Lowe’s Companies, Inc. (NYSE:LOW)
Lowe’s is a leading U.S. home improvement retailer with an advantaged business model in a category that is positioned for continued growth. The home improvement category operates as an oligopoly, and Lowe’s significant market presence results in a scale advantage that allows it to be a convenient and low-cost provider of home improvement products across its more than 2,000 stores and fully integrated mobile and online platform. We believe that Lowe’s has strong future growth prospects as continued growth of the housing market should drive home improvement spending over the next several years. The increasing repair and maintenance requirements of the aging U.S. housing stock should contribute to sales growth over the longer term.
We have avoided investing in retail for nearly five years, but we believe the home improvement category is well insulated from the threat of online competitors, as a significant amount of the company’s products are either difficult and/or expensive to ship due to their size (e.g., lumber and building materials, live plants), regulatory constraints (e.g., paint), installation requirements (e.g., appliances) or are uneconomic to ship due to the combination of their low price point and heavy weight (e.g., nuts and bolts, concrete). Moreover, a physical store presence is a competitive advantage in the home improvement category as customers frequently consult with store employees as part of their purchase process. Customers often prefer to see the product before they purchase it, or they drive to the store because they have an immediate need for the product. As a result, the home improvement category has one of the lowest levels of e-commerce penetration in retail. While we expect overall e-commerce competition in the category to remain relatively limited in the future, Lowe’s online business is growing rapidly with a market share similar to its overall market share.
We previously invested in Lowe’s in 2011 due to our belief that the market did not appreciate the rapid earnings growth that would likely result from an improvement in the housing market following the financial crisis. Shortly after we initiated our investment in 2011, the stock price appreciated significantly, and we exited our position to allocate capital to other opportunities. While Lowe’s earnings and share price continued to increase thereafter, since that time, Lowe’s has materially underperformed its closest competitor, Home Depot.
Prior to the financial crisis, Lowe’s same-store sales growth outpaced Home Depot’s and had similar profit margins to its direct competitor. Since the crisis, Lowe’s has fallen far behind. Lowe’s has averaged 3% same-store sales growth compared with 5% at Home Depot, resulting in a sales gap which has widened to nearly 20%. Lowe’s profit margins are now nearly 500 basis points less than Home Depot.
In response to growing shareholder dissatisfaction earlier this year, Lowe’s appointed three new directors to its board, and announced a search for a new CEO. One of the new directors, David Batchelder, formerly a board member at Home Depot, was appointed to lead the CEO search committee. We initiated our investment shortly after Lowe’s announced the CEO search process, premised on our belief that there were several strong CEO candidates available, including a number with experience in the Home Depot transformation. At the end of May, Lowe’s announced that Marvin Ellison, a former senior executive at Home Depot, would become CEO. Marvin was the leading candidate on our list of potential CEO recruits as we believe he has the relevant experience leadership qualities, and skill set to close the operational gap. Marvin started at Lowe’s in July and has already redesigned the organizational structure to more closely resemble Home Depot’s, and has hired several former senior Home Depot executives for key roles. We expect Marvin will announce a detailed plan to improve performance, likely at the company’s Analyst Day in December.
After appreciating 15% from our cost, Lowe’s currently trades at ~18 times our estimate of this year’s earnings, which do not yet reflect any impact from the management change. Home Depot trades at more than 21 times analyst estimates of this year’s earnings, as the market has rewarded the company’s historically strong execution with a premium multiple. We believe there is large upside potential to Lowe’s if it can narrow the performance gap with Home Depot as it is likely that closing the performance gap will cause the market to reward the company with an increased multiple on higher earnings that reflect the company’s underlying business quality and growth potential.
We believe that the Lowe’s situation is reminiscent of our investment in Canadian Pacific. At the time of our investment in CP, it had underperformed Canadian National for more than a decade, and management claimed that structural differences and weather explained the company’s underperformance. We disagreed, believing that a different management approach would substantially improve the company’s performance. We were able to recruit Hunter Harrison, the former CEO of CN, to CP, who in a few short years turned CP into one of the best performing railroads in North America, rivalling CN. Mr. Ellison is off to a fast start assembling a new senior executive team to organize the Lowe’s turnaround. We look forward to watching him perform.
From Bill Ackman (Trades, Portfolio)'s second quarter 2018 Pershing Square shareholder letter.
