Lowe's (NYSE:LOW) might play second fiddle to Home Depot (NYSE:HD), but a new CEO and strategy could close the gap between them.

In this episode of Industry Focus: Consumer Goods, host Vincent Shen and Motley Fool contributor Dan Kline explore the turnaround story for Lowe's and what investors should know about the company's future.

Also, the cast covers the latest developments in the 21st Century Fox (NASDAQ:FOX) (NASDAQ:FOXA) buyout as Comcast (NASDAQ:CMCSA) prepares a serious counteroffer to Walt Disney (NYSE:DIS).

A full transcript follows the video.

This video was recorded on May 29, 2018.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen, and we're pre-recording again for this episode to go live on Tuesday, May 29th. Joining me in the Fool HQ studio here in Old Town Alexandria is Dan Kline. Hey, Dan! Thanks for coming in!

Dan Kline: Hey, Vince! Thanks for having me!

Shen: Yeah! Back really soon in the D.C. area. What's got you in town this time?

Kline: Just came to see you guys, is probably the best way to put it.

Shen: Okay. So no family stuff?

Kline: A little bit, might see some family. But if I don't see them and then they see this show, then I'm in all sorts of trouble. [laughs]

Shen: Fair enough. Your timing is excellent, because there have been two stories this week that I wanted to talk to you about for this show. The first is the emergence of Comcast with a serious counteroffer for the 21st Century Fox assets that Walt Disney originally claimed in the big deal that they announced back in December.

Kline: Well, it's like a promise ring before an engagement. They haven't made an offer. They've just said, "Hey, we're going to make an offer, and it's contingent on the AT&T-Time Warner merger 

and how the tea leaves read on that one."

Shen: We'll get into all those details. Before we break into the latest developments, I want to take a minute to just recap the deal between Fox and Disney, because there's some important context there as we compare that agreement to what Comcast might ultimately offer. Late last year, for weeks, there were reports that multiple companies, including Disney, Comcast, VerizonSony, I think a few others, they were expressing interest, at the time, in acquiring this basket of assets from Fox. 

Ultimately, Disney was the one to announce a deal. The key highlights from that agreement: the deal would see Disney take over Fox's film and TV studios, including a large portfolio of franchises, TV series, sports content, and other properties that Disney could use to bolster their two streaming services that they're going to be rolling out to consumers. On top of that, there are some cable networks like FX, National Geographic, that's also included, plus international TV assets, so STAR in India and Sky in Europe. Those would give Disney a much bigger international presence and help diversify the business. 

Then, the Fox broadcast network -- Fox News, Fox Business, and a few other networks -- those would not be part of the deal. They would get spun off into a separate company. 

In exchange for the assets that Fox shareholders would be giving up, they'd get 0.2745 shares of Disney for each share of Fox that they hold. At the time of the announcement, that amounted to a value of about $29.54 per share for Fox investors in a $52 billion transaction.

Then, something else to keep in mind is that Disney CEO Bob Iger would be delaying his retirement for a fourth time to 2021 so he can head up the planned integration of the two businesses.

Kline: His retirements are like Elton John. [laughs] You really shouldn't believe it when he says it's going to happen. I think the one thing you didn't mention that's pretty important as part of this is the movie franchises. Yes, there's theme park applications, there's television shows. But for Disney, one, there's returning rights to some of the Marvel properties that it already owns, which when you see the amount of money Avengers made, which is the biggest movie ever, following Black Panther, which was the biggest movie ever until Avengers came along ... so you're going to see Deadpool and the X-Men and a lot of things that make more sense at Disney than they might someplace else.

Shen: Yeah, big opportunity there. Also, something else I didn't mention is Hulu, consortium of these different entertainment companies, with the Fox stake, combined with what Disney already holds, will have a controlling stake in Hulu. That's one more streaming service for them to leverage as they move more into that space.

Kline: It could actually change Disney's overall strategy to having its services, then, with the live TV component of Hulu, theoretically, this gives Disney an end-around if the cable industry falls apart that it would control. Which is an antitrust issue, as well.

Shen: This is a huge deal, it would give Disney an even tighter grip over the more traditional Hollywood and entertainment worlds. There are two things investors can expect to accompany this deal. One, lots of regulatory scrutiny; and two is the potential for competing offers. 

