Chit Chat Stocks - Lowe's (Ticker: LOW) Not So Deep Dive

Episode Date: August 22, 2023

Lowe's Companies, Inc. (LOW) is a prominent home improvement retailer, capitalizing on a robust housing market while tackling competition and supply chain complexities in the evolving retail landscape. At the end of the month, we will publish an Arch Capital episode that will cover the company: Sprouts Farmers Market. Listen closely as Brett and Ryan go through the history, financials, and future prospects of Lowe's. Enjoy the show! ****************************** Subscribe to our Substack to receive free show notes and charts that go along with every episode: https://chitchatmoney.substack.com/ Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Contact us: [e-mail] Timestamps Company Background | (3:52) Industry | (17:05) Management & Ownership | (22:30) Earnings | (26:20) Balance Sheet | (28:41) Valuation | (31:02) Our Analysis | (32:16) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, hosts Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or a recommendation. Now, please enjoy this episode. Welcome to the Chit Chat Money. My name is Brett Schaefer, and I'm joined by my co-host, Ryan Henderson, as always. And today, it is Tuesday, so it is our not-so-deep-dive episode

where we analyze one stock covering its business model, financials, future growth opportunities. We call it the quote-unquote not-so-deep-dive, but that is a little bit in jest. We do want to try to cover this company comprehensively. And hopefully, if this is a company you haven't heard of before, or if you've heard of, well, likely heard of this company, but if you haven't looked at the investment case before, we hope after listening to this episode, you either get inspired to put it on your watch list or not, or you get inspired to keep it off your watch list, you find some red flags that maybe we found as well. Either way, we hope you learned some stuff from this and it helps you along with your research process. Today, we're talking about

Lowe's as we continue as our second week in the share cannibal month. Lowe's has been a really big repurchaser of stock and is a duopoly in the home improvement space along with another company people know, Home Depot. We're going to get into the episode, but first, if you want, again, we say this in every Not So Deep Dive, if you want the show notes, if you want the charts, if you want links to further reading and some of the research we used along with this episode, we would recommend to subscribe to our free newsletter. It's actually just closing in on 2000 subscribers. So not bad. Hopefully, you know, you're not going to get a prize, but you can be the 2000th subscriber there. And if you liked the episode, give us a review

on Apple podcast or Spotify. That's really it. Ryan, anything else before you want to get started and explain what Lowe's does. Because I know people have probably shopped there before, but the business model is unique and there's a lot of moving parts for these home improvement companies. Yeah, and before I get into the Lowe's, I'll just reiterate kind of what you mentioned there.

The reviews honestly really do help a ton. If you listen to the show a lot, please- We just got a funny one. Be so kind as to review or just rate the show. It really helps kind of spread the good word, if you will. Today's episode is presented by the Science of Hitting Investment Research Service. The Science of Hitting was founded by Alex Morris, who spent a decade working as a buy-side equities analyst before launching his own service in early 2021.

You've heard him here on the show a number of times, but Alex produces really, really high-quality equity research. And in addition, he provides 100% transparency into all his portfolio decision-making. We were early subscribers to the Science of Hitting Research Service, and we genuinely believe that Alex produces research that is on par with top Wall Street analysts at a fraction of the cost. I mean, the fact that you also get complete portfolio transparency and 100% accountability is just icing on the cake. Effectively, you're outsourcing a full-time equities analyst role for just $349 per year. Brett and I both pay for the service on our own,

and we can tell you that it's honestly worth the money. Some of the companies that Alex covers includes Microsoft, Netflix, Meta, Roku, Costco, Match Group, Berkshire, tons of others. So if you're interested, check out the TSOH Investment Research Service today at thescienceofhitting.com. Anyways, Lowe's. Lowe's is the world's second largest home improvement retailer behind Home Depot. And I say the world's largest, but they only operate in the US. They used to operate in canada but uh since divested or sold that business um so it's really all their stores are now on u.s soil um and they've got about just over 1700 stores located throughout the u.s each one of these averages pretty much 144 000 square feet in size if you include the outdoor garden section

so a lot of these have a garden section segment that's like adjacent or attached to the building Love those segments, sections. That's the Mother's Day place. That's where I go every May. Yeah, that's exactly right. But to kind of give some context on that, Home Depot is about the same size, but it's like Walmart is, the average Walmart is around 187,000 square feet. So kind of 75% of the size of a Walmart, if you want to think about it like that. I'm sure people are familiar with the Lowe's layouts, but Lowe's sells a ton of different stuff. Their sales come from lots of different categories and they break them down and it's pretty diverse in terms of the segment revenues. But the four largest are appliances, lumber, outdoor living products, and lawn and garden.

