What is zone recovery at lowes?

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Many brick and mortar retailers have suffered significantly during the pandemic attributed to lockdown conditions, resulting in some permanently shuttering. However, home improvement retailers like Lowe's (NYSE:LOW) are actually showing strength when other retailers are struggling to recover, primarily due to the housing market. There is also a whole host of reasons to believe why LOW will continue to recover well into a post-pandemic world, allowing it to be more competitive. To further augment its qualitative excellence, LOW is also undervalued with significant dividend growth potential, making it a prime candidate for investment.

The pandemic has been an area of weakness for many retail chains due to lockdowns and the general inability to get out of their own homes to purchase items. This problem is worsened for the consumer discretionary sector, which includes home improvement retailers like Lowe’s, because the non-essential nature of products means that when households tighten their belts to save for daily necessities, they have comparatively lesser disposable income to afford new lawnmowers, new décor and new building projects. However, as the economy recovers from the coronavirus and employment picks up, Lowe’s is able to leverage effectively on it, providing added strength moving forward.

Consumers have been stuck in their homes for a long period of time without the opportunity to deal with deteriorating housing conditions, suggesting that there is some sort of backlogged demand for home improvement and maintenance works. As consumers feel more comfortable exiting their homes as more of the population gets vaccinated for the pandemic, this backlog is expected to translate to increased sale growth in the next few quarters, until the economy fully returns to normalcy.

Lowe’s current Q3 performance is a good look for them, with comparable sales in the US home improvement business increasing 30.4% in that quarter, implying that consumers are gradually returning to purchase home improvement items, in order to clear this pent-up demand.

More importantly, LOW is expected to show stellar growth in the near future because of the strength of the housing market.

Unsurprising to many, home sales have also increased (both on a year-on-year basis and by quarter) together with economic recovery, as consumers seek to leverage on historically low mortgage rates. According to Goldman Sachs in the infographic below, the Redfin Homebuyer Demand index has increased close to 40% year on year together with an increase of 28% for the associated household cleaning compounds in October of 2020, showing that this sector is experiencing accelerated recovery as compared to other retail sectors like diners that are still struggling in negative growth territory.

(Recovery at a glance. Source: Goldman Sachs)

Currently, existing home sales are at 5.64 million, at their highest level since 2006, with unsold inventory remaining at an all-time low. Given how well pandemic re-opening conditions have benefited the housing market, a similar level of benefit is expected to accrue to retailers like LOW as an increase in demand for homes will lead to an increase in derived demand for home improvement products.

Moving forward into 2021, we can also expect similar improvements in sales as the economy fully recovers from the coronavirus situation, catalyzed by additional fiscal stimulus providing the disposable income needed to carry out the much-delayed home improvement works, together with GDP growth returning to normalcy. The momentum in the housing sector has also fallen in line with projections of increased sales in the next quarter issued by LOW, indicating an optimistic outlook for this year as well.

There is no doubt that home improvement retailers will be able to benefit from economic recovery and the easing of pandemic related shelter-at-home conditions. While there are many other retailers in the market, I will be focusing on comparing between the two behemoths in the US home improvement space – namely The Home Depot (HD) with 34.3% market share and LOW at 24.8%.

(Market Share in the Home Improvement retail space. Source: America Retail)

Goldman Sachs had also noted in October that home builder firm NVR (NVR) reported strong Q3 results with orders up 40% year-on-year, led by strength in the Northeast and Southeast America segments, growing at 68% and 56% respectively. To clarify, NVR classifies New Jersey and Eastern Pennsylvania as the Northeast region, and North Carolina, South Carolina, Florida and Tennessee as Southeast.

Because these areas are typically more mature and reflect the more affordable regions in the country, breaking out of the single-digit growth patterns for these geographical regions is indicative of buyers actively seeking out more suburban locations and seek to leverage on historically low mortgage rates. Over here, Lowe’s is poised to take advantage of this trend because their stores are strategically concentrated in the abovementioned suburban areas.