On the regulatory side, the business world -- you mentioned this earlier -- is right now awaiting the final word on the AT&T Time Warner merger. The judge on that case should be ready to announce his decision by mid-June. What that decision ultimately is should give us some clues as to what we can expect for any deal, regardless of who the buyer is, for the Fox assets.

Kline: It's also worth noting that Disney has to pay Fox $2.5 billion if the deal breaks apart for regulatory reasons.

Shen: Yes. The competing offer is very relevant right now just because there's reports that Comcast is in the final stages of preparing this deal to bring to the table.

Kline: They've lined up the cash, is the important part.

Shen: And various sources right now are claiming that the Comcast deal will be an all-cash transaction, so, different than the stock deal that Disney offered. And it will top out, in terms of value, over $60 billion. That will definitely raise the stakes. 

Keep in mind that this is not the first offer that Comcast has made to Fox. Before Disney and Fox announced their deal, Comcast made their own offer, but leadership at Fox showed little interest because of a few concerns. One would be that Comcast would have a tough time getting the deal approved. Then, apparently, they also offered a relatively small breakup fee. Disney put up $2.5 billion. I think Comcast was much lower than that.

Kline: $1.5 billion if it's for any reason other than regulatory.

Shen: Yes, for either company to walk away from the deal. The breakup fee is usually paid by the acquiring company if the deal fails to go through, especially for regulatory reasons. So, Disney is on the hook for $2.5 billion if, for example, regulators do end up blocking a deal between Disney and Fox. 

Looking ahead, until we have the official details behind this Comcast offer, there are a few things that we think listeners should keep in mind. First is that Fox shareholders should be pretty happy, because in their ideal world, Comcast will toss up a generous $60 billion-plus offer that forces Disney to bump up their own deal, and then maybe some type of small bidding war ensues. We'll see what happens there. Then, second, regardless of who Fox decides to go with, there will definitely be those antitrust challenges. Both Comcast and Disney have businesses that overlap pretty significantly with Fox, so there's no solely horizontal argument to be made here. 

Then, the last thing, the eagerness, I think, with which both of these companies are going after the Fox assets should definitely signal to investors how important and how much of a priority it is for these traditional entertainment companies to essentially sure up their businesses as they compete with the upstart tech companies and platforms like Netflix. It's gradual, but there's definitely a shift in how people are consuming their entertainment. Comcast and Disney, I think they very much want to be at the forefront of the developments there and have all the tools that they can at their disposal to address the challenge.

Kline: I think it's also possible that, if there does appear to be regulatory resistance to this, Fox gets split up, that Disney buys some of it, Comcast buys some of it. Maybe, as I mentioned before, the controlling stake in Hulu is something that regulators are going to be very concerned about. Maybe these assets are worth more as pieces because it's going to be easier to get it through when two or even three companies are sharing them.

Shen: We'll check in again once we have the Justice Department decision from the AT&T Time Warner deal. That's something that we need to follow up on anyway. And also, once we have the official deal details from Comcast. A really interesting developing story there, big implications for that industry.

Now, let's transition to our second and main topic for today. Two days ago, Lowe's, the home improvement retailer, announced that they poached Marvin Ellison to become the president and CEO starting in June or July. Ellison is currently the CEO at J.C. Penney. Before then, he did spend 12 years working with Home Depot as the head of their U.S. stores. Before that, he had a long tenure with Target. So this is definitely someone with a lot of retail chops and not only that, he specifically has experience in the home improvement sector. Ellison's coming on as the current Lowe's CEO, Robert Niblock, plans to retire after a 25-year stint with the company. 

With all that in mind, I thought this would be a good opportunity for us to talk about Lowe's, given how popular its rival, Home Depot, is in the Motley Fool community and how well that stock has performed for investors -- up 135% in just the past five years, almost 700% going back a decade. But Lowe's stock has not been a slouch itself. For those same five and 10-year periods, shares are up 125% and 350% respectively. It's only if you look at the more recent short-term timeframe that performance for Lowe's has been lagging Home Depot and the broad market.