All those combined account for a little over 40% of the company's revenue, but they also sell kitchen and bath products, paint, tools, rough plumbing products, and plenty more. Basically, if you're doing anything to improve your home or build, there's probably an item at Lowe's that you might need. Now, Lowe's sells to, I would say, three different customer types, really two big ones, but there's another one that they generate revenue through. So DIY or do-it-yourself and pros are the two big businesses here. There's also the Do It For Me, which I'll just address it right now.

The Do It For Me is a small business for them. It accounts for only 5% of their sales, but basically Lowe's offers installation services to customers through a network of independent contractors. So this means if customers want to do something for their home and they see some items at Lowe's, they can also get the installation services. So you can get flooring put in or you can get big kitchen or bathroom items installed, stuff like that. But really, the bulk of the revenue is driven by the do-it-yourself customer. DIY makes up around 75% of sales.

They don't break this out every quarter, but it's roughly 75%. This is your typical homeowner that's renovating their house or making some kind of improvement. and it's been a growing market for them as it's kind of been two tailwinds. One, the number of housing units in the U.S. has grown by about 1% to 2% a year for a really long time. It's just steadily gone up and up. And the average age of the home in the U.S. continues to rise as well, which means there's a lot more improvements that are needed, a lot more servicing to those houses, which means more customers for Lowe's. The second segment, this is the pro segment and it's around 25% of sales and it's selling to people like tradespeople. So

painters, plumbers, electricians. For example, I worked for a painting company once in my day when high school and they have to buy a bunch of products and they choose one of these outlets to go and get their stuff. Yeah. And there's also repair people, remodelers, and even property managers that they consider all those pros. And the segment really requires a lot of its own customized features in terms of the shopping experience. That means you need typically a separate checkout, separate customer support. You need your own online dashboard if you're a pro. You need, well, Lowe's needs to offer bulk discounts. You often need loading assistance.

There's membership awards. So you can get like a credit card through them and get some points back if you're using it a lot. Basically, if you're a small team or you're a pro contractor, you're going to be coming here so frequently, you need a different experience. And Lowe's has been a little slow to the game, which is kind of interesting considering that we're going to look at their history in a second, but that's where their genesis really was. They catered to the contractor for the majority of their history until about the 80s when they

started to push more towards the do-it-yourself segment. And now they've been slow to adapt to what Home Depot has done, which has been... I mean, Home Depot gets 50% of their revenue from the pros segment and they have a larger revenue base than Lowe's. So it's almost three times the size Home Depot's pros businesses. And so Lowe's has really been a catch-up mode and they've done a pretty decent job of that, making some headway, especially in the small to medium size pros. And we're going to talk about that segment a lot today, but it's a big growth market for them. So it's something to keep an eye on. I guess the focus over the last decade or so has really been this total home strategy. They're going to talk about this a lot.

And when you look at the store count over the last decade, it got up to like 2100 around stores in total, and now it's back down to 1700. But really, store growth has not been a big pillar of the overall revenue growth strategy here for Lowe's. it's really been kind of the hard stuff, which is generating a higher sales per square foot of your existing logistics or your existing infrastructure. And a lot of that has come through building out omni-channel functionality, giving the right resources to pros to come back and order bigger bulk items and order more, improving the supply chain so that you're getting these products sorted on the shelves in a cheaper manner

and really driving the operating income on a per-store basis as opposed to just... Or one other thing I would mention there that they talked about is they used to,

under the old management, not have the right items for specific geographies. So they said they would have a bunch of stuff for rain in Phoenix for some reason because they just distributed all throughout the region

and it wasn't probably that egregious of just a bunch of stuff for rain, but they took out Things that each region needs and they really distribute it across, you know, they're just being a lot smarter, I think, and doing the small things right. Yeah. And that's, I mean, there's five pillars under their total home strategy and it's one drive pro penetration to accelerate the online business, three, expand installation services for drive localization. Like Brett just mentioned, this Lowe's was just basically expanding so quickly nationally that they were just kind of replicating the same store across the country. And in Phoenix, yeah, you probably don't need that much rain protection products like you might in Vermont or something like that.

So yeah, that's been another pillar of their strategy. And then the fifth one has been to elevate the assortment. Um, they've, they've kind of shifted to a lot of private brands in, in recent years, which frustrated some pros because pros tend to be brand loyal. Um, and so they've been trying to improve the assortment to kind of cater to not only the do-it-yourselfers and the higher margin proprietary products that Lowe's has like stain master and stuff like that, but also, uh, the national brands that, that pros know and love.