(States comparing the relative frequency of LOW vs HD stores. Source: Author estimates)

In the diagram above, the blue states represent states that have a greater proportion of LOW stores than HD, and orange states represent the opposite. We can see that with the exception of Florida and New Jersey, all of the states that showed tremendous growth in homebuilding orders from NVR in the Southeast and Northeast region are locations with more LOW stores than HD stores. Whether this is purely by chance or whether it was a strategic option to target the relatively more rural/suburban populations, the fact remains that with a greater proportion of LOW stores, and the working assumption that indifferent consumers will approach the closest home improvement store, there is a greater probability of purchasing from LOW instead of HD, leading to greater revenue gains in the next few quarters.

While both LOW and HD are vying for the same consumers, and are close competitors in a duopolistic US home improvement market space, the key target market is a distinctive factor between the two retailers. Qualitatively speaking, the industrial-aesthetic interior setup of HD appears to appeal to home improvement professionals, with tall shelves that are sometimes only accessible via forklift. This contrasts with LOW’s elaborate floor and décor display in their retail chains, and seems more geared towards the average retail consumer trying to spice up their homes. This is also evidenced by analyst estimates of professional contracts accounting for 20-25% of sales at LOW and 45% at HD.

(Comparison of HD and LOW store presentations. Source: HD and LOW's 2020 Investor Update)

However, because HD’s target demographic is more geared towards the professional homebuilder sourcing for materials and equipment, they are expected to recover more slowly from the pandemic compared to LOW.

However, the forecasted persistence of pandemic conditions in addition to the time lag between stimulus and true economic recovery means that consumers can be expected to hold back on big-ticket purchases like home overhauls and big construction projects, and instead focus on some minor DIY improvement works which can allow them to hedge against any further economic contraction better. As a result, because HD’s target demographic is more geared towards professional homebuilders that are sourced for large projects, they are expected to recover more slowly as compared to LOW. While LOW had comparable sale increases of 30% in Q3, HD’s equivalent metric was only at 24%, affirming the thesis above.

For the medium term, and especially in 2021, LOW looks better positioned to leverage on recovery purely based on the rate that consumers return to the retail stores, which could provide them with a necessary head start to improve and develop other aspects of their business which can make them more competitive in the long run.

2018 signaled the end of an era with long-serving CEO Robert Niblock handing the reigns over to new CEO Marvin Ellison. This change was followed by a strategic refocus on revitalizing its core business, and addressing the shortcomings that they had in the past with regards to two areas in particular – digital innovation as well as targeting pro consumers.

Where LOW’s online presence was almost non-existent a few years back, they have taken more steps in modernizing its retail technology moving forward.

Their foray into technology has been beneficial for LOW. In Q3 of 2020, LOW recorded a 400 basis-point improvement in customer service calls from 2018, suggesting the possibility that consumers that were once deterred away from LOW due to poor online engagement are now willing to give it another shot.

(Improved Customer Service Scores. Source: 2020 Investor Update)

In addition, LOW’s online segment growth has consistently outpaced that of HD for the previous three quarters of this year, which could be attributed to their greater recovery potential, but is nonetheless supported by the newfound robustness of their online platform. In terms of efficiency measures, they have also successfully increased their operating margins from 5.6% in the period ended 1 Jan 2019, to 8.8% for the same period ended 1 Jan 2020. For the previous three quarters, operating margins have also beat those from a similar period one year before.

Another area of weakness that LOW has identified is in their lack of focus on pro customers, which represents a large buyer class. While HD has been effectively targeting them for many years, LOW has not, but it is this area that further represents additional revenue potential if they are able to successfully capture back some of the pro market share. Similar to their digitization program, LOW has also started on many new initiatives to incentivize professional customers to return to the store:

This focus on pros sets a good precedent moving forward. As pandemic conditions end and pros receive more business from homeowners, positioning their products and services in line with the pro’s expectations will allow them to better leverage on this demographic in the future, and can serve to take back some of the market share from HD.