Given all the problems that we often talk about with brick-and-mortar retailers, what they're struggling with -- online players, weak foot traffic, price competition -- the home improvement sector has been very strong and resilient in the face of that.

Kline: What jumped out to me in reading their recent earnings report is, only 5% of their business is digital. But the Ellison hiring suggests that they realize what some of the slow-to-digital players have realized, Costco would be a good example -- that even the so-called internet-proof segments are becoming less internet-proof. Part of the reason you hire an Ellison is, he has experience taking J.C. Penney, an antiquated company, and building it to an omnichannel capacity, meaning that you can look at something at home, pick it up in the store, see it in the store, have it delivered to your home. 

And with home improvement, while you're probably not going to order drywall on their website, the day where you order a light fixture or something that previously would have been a look-and-touch purchase, that's going to change. So this hiring really says, "Yes, we are immune to the internet for now, but we are going to have to make some slow changes." Again, nobody is going to buy paint based on viewing it on a website, unless they don't really care that much, but the day when they do is probably not that far off.

Shen: Alright, before we get into the nitty gritty for this company, I want to provide some context and background for this business. It's a huge retail operation. They have 2,150 locations spread across the United States, Canada, and Mexico. The U.S. is, not surprisingly, the most important, it makes up over 90% of the company's top line. The typical Lowe's is a pretty big store. They average about 150,000 square feet when you include both the indoor and outdoor departments and areas. The company employs over 300,000 people, so a big, big operation. 

Listeners, I think, if you're looking at the home improvement sector within retail, you have to be aware of some of the backdrop for this industry. The home improvement retailers have been able to fight off e-commerce thanks to the highly specialized products, often bulky products, they carry. Even an Amazon is going to have a tough time fighting with Lowe's or Home Depot on things like lumber sales, or when you need that specific-sized piece of hardware, for example. People want to be in the store to be able to handle that, see how it fits with the other parts of their project. And that's allowed these brick-and-mortar retailers to remain pretty resilient.

Another important thing to know about this business is how the companies classify their customers, too. You have your everyday homeowners, who get divided up further among the do-it-yourself crowd and the do-it-for-me customers. They target them very differently. Then, you have the professionals, the contractors and repairmen, who also have their own set of needs, and they get targeted differently, as well, by management.

The last thing I'll mention in terms of backdrop is when you have two major chains competing in North America and they both already have thousands of locations built out, and the market is largely saturated. Both Lowe's and Home Depot right now are focused at the moment on optimizing their current store base and the performance in their current store base rather than expanding their footprints very significantly.

Kline: Lowe's is only opening about 10 stores a year. That amount is really communities that are newly developed. It's not moving into existing areas. What their big focus on -- for anyone who's shopped in one of these, in a Lowe's, this is a big change -- is, in the last year, they've seen the amount of closes go down. Meaning, I walk into the store with an intent to buy something and I don't buy it. There's a massive training effort under way at Lowe's, where the goal is to have better customer service, to make sure that if me, someone who knows absolutely nothing about home improvement, walks in and says, "My sink is leaking," someone can actually help me get what I need, not have that sort of condescending, "We mostly serve do-it-yourselfers and experts" attitudes. 

They're really rebuilding. They trained 17,000 back line workers to be able to step in when times are busy. Meaning, a guy's job might be shelving or logistics, but when the line at the paint counter gets too long, he's now trained to mix paint or help a customer. They're really putting a focus on doing a better job, because I think they realize that Amazon can compete on some of this stuff if you don't deliver a good experience.

Shen: Yeah. The company reported their fiscal 2018 first quarter yesterday, very recently. I was going through the transcript, looking at the press release, some of the headline numbers there. Comps were up only about 0.6%. Revenue growth, a little bit better than that. But they're still not where management wants to be.

Kline: It's a little bit deceiving. A few weeks ago, they actually put out a comment, a warning, saying that seasonality -- it was cold in the Northeast longer. A big part of their business in the spring season is gardening. They actually had a huge drop in sales under $50, and that's people who come in and they're buying a small amount of stuff for their home garden, but it's a huge volume of customers. We talked about seasonality. In some businesses, if the season doesn't start on time -- the ski business. If it doesn't snow, you can't make up days in December in July. In the gardening business, someone is not going to say, "Well, now I'm not having a garden. It started two weeks late." So they will catch up these sales. They're actually predicting that they will make them up in the next quarter, and say that so far, they're already trending well ahead.