When we look at the history, the origins for Lowe's started in 1921, actually, so 50 years, I think, before Home Depot ever came on the scene, although it was really not much of a business at the time. So Lucius Lowe opened a hardware store in North Wilkesboro, North Carolina. The store was moderately successful, but Lucius never really wanted to expand the business, and Lucius Lowe actually passed away in 1940. and the business was kind of a weird family thing, but it was inherited by the sister who then sold it to her brother. Smells like taxes. Smells like tax avoidance.

Well, maybe. There was a lot of mixed different... There was some mixed histories here in terms of different sources kind of telling different things, but her brother went off to serve in World War II and... And at the time, the sister was kind of running the stores, but it was pretty close to failing. And she was married to a guy named Carl Buchan. And Carl, who was also serving in World War II, got honorable discharge.

And so he came back and the brother was like, Buchan was like, hey, I'll run this business for you. And Buchan is largely credited with building the modern Lowe's. And he said, I'll help run this business. And I think his name was Jim Lowe, who was still abroad at the time said, okay, you can do it, but you have to go mark all the inventory and buy it all from me. And then we can become 50-50 partners. And so that's exactly what he did.

And Carl Buchan had the kind of the awareness or he apparently anticipated that he thought there was going to be a post-World War II construction boom. And so prior to 1943 timeframe, he was more of like the store was more like farm stock, stuff like that, like seeds, not necessarily catered just to home improvement. And so, Buchan really transitioned the business to being focused on hardware and building materials, which ended up really successful for them. And so, they began to expand into other locations throughout North Carolina. Around that time, Buchan, I'm not sure why, I don't know what drove it, but he became the sole owner of the hard goods business. and Jim Lowe instead started the Lowe's Foods grocery chain, which I'm not sure what happened to it, but I don't hear about it much today. So unless it was acquired or something, it seems like it's probably not around. And then the 50s really marked a period of steady expansion for Lowe's and really just kind of overall, they more professionalized the operation. So they had like an actual management team by the end of this. It wasn't just one guy kind of running it.

And Buchan actually died 44 years old of a heart attack in 1960. And so the management team the next year decided to take the company public. Interestingly, at the time, Lowe's was still focused on the professional builder, which I find kind of interesting given where they're at today. And it wasn't until about 1978 that they began to market themselves as the DIY demographic. Like if you're improving your home, come here, they would have like posters up all over the place to like, you can improve your home on your own, that kind of thing. And then from that point forward, I guess the Lowe's story has been really an expansion of that hardware, building materials, do-it-yourself model all across the country. And the expansion, I guess, in terms of storefront kind of stopped around the 2010 timeframe. That's also, coincidentally, between 2005 and 2010, they started making the operational improvements in-store.

That was really the focus. And they started to buy back shares really consistently. The share count since 2010 is down 60%. So share count's down 60% in the last 13 years. Last 13 years, that might be the best. I'm not really sure. Maybe. AutoZone, I think.

It's pretty good. AutoZone was, what, almost 90% since 2000? Yeah. So. Little spoiler, maybe Sprouts will catch them in the 13 years from their start, but they started a little later. We'll see. But yeah, that's, I mean, that's the bulk of the history here. At this point, they're running a duopoly with Home Depot.

They copy a lot of each other's products. They've been in catch-up mode on the pros business, but they've done a decent job cutting into market share. And all in all, Home Depot and Lowe's have just eaten market share from a lot of the mom-and-pop shops. The other thing I'll mention here, 2018, Bill Ackman made this 25% of his portfolio at Pershing Square, and he still owns 1% of the company today. So it's not a big piece, but he is still involved. Yeah, and a big piece for him. So there's some letters from Pershing Square that we'll include in the source notes here. Let me hit the industry and competition.

As anyone might expect, Lowe's clearly has a large trustable market. It operates in the home improvement building space and manages the annual spending there at approximately $1 trillion. So you look at Home Depot, you look at Lowe's, they're at approximately, I think, $250 billion in revenue. Home Depot is slightly larger. So Lowe's at $96 billion in revenue or just slightly under $100 billion is closing in on around 10% market share for the entire industry. So they are a large competitor, but they're not anywhere near.

If you look at Home Depot and Lowe's combined, they're at about 25% market share. And if you look at some other retail concepts or some other, I guess it's different industries will have different market shares for the leaders. and when these duopolies form, you typically see the market share is higher. So I think that's a big positive for me is you wouldn't be surprised if that's inched up to 30, 35%, 40% over the next couple of decades. Yeah. And I'd add, although Home Depot's store base is not really that far off from Lowe's, they are about 50% larger in terms of revenue. I'm not sure, the numbers were a little bit confusing in terms of what you mentioned there, but 50% larger, pretty much. Yep. Yeah. And well, combined Lowe's and Home Depot do about $250 billion in revenue. So about

