October 24, 2021

Home Zona

It Is What You Do

Checking In on Home Depot and Lowe’s

17 min read

In this episode of Industry Focus: Energy, Motley Fool analyst John Rotonti, with host Nick Sciple, returns to the show to take a look at Home Depot (NYSE:HD) and Lowe‘s (NYSE:LOW) recent earnings reports. Which one is a better investment for the “value” or “growth” investor? Do they pass the David Gardner “snap” test?

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This video was recorded on August 26, 2021.

Nick Sciple: Welcome to Industry Focus. I’m Nick Sciple. This week, I’m excited to welcome Motley Fool analyst John Rotonti back to the show to break down what’s going on with Home Depot and Lowe’s, America’s two biggest hardware stores. John, how’s it going?

John Rotonti: Doing well, Nick. Thanks for having me on; my fifth time.

Sciple: We’re going to the hits here. We played the B-sides with some under-the-radar companies, and now we’ll go into these big stalwarts of American commerce here with Home Depot and Lowe’s. We’ll get to these earnings reports which both came out last week. Before we do this, to set the stage, think about the role that Home Depot and Lowe’s play in the American economy. How can you put that in context for folks?

Rotonti: The way that I think about it, Nick, is that both, like you said, they’re the two largest home improvement retailers in the U.S. but really the world, even though they really only operate in the U.S, Canada, and Mexico. They’re the largest in the world by sales, but housing serves a crucial economic need. Housing is really important. It’s part of the American dream. It’s where we build a lot of our memories and spend most of our time or a lot of our time. For many of us, housing is our largest financial asset, our largest investment. I think, and history has proven based on their sales growth, which is not very cyclical at all. I think going back 30 years, Home Depot sales have only fallen four times, and three of those were in the global financial crisis, the housing bubble. Really, steady sales increase shows how important they are to our economy, and what happens is people always invest in their homes when times are good, and people are feeling flush, households are feeling flush like right now. They do big renovations, they do major projects, they add a wing, they redo their kitchen, they redo some bathrooms. Then when times are tighter, they still need to do maintenance and repair, so you get that predictable business from them.

Sciple: I can tell you, I just moved into a new apartment. We’ve got a little backyard situation, and I can’t tell you the number of times I’ve been to Home Depot to get little things to put in the backyard or mosquito repellent or all types of things. These are absolutely essentials to our life, and also, you get luxuries like you get a grill. You need to grill for the backyard too, so both essentials, and that you can’t live without like literally can’t live in the backyard without some of the things you pick up at Home Depot. Then also just those things that are nice to have that are part of the American dream, I suppose. One thing I thought that was interesting as we were preparing for the show I came across, there’s a Bank of America report recently that says together, Home Depot has about 17% market share in their industry; Lowe’s about 12%, still only about a third of the overall hardware store market controlled by these two companies, which just blows my mind when I just think about how ingrained they already seem into our lives.

Rotonti: What you’re suggesting is that it’s still a largely fragmented market because there are a lot of smaller mom-and-pop hardware stores out there, so they still have a lot of room to grow by taking market share. Neither Home Depot or Lowe’s are opening any new stores in the U.S; any new locations are coming in Canada or Mexico for Home Depot. But the fact that there’s still so much market share to take, it’s such a fragmented market. They can grow organically, I think, over the long term, mid to high single digits, so let’s call it 6%, 7%, 8% organic revenue growth.

Sciple: Yes. Let’s get into what revenue growth they’re putting in. Today, maybe we start with Home Depot because they were the company to report first, and came out with their earnings on August 17th. The market hasn’t really liked it, shares are down 4% since that report came out, and they declined sharply on the day after the report. What stands out from you? What do you think is going on with the market here?

Rotonti: Their sales increased 8%. Earnings per share increased nearly 13%. It was their first. Their comp sales or same-store sales, so sales from stores open at least 12 months, increased 4.5%. They have their first quarter where they generated over $40 billion in quarterly revenue. It just comes down to expectations, Nick, like with everything else. The stock had done really well throughout the pandemic, it traded at a much higher P/E multiple than Lowe’s, and we’ll get into that when we get to Lowe’s. I just think that, on some of the other key performance indicators or KPIs, they didn’t quite meet market expectations, which is a little strange, but I think they had just honestly a really solid quarter.

Sciple: Yeah. I think one of the things we can maybe dive into a little bit, you mentioned same-store sales up 4.5%. Obviously, a great number. You want to see that number going up and up, but if you break into the components of it, customer transactions are actually down 5.8%. What’s really driving that same-store sales number up is ticket size, up 11.3%, which a big chunk of that is inflation, which we’ve seen in the market in lumber and things like that. I think some of that is slowing traffic, which makes sense, leaving our houses a little bit more coming out of the pandemic, but also they benefited somewhat from inflation.