Shen: Seasonality comes up a lot in our discussions of other companies in different sectors, especially for retailers, but this is a business where I actually take any "excuses" that they make around seasonality pretty seriously, just because, obviously, the summer months are by far their busiest, and the winter months are their weakest.

Kline: And if you look through the history of the company, sales shift around based on when the winter ends. As simple as, let's say you're putting a fence in at your house. You cannot put a fence in when the ground is frozen. So, you're not going to go buy fence posts and all that, but you're still going to put the fence in. So, this is a case where, yes, comp sales were a little bit weak, overall sales were up about 3%, which is based on higher tickets, traffic was actually a little bit down. But that should all even out over the course of a year.

Shen: Sure. Something else that they updated with the latest earnings, full year 2018 guidance, just so listeners have an idea of what the company envisions for the remainder of the year, they see revenue up 5%, comparable sales up 3.5%, and operating margin down 40 basis points. We'll get to the profitability operating margin part in a second. But I look at those two numbers and I think to myself, that's pretty darn good for a brick-and-mortar retailer. That's quite enviable. I think a lot of brick-and-mortar businesses would look at that and be quite pleased if they were able to deliver numbers like that.

Kline: Yeah, especially because it's a brick-and-mortar retailer that -- I mean, Home Depot and Lowe's both obviously have websites, but they're not great. Lowe's is putting in an effort to improve that. One of the functions is building up their back channel so they can handle some of the different capabilities of ordering and in stock and that type of stuff. But for a chain that's doing 95% of its sales in the store, a 3.5% increase is incredible.

Shen: Yes. This is a good time for us to transition to what you mentioned in terms of the investments and initiatives that they're pushing with more sales associates on the floor, better customer service, more infrastructure for their online business because of the growth they're seeing there. I want to touch on six areas that management mentioned, I believe, during their fourth quarter call, so, earlier this year. These are areas that they believe are really important to their long-term growth.

First, they want to get to know customers better, including their plans and needs. They want to increase the use of data collection and analytics. Home Depot is already really strong with that, and I think they're realizing, this is something we need to be better in. Second, they want to invest more in the technology to greater personalize their marketing and to also improve their service in the store. We touched on that a little bit. Third, they want to also invest in the infrastructure for online delivery and in-store pick up, and they're also opening a new fulfillment center and pushing a few other initiatives around that. Fourth, they want to try to stand out from the competition with some strategic brand partnerships with big names like Craftsman to bring customers in the door. Fifth, they want to better serve their professional customers and then develop their store employees to have more of the skills to serve this customer base, maybe become professional contractors themselves. That's obviously a big part of their focus, given how important that specific segment of customers is. Then, the last thing, they want to grow the do-it-for-me segment with things like services, so installations, in-home sales, and project specialists.

I think, with those six initiatives that management has specifically called out, there are some really important themes. Some of these came up earlier in our discussion in terms of the backdrop of the sector, some of the competitive dynamics. For example, omnichannel is always a big thing that comes up when you talk about a business like this.

Kline: It's a significant challenge, though. If you look at J.C. Penney or Target, they're not shipping two by fours or ladders. So in some ways, you have to build a different kind of system. If you order from Lowe's as a contractor, you can get a delivery. And it's a truck, it's a dedicated Lowe's truck.

Shen: Job-site delivery, yeah.

Kline: Yeah. So, you have to figure out how to have the right quantities of stuff and how to incentivize that either they pick it up or that they deliver it, and to make these things efficient. You can't just use the post office or FedEx the way other companies can. 

The other thing is, on the customer service side, they talked a lot about centralizing some of the non-customer-facing pieces of this. I went to Lowe's to get a quote on redoing a bathroom at our other house. It took the guy two hours to put in all the stuff, and I was sitting there, and it was very uncomfortable. Now, the person meets with you, figures out what you want, and then a centralized quoting office does the quote. That allows the person in the store to see more people.

Shen: Not spend two hours right there, worrying about it.