25% of the market. And if you do the math there, that means Home Depot is about $150 billion in revenue. And that comes into the pros business, which we'll probably discuss later. They can divide the, or excuse me, you can divide the total addressable market into half pro customers, half DIY individuals, but Lowe's serves about 75% DIY and 25% pro at the moment. So they're skewing much more to DIY, which may have higher margin, but they're sacrificing a lot of revenue to the competition, such as Home Depot. They want to expand the presence of Pro this decade, or I guess just make a better product for them. It's something they were behind for a long time. And again, we'll discuss that later. Management says that there are three factors that affect,

or at least three macro factors that can affect the demand for its business. This is personal incomes, age of the housing stock, and home price appreciation. And age of the housing stock just means average age of a home. So are they average? Were they built 40 years ago? Were they built 30 years ago? Today, the average age of a home in the United States, I believe, is 41 or maybe 40. I'll have the chart in the newsletter. It's pretty easy to find. And that's up from about 31 in 2005. So the housing stock in the United States is getting older, and a lot of it is going into renovations for these houses, which as a home improvement store is something that benefits Lowe's. Now, if you look at competition, there's tons of it out there. Given it's a

trillion dollar industry, you can probably divide this competition into three different categories. One, how it just has itself, say Home Depot, the leader in the space, the only one that's really the copycat of Lowe's or the one that are the duopoly, the same sort of national brand within this. I know there's regional brands out there. And then second is the regional and local competitors. These are the mom and pop shops, the small and medium-sized businesses, the local chains, the regional chains, they compete for these broader home improvement stores. For example, in our small college town, we didn't have a Home Depot or Lowe's, but we had a town building supply thing that provided tools for DIYers. It looked exactly like a Home Depot

or Lowe's, but just a little smaller. It was for that specific geographical area, which is focused more on farmers and serving the college research labs. But besides that, if that turned into a Home Depot or Lowe's, I don't think it would be the same thing. It was essentially the same sort of product. So that's still a big competition out there. And then third one is the niche offering brands, which would be something like a sherwin-williams store who is also a supplier to them there is florida core there's ace hardware there's a lot of stuff that serves these niches i think florida core is a very interesting one that's an up-and-comer uh maybe tractor supply to some extent tractor supply to

some extent as well there are a lot of if you look at los and home depot they cover so many different products that some people can attack them from these individual things like if you go to a sherman williams store you're going to get better served on paint but you can only get paint so it's a give and take there all right let's move to management ownership unless ryan you have anything else to add before we move on no obviously a huge addressable market here but they have done a pretty good job both combined lows and home depot really eating into the market and i think i think think the big takeaway for me would be they still have room to steal share from a lot of the mom and pop providers. Yeah. It'd be interesting if they eventually start trying to grow store count or

buy out these local mom and pop providers in certain areas across the country. Again, our college town was a clear example of that where they can do that. I'm not sure if there's an opportunity there or not, but yes, the market share isn't as big as you might think. And it's easy to see why they are going to have better value proposition for everyone. It's similar to Walmart. It's similar to Amazon. They can have a better price, same margin. They're going to negotiate with the suppliers better. Okay. Management and ownership. Lowe's is led by Marvin Ellison today. He is someone who has been around the retail business for a long time. He was appointed CEO of this company in 2018 after getting appointed to turn around

JC Penney. Before that, I don't think we can fault him for the company failing there, but I think he was given that JC Penney job because he has a great track record. And if anyone could fix it, they could, but that probably was an unfixable business. Previously, before the JC Penney tenure, he worked at both Target and Home Depot. The Home Depot experience is quite interesting. Here's a quote from his bio, quote, he has extensive experience in the home improvement industry having spent 12 years in senior level operation roles with the home depot most notably he served as executive vice president of u.s stores from 2008 to 2014 dramatically improving customer service and efficiency across the organization and as he oversaw u.s sales

operations installation services tool rental and pro strategic initiatives it seems like he's taking all of that and applying it to Lewis. What do you think? Yeah, I totally agree. What are your thoughts on Marvin Ellison in general? Perfect pick for this company. Yeah, I agree. I wonder how old he is because he has been in the industry for 35 years, but doesn't look that old. I guess I didn't check. I'm guessing he's probably in his 60s or late 50s. Yeah, just based on looks, He looked fairly young, but it might be an outdated picture or something. No, he seems like he has a really good grasp on the operations and how to actually serve the customers, which is, in my opinion, kind of the hard stuff. It's a complex industry.

