While the retail space undergoes major changes, the standout of the sector continues to be home improvement. When Lowe's Companies, Inc (NYSE:LOW) reported its earnings earlier this month, just a week after rival Home Depot Inc (NYSE:HD) reported its own stellar quarter, this trend was confirmed: The home improvement business in America is booming!
In Lowe's second quarter, revenue rose to $20.9 billion, a 7.1% increase year over year, and adjusted earnings per share (EPS) grew to $2.07, a 31.8% increase year over year. Comparable sales, the all-important metric for any retailer, increased 5.1% over 2017's second-quarter results.
Another second-place finish
Most companies in the retail sector would kill for numbers like this. Yet, the one nagging thought I have always had when it comes to investing in Lowe's still persists: Lowe's might be a good business and investment, but by nearly any measure, Home Depot is better.
In what has become a familiar refrain, Home Depot's revenue, earnings, and comp sales all rose by higher percentages this quarter. Home Depot has higher penetration among Pro customers, a better supply chain, and more robust omnichannel offerings. Since I've been following these two companies, it just seems as though Lowe's is always playing catch-up to its larger rival.
But, hey, don't just take my word for it. In the company's second-quarter conference call, Lowe's new CEO, Marvin Ellison, was extremely gracious toward the previous management, but here's what he had to say about the gap between Lowe's and its competition:
[W]e have work to do. Despite delivering a 5.2% comp and $2.07 adjusted EPS for the second quarter, we have a lot of opportunity as a company, specifically, we're significantly behind in our supply chain strategy, our in-store technology is dated, overall execution is impaired by complexity, we have a large number of out of stocks in our stores that must be addressed, and we need to increase the rigor with which we evaluate capital investments. Although it's never good to be behind, our current position presents significant upside potential for Lowe's and for Lowe's shareholders.
The game plan
Fortunately, Ellison is confident Lowe's can tweak the way it does business to catch and surpass Home Depot. The primary culprit, in Ellison's mind, seems to be the company's misuse of cash and, to this end, he believes it can do a better job of prioritizing projects. For example, management announced it would be closing its Orchard Hardware Supply stores. The 99-store chain, with locations in California, Florida, and Oregon, maintains a much smaller footprint than the average big-box Lowe's store model. Ellison said that after evaluating the brand from a high level, big-picture perspective, he realized that even if Orchard's grew into "the most dominant, small box specialty home improvement channel in America," it would still only have a "minimal positive impact" on overall sales and earnings. When Lowe's management saw this, they realized the chain was not worth the drain on intellectual and financial capital that it was costing the company.
Ellison also said the company seemed to be in the habit of throwing "payroll" at problems, instead of looking for better, more efficient solutions. For instance, Ellison noted there was no corporate-wide policy for unloading trucks at stores. He said this type of lack of engineering processes can kill productivity. He believes that by adopting standards for these types of tasks, Lowe's stores will recognize much greater efficiency.
So, where does Ellison believe capital should be allocated? Three areas he consistently called out during the conference call were improving its supply chain, updating the stores' technology, and improving the company's IT infrastructure. From my view, these are all worthy endeavors and, not coincidentally, areas where Home Depot currently enjoys a lead over Lowe's.
The capital projects that did go toward a prioritized strategic initiative were being eliminated, freeing up about $500 million that will be redirected toward the company's share repurchasing program. In my mind, this was the most puzzling announcement of the conference call. With so many areas starving for attention, such as expensive supply chain infrastructure, I wonder if that capital could be better used elsewhere.
Shares popped the day Lowe's announced its earnings, and after reviewing the numbers and reading through the conference call, I can see why. Ellison appears to be a CEO who understands where the goal line is: It's not comparing Lowe's against the greater retail sector, but against its primary rival in the home-improvement space. He appeared confident that the problems ailing Lowe's could be fixed, with some of the worst problems appearing to be low-hanging fruit, such as standardizing in-store tasks. He said more details about the company's long-term goals would be forthcoming this December at the company's investor conference.
Still, Lowe's shares sport a P/E ratio of 22.45, while Home Depot shares are valued with a P/E ratio of 22.85. If Lowe's shares were undervalued, I believe they might warrant an investment here. Given the similar valuations and Home Depot's track record of out-performance, though, I would still much rather invest in Home Depot over Lowe's at the moment. While I am looking forward to hearing Ellison's vision for the company in December, the company is seemingly already being rewarded by the market for successfully finishing its turnaround before it has even begun. No matter how competent management appears to be, I would much rather wait for the details of the plan, and tangible signs of success, before buying shares at these levels.
Matthew Cochrane owns shares of Home Depot. The Motley Fool has the following options: short September 2018 $180 calls on Home Depot, long February 2019 $185 calls on Home Depot, and long January 2020 $110 calls on Home Depot. The Motley Fool recommends Home Depot and Lowe's. The Motley Fool has a disclosure policy.