SG&A, spend to 17.1% of sales by the end of our forecast, from 18.4% in 2022. All in, these factors should lead to an operating margin of 14.5% in 2032 (up from 13% in 2022). 

With consumers increasingly favoring retailers with a robust omnichannel presence, manufacturers without such capabilities to offer a seamless multichannel shopping experience could struggle to attract customers. We surmise around half of e-commerce transactions (which represented a low-double-digit percentage of 2022 sales) at Lowe’s were ordered online and picked up in store, implying more than $10 billion worth of goods stemmed from an omnichannel transaction over the year. For perspective, online penetration was just around 5% in 2018, but we expect it can continue to expand to a low- to midteens rate in the near term as buy online pickup in store and other omnichannel efforts are adopted more widely by the professional consumer base. From our vantage point, this offering should prompt further market share gains, with our forecast calling for the firm to garner a 13%-14% market share over the next decade.

In our opinion, it would be difficult for another retailer to enter the market and threaten Lowe’s position, as smaller retailers would have a hard time building vendor relationships strong enough to undermine the company’s pricing prowess. While the threat of manufacturers creating their own retail network could jeopardize the availability of product in Lowe’s retail channel, we doubt such an endeavor would be successful in the longer term. In our opinion, manufacturers would be poised to move more product by maintaining a beneficial relationship with a wholesale network like Lowe’s, rather than on their own; additionally, we expect that consumers would still prefer to save time and effort by visiting one shop for all of a project’s needs, rather than purchasing products separately from each manufacturer.

Wide

Economic Moat

Lowe's

Orchard Supply Hardware is an American retailer of home improvement and gardening products. Headquartered in San Jose, California, Orchard Supply Hardware has dozens of locations throughout California, with expansions into Oregon and Florida.

Orchard Supply Hardware

Rona is a Canadian retailer of home improvement and construction products and services. Founded in 1939, the company operates a mixture of company-owned and franchised retailers under multiple banners, including Rona, its big box formats Rona Home & Garden and Réno-Dépôt, as well as smaller brands such as Rona Cashway, Marcil Centre de Rénovation, and Dick's Lumber. On February 3, 2016, U.S. retailer Lowe's announced that it would acquire Rona for $3.2 billion pending government approval. Lowe's plans to maintain the Rona name in mid-sized stores post-merger.

Rona

Lowe's Companies, Inc. engages in the retail sale of home improvement products. The firm offers products for maintenance, repair, remodeling, home decorating and property maintenance. It also provides home improvement products in the following categories: appliances, bathroom, building supply, electrical, flooring, hardware, paint, kitchen, plumbing, lighting & fans, outdoor living, windows and doors. The company was founded in 1946 and is headquartered in Mooresville, NC.

Earnings data Q1 2024

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Lowe's Companies, Inc. (NYSE:LOW ) Q3 2023 Earnings Conference Call November 21, 2023 9:00 AM ET Company Participants Kate Pearlman - VP, IR Marvin Ellison - Chairman & CEO William Boltz - EVP, Merchandising Joseph McFarland - EVP, Stores Brandon Sink - EVP & CFO Conference Call Participants Steven Forbes - Guggenheim Securities Peter Benedict - Baird Simeon Gutman - Morgan Stanley Christopher Horvers - J.P. Morgan Seth Sigman - Barclays Michael Lasser - UBS Brian Nagel - Oppenheimer Operator Good morning, everyone, and welcome to Lowe's Companies' Third Quarter 2023 Earnings Conference Call.

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