Yeah. If you put me in charge of customer stuff here, I would be lost. It's very complex. yeah i mean you look at the pros business like there are so many nuances and little things the pros need like uh loading help or you know their own software dashboard that tracks how much they've spent on lumber how much they've spent on all this different stuff that's like you need someone who knows the pros business which marvin ellison seems like the perfect guy yep and they do i think it's funny. I find it funny when they talk about continuous improvement, kind of stealing that from

some of the other companies that use that. But I think that's also a good thing to do, have that sort of mindset, have that sort of culture thing, even though it might just be plastered over a bunch of IR presentations. If we look at executive compensation, they use the standard base salary, annual bonuses, and stock awards. If we look at annual bonuses, pretty good targets here. You have sales targets and operating income targets. I think those are both solid, and then you have a tiny amount is based off of pro sales growth and inventory turnover. And if we look at their performance stock units and options, they are based on ROIC hurdles, or some of the options are time-based, but they have the performance stock units that

are return on invested capital hurdles, and then total shareholder return hurdles relative to the S&P 500. I find those both to be fine, and that should incentivize them to continue repurchasing shares. I would say if we look at their ownership page, nothing special, no real insider ownership, basically just a bunch of investment banks and passives owning it here. It's just a lot of the big funds, as you might expect with one of the largest companies in the world. Super boring there, nothing exciting on the ownership page. However, for a company repurchasing a lot of stock, this should give them endless firepower to repurchase more shares because you can just buying back from all these passive holders. Okay. Let's move to the financials. Ryan,

what do the earnings look like for this business? So I'll go just through the last 12 month numbers and then talk about the decade as a whole. So last 12 months, they did $96 billion in revenue. Revenue has declined slightly due to weakness in the DIY category. And then also there was a lot of lumber inflation that they're starting to lap. And so as the costs come down from their suppliers, they're passing through some of those cost savings to the customers, which leads to kind of headwinds on the top line. However, the operating income has been a little more consistent. So there was like, I think, a 4.5% total revenue decline for Home Depot the last quarter, whereas operating income was, I want to say almost flat. I'll come back to that.

But $12.2 billion in operating income, $9 billion in earnings before taxes. there is a lot of interest expense here because they do load this thing up with debt. But over the last 10 years, revenue has grown at 6.5% annually. Store count's actually down, but part of that's from selling the Canadian business. So revenue grown at 6.5%. Operating margins have gone from 8% to 13%. And now still at 13%, it's like 12.8%. And then earnings per share is up 18.5% annually. I put here in parentheses, God bless that buyback. They have used all their cash and then some to repurchase shares, which is really, you can see revenue growth plus margin expansion, plus a great buyback program that is a recipe for

great shareholder returns. Anything else there? Nothing. Pretty simple. It's been a pretty simple story after the great financial crisis. They are a bit cyclical because like I mentioned, they said there's three macro factors, personal income. So during a recession, they're going to get hit. Age of the housing stock, which I guess is more of a durable tail end, but then home price appreciation, which I guess some people think home prices can't fall, but there is a chance we'll maybe talk about it later. It has stagnated after the mortgage rates started to rise again. So that could be another factor affecting people or affecting their business. Yeah. And the other part is just,

There was just a lot of home renovations during COVID, which coming out of that, it's been a tough market for them on the DIY side, but the pros business seems to be pretty steady. When we look at the balance sheet, $3 billion in cash. They do have a lot of money tied up in inventory, as you might expect, and then they own 90% of their stores, so $17 billion in property value, essentially. I don't know. Probably doesn't matter unless you're liquidating the business or anything, but just worth noting, I thought. Liabilities, the big one here is that they have $36 billion in long-term debt. They've done a wonderful job structuring their debt. 70% of it is due after 2027. The weighted average interest rate is 3.8%, and their net debt to EBITDA is basically at three times so they have used that debt to basically buy back shares and juice the earnings per share

and i would say it's probably been one of the best levered buyback programs i've looked at over the last 10 years i'm not probably haven't seen that many but they have to just match all right yeah the i'm thinking moving forward rates are a little bit higher so they've had a couple rounds of new bonds they have offered at slightly higher rates. But even at those rates, they're getting a good return because they're getting good returns on invested capital and new stores and stuff like that. And then they're also repurchasing shares at what, basically 6% or 7% free cashflow or operating income, operating earnings yield. So really, it feels like they can continue to do it. maybe from here, they start to buy back a little more. They start to use more of the free cashflow

to power the buybacks as opposed to the debt, just because debt's been so cheap for them over the last five to 10 years. But really I thought all in all, this is probably one of the better balance sheets I've ever looked at. Yeah. And you mentioned new stores, but part of their strategy is really not to open stores. So I think I'll just make that clarification for listeners. It's more of running the existing stores and the supply chain and stuff. Yeah. It's mostly technological investments, but they're not avoiding new store openings. They do open some, but they're just basically reassessing their real estate footprint and they also close some. So it's been essentially breakeven.