Based on a blended valuation method from comparable ratios and my own DCF analysis, the fair value range of LOW can be estimated to be in the range of around $171-190, but I have skewed the valuation slightly upwards placing more weight on the DCF implied target price, to be in the range of $185-195. This new range also falls in line with the average street target price of $190.10, representing an upside potential of around 8-14%. The below lists some of the assumptions guiding the valuation.(Football Field Valuation. Source: Author Estimates)

(Comparable Firms. Source: Seeking Alpha)

I have compared LOW here to its major competitor HD in the consumer discretionary home improvement retail space, as well as Tractor Supply (TSCO) since it is a competitor in the same space as well, albeit with a much smaller market share. Over here, I have included Walmart in the valuation as a benchmark to the overall retail space, which will benefit similarly to the recovery from the coronavirus. There are other competitors that exist in the home improvement retail space, but I have chosen to exclude them because their negative earnings or inflated metrics stray far from the trading ranges of these similar firms and will inevitably distort the valuation.

Below are some of the assumptions used in building the DCF analysis. Note that FY21 refers to the year ended January 2021, and represents the earning season of 2020.

(DCF and Terminal Growth Assumptions. Source: Author)

Based on a solid long history of dividend issue and growth, LOW is also a prime investment candidate for investors looking for stable returns from dividends. In the past 10 years, dividends grew at an average of 19.04% CAGR, with that number being 17.27% over the period of 5 years. At the current dividend yield of 1.38%, this number is expected to further increase to 2.18% in 2024 based on estimates from DividendStocks.cash.

(Dividend Yield Expectations. Source: DividendStocks.cash)

As usual, I will present the main counterarguments for an investment in LOW to provide balanced viewpoints when assessing its potential as a candidate for investment.

Limitations of their omnichannel commerce

While LOW definitely has omnichannel capabilities, online purchase and pickup is only applicable for certain products and services. Some of the more common household appliances that require installation such as dishwashers, washers and dryers require additional appointments at a physical Lowe’s outlet in order to finalize the purchase. Granted, these appliances are not often replaced, but the fact they require a physical visit to the store compounds the hassle the buyer already faces with a faulty product in their home. Moreover, the same types of appliance delivery at HD does not require any prior appointment and can be done from the comfort of their homes.

Underpenetrated Online Sales

As of Q3 2020, online sales from lowes.com was still underpenetrated with it only representing 7% of overall sales, and is comparatively lackluster compared to the 13% online penetration of HD. While LOW has definitely invested significantly in their online channels, there may be a chance that they are simply playing a game of catch-up with HD. If HD innovates their online and omnichannel capabilities at the same rate as LOW, there is a high likelihood that revenue gains from venturing online may be limited moving forward, and will not contribute much to more market share going the way of LOW.

Even so, it is still necessary for them to invest in digital solutions for both pros and consumers in order to avoid losing market share in the future. This point is especially salient during pandemic conditions, as more consumers opt for digital and contactless transactions.

Macro Weaknesses

While the current outlook for the housing market remains strong, a full recovery from the pandemic may see trends reverse in direction, which may constitute headwinds for LOW instead of tailwinds. For one, with the median price of existing homes near its peak, we could see increases in mortgage rates that serve to cool down the housing market, causing a fall in demand for households and therefore derived demand for household products.

As economic conditions improve, there may also be a reversal of the secular shift towards more affordable suburban locations where LOW is more prevalent, causing revenue gains to be stifled. I assess the probability of this happening to be relatively low, however, given how consumers tend to be more cautious and conservative with their capital for a period after economic weakness.

(Median Housing Prices vs Inventory. Source: Citi via Primary Dealer)

There is also an added competitive risk from full economic recovery, where we could see HD outperform LOW due to returning strength from the pro segment. This can be attributed to more consumers having the disposable income needed to pursue larger and more elaborate construction projects which may require the service of the pro customers. The overall effect of this will depend on how effective LOW is at targeting the pro consumer, but as it stands, LOW still derives a large proportion of its revenues from DIY consumers, with DIY comps outpacing pro comps in the third quarter of 2020.

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