Rotonti: That’s true. I don’t think the decrease in traffic growth was a surprise because last year, traffic was unprecedented because of PPE, people going in to buy personal protective equipment or PPE, masks and rubber gloves and other cleaning materials and sanitizers and stuff like that. Both Home Depot and Lowe’s saw literally unprecedented DIY or do-it-yourself traffic, people going in buying PPE. Coming off that amazingly high growth rate, same quarter last year, I think it’s reasonable to expect a decline. The important thing about Home Depot’s business is that almost 50% of their sales, the actual number is 45%, almost 50% of their sales come from Pros or professional contractors. Even though DIY or do-it-yourself traffic is down, they still increased comps 4.5%. They still increased overall sales 8% because almost 50% of their business comes from Pros, these professionals. Pros spend significantly more than DIY customers. To put that into perspective, Pros make up only 4-5% of Home Depot’s customer base, but as we said, they generate 45% of sales. Home Depot has this really strong diversity and balance in their revenue mix, almost 50/50 between DIY and pro. I think what the market was most disappointed in is that their digital sales were flat in the quarter, which just means no growth, but they were lapping 100% digital sales growth in the same quarter last year, Nick, and on a two-year stack basis, which means if we look at the sales in Q2 2021 relative to Q2 2019 as opposed to Q2 2020, their e-commerce sales are up 100%, so they’re up a 100% on a two-year stack basis. Their e-commerce business is a monster. I just think the market was a little disappointed that it was flat in the quarter.

Sciple: You can’t grow to the sky, obviously. As I mentioned, really people leaving your homes. Things such as that, maybe that ties into you mentioned the Pro business and how important that is to Home Depot. As we talked about Lowe’s later, it’s important to the competitive dynamic between these businesses, but when you get this earnings report from Home Depot, is that where you are jumping to first? Is it the Pro business, what you think is the driver that’s most important to you?

Rotonti: Home Depot? I would say, yes. There’s a basic formula, Nick, for brick-and-mortar retail. If you look at Home Depot and Lowe’s gross margins, they are almost identical. I think Home Depot has gross margins, let me pull up really quickly, Nick. Home Depot’s gross margin is 34%, Lowe’s gross margin is 33%. Very similar gross margins where Home Depot separates itself, oh, and they have virtually the same amount of stores as well, around 2000-ish stores. But Home Depot generates so much more revenue from roughly the same amount of stores. They have roughly the same gross margins, but they have much higher operating margins, Nick. That’s the difference between the two business models. That is driven largely by the Pro business because Pros are such higher-margins. Pros shop so much more frequently and they spend so much more per ticket per transaction. What that does is, it’s a very simple formula in retail investing, it drives higher sales per store and higher sales per square foot. You can have two companies with virtually the same number of stores and virtually the same gross margins. But because Home Depot has such better store efficiency and productivity, largely driven by that Pro business, that leads to higher sales per square foot, higher sales per store. That leads to higher operating margins, which leads to higher returns on invested capital and free cash flow. They then take that free cash flow and reinvest it back into omni-channel retail, a digital supply chain, having the best brands that are in stock and in demand, and that drives more business. 

The fact that they have higher sales per store that allows them to reinvest and it becomes this perpetual reinvestment and free cash flow machine. The Pro is a large driver of that. The other one is location, location, location. 90% of the U.S. population lives within 10 miles of a Home Depot store. 90% of the U.S. population lives within 20 miles of a Lowe’s store. Another stat that just really brings this to light is in the top 25 largest metro markets in the U.S, Home Depot has 80% more stores in those top 25 markets. Because Home Depot has the best locations and even more locations in these dense urban areas, once again, that drives more traffic to the stores, higher sales per square foot, higher sales per store, and then you get the higher operating margins. It’s a really interesting dynamic; two companies, almost the same-store size, but one has dramatically more revenue, and that’s Home Depot and dramatically higher operating margins.

Sciple: Yes, you look at the Home Depot, […] $30 billion in revenue versus around $90 billion or so for Lowe’s. What you’re saying is primarily driven by the Pro business. Any last thoughts on Home Depot? Because I think it’s a good transition to move onto Lowe’s. This is a fundamental part of why maybe Lowe’s has a bit more positive response to its earnings than Home Depot did.

Rotonti: I don’t have any last comments. I think it was a strong quarter. Sometimes, things sell off just because expectations get a little bit ahead of themselves. Sometimes, with the valuation, the market just gets a little concerned by valuation. For a long-term hold, I own it, Nick, it’s one of my larger positions and it’s a long-term conviction, long-term hold for me.