Yeah. All right. Let's hit valuations very quick here. With these share cannibals, a lot of them have run the levered buyback strategy. So I like to look at the EVD operating income and then price to free cash flow. Price to free cash flow, again, it's just taking the market cap. So you can look at the price versus the free cash flow and how much firepower they have to buy back stock. Current market cap, 128 billion. Current EV, 161. EV to operating income trailing is 15.9. So a little cheap. The market might be pricing a little bit of a decline here over the next few quarters on their business. I think people are worried about that from the come down from COVID. And then we got price to free cashflow, it's 21.8. So significantly higher

and their cashflow, it is a little bit lumpy. And I think right now we're in a little bit of a lumpiness where it's way below their operating income, but typically it has been below their earnings. So I think that's one disadvantage of this business. As I mentioned, a lot of inventory. They're not going to generate a working capital advantage. In fact, they're going to have probably a working capital disadvantage. So that's something that's going to hurt them, but not too much. It generally, cashflow, if I looked at a long-term chart, generally tracks operating income, but just slightly lower. All right.

Any little evidence, Ryan? Probably not too important here, but what do you think? Anything important for listeners? Yeah, I think I'm kind of the same as you here because I'm reading yours. when i think okay i need to go get something to whatever something industrial it's i always think home depot like it's just the first thought in terms of where i go but i've been in some lows and they're really not that different for some reason the home depot brand just is kind of the first thing that pops into my mind yeah i go to home depot for some reason but no i think i'd be

happy at a Lowe's I don't know why I go there maybe it's just closer from my house Lowe's always has like that really sweet lawnmower setup right out front you ever see it's like just like just rows of John Deere yeah I guess uh all right any else before future growth opportunities no I don't think so okay what do you you got the important one so why don't you talk about the pros penetration because this could be the biggest growth driver for the next decade or so yeah so you know despite its roots being pretty much based in the contractor's business lows i've already talked about it but they've been behind the ball when it comes to properly serving the pros group and so there was actually on a recent uh at a recent conference

Marvin and Ellison went through when he stepped in the changes that they tried to make. And so he said when he got to Lowe's, they ran a survey of contractors or tradespeople that had left Lowe's and started shopping elsewhere. And they said, basically, why did you do that? And he said, there's five things. One, they said Lowe's is always out of stock. Two, the associate training consistency is all over the place. So some of the associates know what they need. some of the associates have no idea. It's basically like they're not getting enough consistency. Three, they can never count on Lowe's to have loading assistance, which is very basic and fundamental. Four, they said, you can't distinguish me from anyone else.

So if I'm sitting in line, I'm paying the same price as everyone else. I'm sitting in the same line and I'm buying $100,000 worth of something over a certain time period and they're buying $100. Five, they don't have the national brands. They had this big move to private brands. And because pros are so brand loyal, it was kind of a motivator for them to leave. They say they've been working on all of this and it's starting to bear fruit. There has been 600 basis point improvement in their pro penetration as a percentage of overall sales. And that's at a time when do-it-yourself is actually growing as well. So it seems like they're taking the right steps, but I just think like, I did like kind of this long, I read this long comparison

right up on the two programs, the two pros programs, Lowe's and Home Depot. They seem very similar. So I wonder what's driving Home Depot's big success here. I think Lowe's just bad at it for many years. It's going to be a long road of Lowe's to gain some market share but i can see it happening it's just gonna be long and steady and not gonna be overnight yeah i did see one thing that said home depot is just has better like uh business management tools if you're a contractor so if you're like a big business and you're like you can like send runners to get the stuff and it's like just the software is all easier from home depot but it's kind of just anecdotal from a couple couple surveys all right well that leads

into uh yeah leads into my future growth opportunity is the getting off of the legacy software and operating systems they identified this a couple years ago i think it was probably when ellison took over as ceo so when you look at a core future growth opportunity for lows it's really difficult because they just want to drive more volumes into their existing stores and ride u.s economic growth there's not some crazy thing that product they've come up with maybe the pros thing was a big focus but one way they are trying to you know reduce friction and hopefully that which leads to increasing volumes better efficiency is to get rid of the legacy software programs that they had for decades and upgrade the entire lowe's ecosystem to modern software

programs modern systems which can really help the omni channel experience so it'll make it easier for them to serve pros individuals ecommerce delivery basically everything a lot more seamless for their workers which is a lot more seamless for their customers hopefully it leads to steady comp sale increases or growth even without increasing much in cost if we look at this chart that'll be in the newsletter in 2019 they're on 90 legacy systems and by 2024 they plan to eliminate all of the legacy systems into modern systems which i assume are just internet connected cloud connected not really bulky old products and hopefully getting everyone in real time all into this lowest ecosystem to help a store run much more efficiently for their customers which will make

make them more money and make their customers more happy. Yeah, that's really it. I mean, the total home strategy, it's kind of this general concept that they talk about every single quarter, but it's really in just the very basic fundamental things that they're improving, which is kind of hard to talk about as an investor.

