2023-08-24 16:51:22 ET
Summary
- Lowe's beat revenue and earnings estimates, sending shares up almost 4%.
- Same-store sales declined, but showed improvement compared to the previous quarter.
- Gross margin improved, and profit margin expanded despite pressure on cost structure.
Investors likely breathed a sigh of relief after Lowe's (LOW) beat Zacks’ consensus estimates for revenue and earnings and affirmed its guidance for fiscal year 2023 (F2023). This sent shares soaring almost 4%. The results still represented declines in revenue, same store sales (SSS) and profitability as LOW’s feels the pain of inflation and higher interest rates. While this quarter’s results appear to reflect solid execution amid tempered expectations, favorable trends are emerging that a well-run company can capitalize on.
Approaching Trough in SSS
LOW’s SSS declined 1.6%, and the full year guidance suggests the third straight quarterly decline isn’t the last. However, there is still reason for optimism. The decrease in SSS was milder than it was in 1Q23, and LOW did a bit better than its primary competitor, Home Depot (HD). Additionally, Pro, LOW’s segment that serves contractors and construction professions, reported sales growth, as did its Online segment.
The mild decline in SSS for 2Q23 could be evidence that LOW’s four-pronged strategy is working. The strategy clearly has potential. It emphasizes four areas that are integral to generating revenue. They are also distinct; therefore, there is less potential for confusion among employees responsible for execution.
- Drive Pro Penetration.
- Accelerate Online Business.
- Expand Installation Services.
- Drive Localization.
Sales for Pro and Online were favorable. Although LOW didn’t provide any sales statistics on localization, management talked about several times during the earnings call. Below graph shows that LOW’s recent SSS compares favorably with HD.
Source: SEC.gov
Gross Margin Improvement
LOW reported strong gross margin improvement in 2Q23 of 42 basis points (bps) relative to 2Q22. During the call, management attributed the improvement to these things:
- Perpetual Productivity Improvement ('PPI') strategy
- Favorable product mix
- Transportation cost relief
- Price increases taken in 2022
The key is whether the above items become drivers of permanent improvement in gross margin, or simply explanations for a statistical aberration. Over the past five years, LOW reported annual gross margins within a tight range of 32.12% (2019) to 33.30% (2021). The CFO believes the PPI will accelerate in 2H23. It’s also reasonable to assume gross margin will benefit from the upward trend in pricing and deceleration of inflation. Therefore, LOW’s gross margin should have favorable tailwinds for at least the remainder of the fiscal year.
Profit Margin Expansion Despite Pressure on Cost Structure
LOW’s profit margin increased as the expansion in gross margin more than offset the impact of lower revenue on sales, general and administrative (SG&A) expenses and depreciation and amortization. SG&A also likely increased as a percentage of sales due to increase in employee compensation. LOW’s press release mentioned it paid $100 million in discretionary bonuses and profit sharing during 2Q23, compared with $55 million in 2Q22.
Likely Rebound in Home Purchases beginning in 2024
The Mortgage Bankers Association’s (MBA) forecast for mortgages for home purchases provides optimism for a turnaround in LOW’s revenue. The correlation between annual purchase mortgage transaction volume from 1990-2022 and major appliance purchases for the same period is positive 0.74. This correlation likely stems from two sources.
- Some sellers purchase new appliances shortly before putting their home on their market. If the seller doesn’t update the appliances, the buyer may elect to do it after closing.
- The chart illustrates that mortgages for home purchases tend to increase when interest rates are declining, employment is strong or improving and home prices are rising. These conditions are also ideal for major home renovations, which are often financed.
Sources: Freddie Mac and MBA
The forward yield curve for one year Treasuries shows the market agrees with the MBA’s view that interest rates will begin declining in 2024. That would be good news for LOW as long as the catalyst for the decline isn’t a recession. In addition to reinvigorating home purchases, lower interest rates would also reduce the cost of credit card debt and home equity loans, both of which are sometimes used to fund large appliances or home renovations.
Source: U.S. Department of Treasury
Even in the best case, interest rates will probably be neutral to demand for home renovations and major appliance purchases, unlike two years ago when historically low rates helped drive demand for LOW. The yield on one-year Treasuries was 0.1% in August 2020. The low rates coupled with pandemic restrictions on travel and dining explain why LOW’s SSS jumped 26% in 2020.
Fortunately, for LOW, a moderate decline in interest rates is only part of the favorable medium-term outlook. Pent-up demand for housing is the other. The National Association of Realtors recently stated that the U.S. is in the midst of the largest housing shortage we’ve ever experienced. The chart below shows that homebuilders dramatically reduced their production after suffering significant losses in 2008 when home prices cratered. They have been gradually working back toward the pace necessary to replenish destroyed homes and satisfy demand created by new household formations. The steady increase in housing starts will provide a source of demand for LOW’s products.
Source: U.S. Census Bureau
Wage Growth vs Inflation
Stubborn high inflation has been a bane on LOW’s top line and likely explains some of the 194 bp increase in SG&A in 2022, but workers responded to the persistent increase in their cost of living by requesting (and getting) larger paychecks. Below chart illustrates two key points.
- The gap between inflation and wage growth has almost been eliminated.
- Wage growth outpaces inflation in most years. When this phenomenon resumes, households will have more discretionary spending power, which should translate into additional revenue for LOW.
Sources: Bureau of Labor Statistics
Valuation and Conclusion
Although LOW’s shares are not as cheap as they were before it announced 2Q23 results, they’re still a good value. LOW is trading at 16x analysts’ average estimate for F2023 earnings. This ratio is less than HD's P/E multiple of 20 and at the low end of its historical trading range. Investors should also consider the below factors that could lead to significant earnings growth.
- Results for 2Q23 demonstrate management is executing a sound strategy.
- Experts predict interest rates will decline and home purchases will rebound, which will trigger demand for LOW’s products.
- Discretionary spending for large appliances and home renovations will increase as the Fed tames inflation and wages continue to grow.
Sources: Yahoo Finance and CFRA
For further details see:
Lowe's: Potential Trough In Revenue Could Be A Lucrative Opportunity