Sciple: I own Home Depot as well. Same, it’s integral to my life. The David Gardner snap tests, if you snap your fingers and Home Depot disappeared, I think a lot of people’s lives will fall into disarray. It’s a huge pass-through of that test. Moving on to Lowe’s, so Lowe’s reported actually the day after Home Depot here on August 18th and shares were up following earnings. What were your takeaways from the Lowe’s earnings report?

Rotonti: Lowe’s is benefiting from the same tailwinds as Home Depot, namely a really strong housing market, plus people working from home during the pandemic. When you’re working from home, you’re going to spend on your home. Then the last thing is, home prices are at an all-time high, which means people have a lot of home equity in their homes, which means there’s a wealth effect. What happens is, without fail, when people have a lot of home equity in their homes, they see spending on the home either for a big renovation or for just maintenance and repair, they see that as an investment and not as an expense. People are more willing to invest in their homes. That brings you into Home Depot, it brings you into Lowe’s, which is the one we’re talking about now. We didn’t say, but we should mention, we’re almost four million homes short of what we need in the U.S. So there’s a long runway of growth ahead as we need to build more homes. As you just said, when you move, you need to go to Home Depot or Lowe’s. Lowe’s, their comp sales were actually down 1.6%, I believe. But once again, they were lapping unprecedented demand from the same quarter last year. On a two-year stack basis, their same-store sales or their comparable sales were up 32%, Nick, which is just fantastic. 

I think where Lowe’s stood out in the quarter was their online business. For one, I mentioned Home Depot’s e-commerce business was flat, Lowe’s was up seven%. That may not sound like a ton, but that’s on top of 135% online sales growth in the second quarter of 2020. That is 7% growth on top of 135% growth, which is just, to be able to lap that, is just really phenomenal, Nick. This is where it really gets interesting. Their Pro business grew 21% in the quarter and is up 49% on a two-year stack basis. They are, and I’m coming off a much lower base here. The business model has been around DIY, the business model is built around DIY. They did not have a Pro business model for much of the last decade. They really didn’t have one or a good one, let’s say. But ever since their new CEO, Marvin Ellison came in in 2018, they’ve done a ton of things to turn around this business, which we can get into, I can bullet point those for you if you’d like. But one of them is to focus on that Pro business because Marvin Ellison is a retail genius. By the way, he came from Home Depot, he was 12 years in Home Depot. He knows how important that Pro business is because there’s such higher margin customers. They have been heavily leaning into their Pro business. In fact, on the call, Nick, they said and I quote, “We are striving to demonstrate that Lowe’s is the new home for Pros.” They are trying to diversify and balance their revenue in a way that is similar to Home Depot. Currently, only 25% of Lowe’s business comes from Pros versus 45% of Home Depot’s business that comes from Pros.

Sciple: When you look at the growth of the Lowe’s Pro business, is that just cannibalizing market share from Home Depot, or are there other smaller players in the market they’re taking share from? How much of this is just these two giants just battling it out?

Rotonti: I don’t think a whole lot of the share is coming from Home Depot, honestly, because Home Depot has been out at it much longer. They do have, I believe at this point, a more efficient, more customer-friendly Pro business. Home Depot’s website, they have a separate HomeDepot.com tailored just for Pros. It’s almost like a SaaS platform for Pros, honestly. I don’t think a lot of the share’s coming from Home Depot, maybe some of it is. I think it’s coming from that fragmented market that we talked about earlier. There’s a lot of other players in the market and that’s low-hanging fruit for Lowe’s, honestly. I don’t want to underplay Lowe’s. The transformation that is happening at Lowe’s under Marvin Ellison is nothing short of fantastic. It’s really, really incredible what’s going on.

Sciple: John, you mentioned walking us through some of the things, and I think just to give us maybe more context, obviously this big push into the Pro business. I guess, how far behind was Lowe’s, if you can put that in context for us relative to where Home Depot, you talked about how sophisticated they are and all those things?

Rotonti: Like I said, Home Depot’s business model going back at least a decade, was focused around the Pro business because it is such a high-margin. It drives retail metrics for the home improvement industry. Lowe’s didn’t have that. They were focused on providing the best white-glove customer service to do-it-yourselfers. They still have that. They still provide great customer service at Lowe’s, but now, they’re trying to balance out that revenue mix, and it’s working for them. Other things that they did under Marvin Ellison, they refocused on the core business. They got rid of underperforming lower-margin businesses. They got rid of all their Orchard Supply stores, which was a completely separate brand, it wasn’t core. They closed underperforming stores in the U.S. and Canada, and they exited retail operations in Mexico completely. They got out of everything that was not core and that was lower-margin. He completely restructured the leadership team, Nick, by eliminating several positions and appointing new leaders for the CFO, as well as head of merchandising, head of stores, and head of supply chain, so four new executives. They rationalize inventory by reducing low demand, low turnover inventory, and increasing higher turnover inventory, so increasing inventory that is higher in demand. 