It's kind of just this amalgamation of tiny improvements that has driven improved sales per square foot. Yeah, 100%. And inflation. So inflation is nice for them. Inflation is very nice. Okay. Let's talk about highlights, lowlights. Ryan, what do you got for us? Highlights, I mean, it's obviously a very durable business. It's been around for a long time. It feels like they have some good tailwinds at their back. It also has clear economies of scale. So two-thirds of their sales are,

well, this is more for the durability side, but two-thirds of their sale are non-discretionary according to Ellison. So that tells me that they're not going to have... If real estate transactions or the real estate market falls 20%, because so many of their purchases are non-discretionary, they're not going to fall quite as much as the real estate market. They're not going to be as cyclical. The second one is they get better rates from suppliers because they're huge. And suppliers know that they're going to drive more volume. Go look at a company like tracks and look at their financial statements and it'll say you know 50 of our sales come from two customers and you're telling me that trucks isn't going to give them sweetheart deals i think that's

just gives them gives them further advantage over this mom-and-pop shops yep textbook definition of economies of scale yeah and then the second one i think it's honestly a positive that they've They've been kind of losing to Home Depot in a lot of ways, and yet the returns on invested capital and the improvements in operating margins and operating income has been so solid because it makes me feel like if they start to really make up some ground on the sales per square foot or- Well, which they are, which they are the last few years. Yeah.

Then I think it's going to look even better. The other part is, it seems like so much of the focus from analysts and investors is like, how's the competition? How are you faring against the competition? When in reality, they're growing on their own. It's still a good business, even if it's not as good as Home Depot. Third one, I kind of like that Ackman is involved, even though he's not that involved. It just kind of gives me, he's owned this for a long time. and his core positions have been really, really good investments.

Yeah, anything's complicated. I don't like Ackman being involved because he seems to, whatever his track record, that's not the best, but a simple business, an operating business, something that's not a roll-up, something that's just, look, this business is whatever, it's undervalued, it's a great brand, blah, blah, blah. He does this one thing, Chipotle, Hilton, Lowe's, Canadian, the railways.

I mean, he's one of the best at that, at identifying those. Yeah, 100%. Lowlights for me, though, is, I know I just talked about this, but they are losing to Home Depot in the pros category. And they've been so far behind the ball that I wonder if they have Home Depot as such an advantage in the pros that it's going to be hard to catch up. Who knows? Honestly, it doesn't feel like there's a lot of lowlights to me. ties to the real estate markets, probably another one, but it's not, I don't know. It's not that cyclical. Yeah. I mean, it's a short-term thing. I think that's worried for me is I have hit one

of my low lights is the 2020, 2021 housing bubble could be worse than we're thinking, or the fallout from that boom could be worse than we're thinking. They're still going to be able to rise the growth in personal incomes. I mean, where do you think the UPS raises are going? they're going to be spent at lows in Home Depot. And aging housing stock is going to continue to help them. But if home prices stagnate, it's going to be a headwind. And if we don't actually have a big undersupply of housing, which I don't think we do, I'm on that camp because it's a very hard, there's a lot of arguments both ways there. I think they could face a headwind from that in the next five or so years. Is it going to kill the business? No, but this could be not the

cyclical trough as people have maybe talked about in 2023, but maybe the beginning of the cyclical decline for the demand for the next few years. It doesn't destroy any of their competitive advantages, but it could lead to near-term underperformance and could probably lead to a good buying opportunity. But yeah, it might mean the stock's down 30% two years from now. All right. What about highlights? I mean, like with all these share cannibal episodes, there's really a lot to like i find a lot to like with a lot of these share cannibals that have outperformed their duopoly they are doing all the right things to increase their competitive position uh they have good management they treat their customers and employees well i think they

mentioned that they've increased wages to employees by 3 billion since 2018 2019 so they have no problem with that or maybe you're concerned for a walmart where you're getting these ups drivers you're getting these chipotle workers you're getting these amazon warehouse workers costco employees that are getting paid so much now which is a good thing but some people are maybe gonna have to catch up and that's gonna hurt them low seems to be one of the ones that have already you know been proactive with this which is a good thing and then last one most importantly they consistently return cash to shareholders pretty simple now the other low light i would hit is that i think there's a chance they get a little bit attacked by these niche