Kline: Right. I get my quote 45 minutes later in an email, the same way I do from this guy, but he doesn't have to do all the specs while I'm sitting there, while he's not helping other people. So it's that kind of smart back-end functionality --

Shen: More efficient, yeah.

Kline: Yeah. And they've really, for the first time in the past year -- I said this a little bit before -- put a focus on the customer. If people are walking out -- if I need a sink, and I walk out, and I didn't buy a sink, I'm either leaving Lowe's and going to Home Depot, or I'm going to a local hardware store, or I'm going online. So you have to capture that customer. And sometimes, that's just putting a body in front of them. It's not easy, in Home Depot or Lowe's, to get a person to pay attention to you sometimes. They're really putting a renewed focus on that.

Shen: Yeah, absolutely. I will end the omnichannel discussion with, online sales growth for Lowe's, 2017 was 27%. Pretty strong. It came in at about 20% for the latest quarter, I believe. You mentioned, online makes about 5% of their overall top line now. That trails Home Depot. I think Home Depot's online penetration is over 7%. But that gap has narrowed quite a bit in the past few years.

Another important item from those six initiatives that they talked about, I think, is also, in terms of the marketing, the personalization of services. For example, Lowe's wants to offer more services to the do-it-for-me segment. 

They also want to really focus on that professionals business. This is a big one. Home Depot has noted before that professionals make up just 3% of their customer base, but they contribute 40% of revenue. That's huge. Lowe's, again, is trailing in that, in terms of their professional segment only making about 30% of sales. That's something, again, they want to narrow the gap on, because these are customers who are spending thousands and thousands of dollars with these stores every year. It's very important for them to connect with them better and make sure they meet their needs.

On the marketing side, I'll also mention the MyLowe's platform. This is another opportunity for increased personalization, better customer loyalty. Management has said in the past that MyLowe's members, their loyalty program, they spend about 35% more than non-members. They added 4.5 million MyLowe's customers last year. Again, more progress that they're making on that front.

Right now, we have a picture that we're fleshing out here with the current state of the Lowe's business and what priorities Mr. Ellison will have on his plate as he takes on the CEO role. We have a few more minutes here. In terms of big picture takeaway, how bullish are you for the company? Do you think that these various investments that they're making, these priorities that they've set out, do you think that's enough?

Kline: My opinion on Lowe's changed very much in the last few quarters. I have a background, my family has a ladder and scaffolding business, so I know some aspect of the contractor world. But I am not handy, as has come up multiple times. And I find shopping at Lowe's, or Home Depot, torturous. You cannot get someone to pay attention to you. If you don't know what you're talking about, there's no sympathy. So to read, for the past year, that they're addressing the customer on all different levels, everyone from the me to the contractor who knows exactly what he wants and they don't necessarily have it -- the fact that they're putting that in, and then they brought in a customer-friendly CEO, that takes this from a company that, I believed in their financials, to a company I actually like. [laughs]

Shen: More of the story overall.

Kline: Yeah! The history of Home Depot and Lowe's was that they'd come into a market, the local hardware store would go out of business, but the owner and the employees would go work at Home Depot or Lowe's. So, you'd get that expertise. They've really gotten away from that, from that hand-holding customer service. 

Now, hopefully, as they implement these things, they're going to be able to serve me, but they're also going to be able to serve the contractor that's smart enough to know that if Lowe's doesn't offer him a good price on materials or renting scaffolding, he knows where to go. He knows the little professional guy who can handle that. 

To address those things very specifically, that's a huge market they can open up. The middle was fine. The handy guy, Lowe's was a candy store. But the contractor who could deal with the professional side, and the guy who's trying to just do some little home project who knows nothing, those are areas that Ellison's going to address, and it makes me feel a lot better about the company.

Shen: Sure. In my shoes, I didn't follow Lowe's as closely in the past. Reading about this business again, we talked about some of those headline numbers and how strong that is, again, for this kind of business. But I feel like, if you're considering an investment in Lowe's, the ultimate question is, do I want shares of Lowe's, or do I want shares of Home Depot? There's an inevitable comparison between the two companies. 