Maybe most importantly, they invested heavily in supply chain, omnichannel retail, and other digital initiatives such as revamping lowes.com completely, moving lowes.com to the Cloud, I think there are on Amazon Web Services now, implementing digital signage in their stores, putting 115,000 smart handheld devices and associates hands. Also, really importantly, they came up with dynamic modern pricing tools. Now, they can change the prices of their inventory almost instantly and that allows them to change the prices so that it meets market demand rather than having a promotional pricing environment. By getting rid of a promotional pricing strategy, they no longer have as many markdowns. When you sell something at a discount, at a markdown, that’s lower-margin. This also helped boost their gross margins. Then they implemented a true expense reduction culture which also helped improve operating margins and returns on invested capital. I’m sorry. Go ahead, Nick.

Sciple: Go ahead, John.

Rotonti: I was going to say, from 2018 through the end of year 2020, they improved that key retail metrics sales per square foot by 26%. They improved operating margins by 2.25%. They improve customer satisfaction by 4%. Earnings per share grew 70% over those two years, 2018 to 2020, earnings per share grew 70% and guess what? Stock follows earnings up. What would the stock do? It’s up 71%. That’s the total return, including the dividend yield. Over those two years, the stock is up 71% versus the S&P 500 only up 37%. Incredible performance in two years and the turnaround is still ongoing.

Sciple: That was where I was going to go, John. You have this story of Home Depot, which is just a juggernaut that has been executing a strong business model going out for a long time. The leader in the space, you’ve got Lowe’s. It is going through this transformation, a really strong management team and you’re, in the process of that taking place, still want to grow more of the Pro business. When you look at these two companies today as potential investments, which one gets you more excited and why?

Rotonti: Honestly, Nick, the answer is both. I can tell you why Home Depot, because they are the better business. I don’t think there are only better home improvement retailers, I think they are one of the best businesses that I’ve studied and under my coverage universe. With Home Depot, you get a better business with higher margins, higher free cash flows. They have more cash to reinvest in strengthening their moat and serving all of their stakeholders, but it comes at a higher P/E. Lowe’s, you have your thesis there. In my opinion, you have a good business that is dramatically improving, probably in the middle innings of a turnaround that trades at not only a discount to a P/E ratio that is not only lower than Home Depot, that would be reasonable. It’s trading at a steep discount to the market, Nick. Lowe’s is at about a four P/E of about 18. The S&P 500 has a P/E of about 21. To me, that makes no sense at all because based on our research, I think Lowe’s is a far above average business. If the average company in the S&P 500 is trading at 21 times forward earnings, I see no reason at all why Lowe’s should be trading at us three-turn discount at 18 times. I think at the very least, Lowe’s deserves to trade at a market multiple of 21. I think this is the thesis for Lowe’s as you could see if I’m right, you can see both earnings-per-share growth plus P/E multiple expansion. You could get a double whammy from Lowe’s.

Sciple: It’s really one of these where, are you a quality person? Maybe Home Depot is more in your bucket. Are you a ‘value’ person? Maybe Lowe’s leans a little bit more in your bucket. If you’re just somebody who wants to get a quality stock, both of them, check those boxes off of what you’re looking for in a company.

Rotonti: I think so.

Sciple: Still some trajectory to grow, but also just absolutely dominant in their industry is such that I don’t know who else could come for their spot.

Rotonti: They have 2,000 stores. Pretty much everyone lives close to one of them. You’re either going to go to your neighborhood Lowe’s or your neighborhood Home Depot. Yeah, like you said, if you were moving, you’re going to get ready to move to get ready to sell the house and then you’re going to go again once you move into your new property. It’s just like clockwork.

Sciple: Yeah, you discover all these things you didn’t know you need as soon as you move into the new place. John, thank you for joining me as I always love having you on the show.

Rotonti: Nick, thank you for having me on the show. Love coming on.

Sciple: Until next time. As always, people on the program may own companies discussed on the show and The Motley Fool may have formal recommendations for or against the stocks discussed, so don’t buy or sell anything based solely on what you hear. Thanks to Tim Sparks for mixing the show. For John Rotonti, I’m Nick Sciple. Thanks for listening and Fool on.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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