There are some really important differences to keep in mind. Lowe's is valued at about 17x forward earnings. Home Depot has a premium to that, where they trade at almost 20x forward earnings. With that three-turn difference in terms of the P/E ratio, you're getting, in Home Depot, stronger, more consistent revenue growth, stronger comps growth, you're getting stronger operating margins. On Lowe's, I think it's around 9% for the trailing 12 months. For Home Depot, it's closer to 14% to 15%, and that's management's long-term target. 

On the Lowe's side, in terms of the margins, their profitability, we're expecting to see that go down, at least for this year and maybe next year, given some of these investments that they're making. And then, even though Lowe's is a dividend aristocrat -- I think they've increased their dividend every year for 56 consecutive years, really impressive -- Home Depot pays a higher dividend, about a 2.4% yield vs. about 2% for Lowe's.

So there's this constant comparison that you have to make if you're going to buy one of these brick-and-mortar home improvement retailers. The sector is doing really, really well compared to the broad market, retailers in general. But picking which one, you can't help but make this comparison.

Kline: One, you don't have to pick one.

Shen: That's fair.

Kline: You could invest in both of them. I think there's also some added opportunity out there for these companies. If you look at the shakedown in retail, that if you're a surviving brick-and-mortar chain -- which, obviously, these are going to be surviving chains -- they're also not dependent on mall traffic, they're stand-alone locations, in most cases. As you see Sears go out, appliances are going to be a growth area. That's a major category, and it's one that consumers have shown, over and over again, they want to see and touch it. Almost no one is buying a refrigerator just based on a website. 

So, as you see the rest of the retail shakeout -- Sam's Club closing locations is going to kick some sales to Home Depot and Lowe's -- the reality is, it's going to come down to marketing. How often is the Lowe's next to the Home Depot? There's really no reason why you couldn't go to either one. And I do like what Lowe's is saying how about how they're going to reconsider their targeted marketing. Now, I'm sure Home Depot is addressing it as well. But Lowe's does have a bit of the higher-end brand. It's a bit of a Target-Walmart situation. They both kind of do the same thing, but Lowe's has a little more polish, which might help them as they refine how they reach customers.

Shen: Sure. I think you have a company in Home Depot that is firing on all cylinders, doing incredibly well. Again, really popular in the Fool community. Then, on the Lowe's side, trading at a bit of a discount. Maybe you see more of an upside there as a result, if you believe in these initiatives that they're investing in -- which I do think are the right areas, as we've discussed.

Kline: Yeah. I mean, I'd be concerned, over the next six months, to see what happens with the leadership team. What they've talked about is that Ellison is going to come in, he's going to review the plans and put his own touch on it. Sometimes that means everyone leaves, which is not great if you're in the middle of a reinvigoration plan. So hopefully, Ellison comes in and he plays nicely with others, and he can add his finesse to what already seems like a solid plan. 

This doesn't seem like a case where the previous CEO was pushed out. It does seem like a legitimate retirement. So I'm relatively hopeful. But if I was going to buy stock today, I'd probably wait until Ellison has his first earnings call and actually make sure that he's going to continue some of these things.

Shen: Essentially, to make sure that you agree with the direction he chooses, whether that's, I like this plan, let's stick with it -- and frankly, I think it reflects a lot of the changes in the focuses that he's had at J.C. Penney, as well. It's not like they're radically different views.

Kline: I think he's been picked because he fits this plan. I will point out that I'm very bullish on JCPenney, even though I acknowledge that they're on a tightrope for survival. I do think he's made mostly the right moves there. At a well-capitalized company, he should really be able to make an impact quickly.

Shen: Alright, that's all the time we have for today. This is, again, two companies, Lowe's in particular, one that we haven't really covered before on this segment of Industry Focus. I'm glad we dug into it a little bit. We'll definitely follow this rivalry and the succession plan with Ellison in the coming months. Thanks for coming in, Dan!

Kline: Thanks for having me!

Shen: Thanks, Fools, for listening! People on the program may own companies discussed on the show, and the Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Daniel B. Kline has no position in any of the stocks mentioned. Vincent Shen owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon, Netflix, and Walt Disney. The Motley Fool owns shares of Verizon Communications and has the following options: short September 2018 $180 calls on Home Depot and long January 2020 $110 calls on Home Depot. The Motley Fool recommends Costco Wholesale, FedEx, and Home Depot. The Motley Fool has a disclosure policy.