competitors such as florida core over the long term but otherwise from a competitive standpoint i don't it's hard to argue there's a company or if you want to lump home depot and there are two companies in a worse position in retail i think or excuse me better in a better position than them and i think the only two maybe i would argue would be amazon retail and costco but curious if you have any thoughts on that no i mean they seem to be honest like if i had to close my eyes for two decades and say which businesses are for sure do i do i feel like are for sure going to be around los and home depot would be really at the top of the list especially among retailers yep so hard i mean you can't really do this online and well you do some of it online but it has to

be very can't just be a standard buy the button it has to be hard to do streamer online yeah and if it's online it's not really online it's like okay we can help you deliver this lumber to this pros place to maybe skip the store but you still need a very customized service for that yeah 100 uh all right okay you want to go ahead and with the bull case what some numbers here what how How could the stock perform here based on some estimates you made? Yeah. I think they're in a pretty good position, honestly, to generate double-digit returns from here. So I put the numbers down.

I said, if they grow their sales at the same rate as they did over the last 10 years, which I don't think is that unachievable, to be honest. There can be some headwinds with the real estate and maybe this DIY. Inflation could be a factor, but it's unpredictable, I think. Yeah. But I mean, they grew revenue by 6%, 6.5% over the last decade. So I said, if they grow revenue at 6%, margins stay flat, actually down, and they just stay at 12%, and they use all their cash flow to buy back stock, you're probably going to get 12% to 13% earnings per share growth over the next 5, 10 years.

If the multiple drops, yeah, you'll get some multiple compression, but that means the EPS figure is going to grow even higher because they're so committed to this buyback. Or they could even take on more debt from here and juice the buyback even further because I think, frankly, a business this predictable could run at more than three times leverage. You're going to get good returns. You're going to get at least double digits. And honestly, it's not a demanding multiple here. I think it's like 16 times EV to operating income. That's exactly right. That's in line with the historical average.

Yeah, exactly. It's not some sort of peak year. We're not also at the peak 2021 earnings anymore. I would say I think margins can probably rise a little bit, which can be a big factor. you know, if something goes from 12% margins to 15% over a long time period, that can be a huge boost, especially if sales are durable. And for me, the bull case has to be kind of look at it and you can put exact numbers on it, but we don't know what the exact numbers are going to be. They need to be confident in probably three things going right for you, which is one,

consistently positive comp sales, which is probably pretty easy for them to do as long as there isn't giant deflation. If that happens there, we got more problems on our hands. second one steady margin or not compression i wrote compression but i mean basically it stays the same or goes up so expansion and then second or third excuse me consistent dividends and share repurchases which i think they'll continue so you're really betting on the only thing i don't like it as much about home depot and lows is you're betting a little you're taking a little bit of a macro bet i think whenever you buy one of these things at least for your timing at the load of multiple you're not but i think a little bit sometimes like if you bought okay

the multiple didn't look crazy in 2021 but you had the macro had to come into factor for you because it was a bad time to buy macro macro came into if the multiple probably didn't look that great in 2011 but you had to make a little bit of a macro bet there i mean ackman made a macro bet when he bought lows in 2011 i don't think it's crazy to make that bet but it's part of the the It definitely comes into play here. I think a lot of people say that it's kind of a bet on housing in a way, but I think it's kind of muted relative to housing. Obviously, there's correlation, but you're basically betting that the U.S. economy does fine. Yeah, well, what's the U.S. economy?

a lot of it's housing yeah but also like savings rates like you're just assuming that you know we don't go into depression yeah where that where the savings come from housing i don't know there's a lot of ways to go about it it's not the everything but i think it's part of it is if you look at yeah i don't know if you just look at the revenue over the last 20 years i i've only looked at it over the last 10 but i assume you're going to see uh the competitive advantages shine through more than anything yeah yeah yeah but the mac i mean yes over the long term yes of course but i think this is one where i look at it and say that can help me find a good entry point where i want to buy this when the economy's in the tank

because i mean yeah we have we have no we have such a bad barometer for the mac for the economy as a whole like yeah but you can know when i mean it's after it happens so you can buy it like after the bad news is there i mean i mean two years two years of diy sales declines in the mid single digits is i mean that's you could call that ralph fernandes yeah that's true who knows but yeah i mean i think it's more of a like the uh look uh more of a recessionary period not a bullet from the pandemic i think another macro bet you're kind of making is the what's benefiting them or is going to benefit them is the people locked into the three percent mortgages which are not going to be leaving their houses or at least more of them are not going to

be leaving and they're going to take that money and they have these record home equities and and they're going to improve their homes to hopefully eventually sell them. Eventually they will. So I think that's going to be a benefit for them. But again, you're making a slight interest rate bet there, I think. It's not the entire thing. It's not a huge factor, but I think it's something. Now, what do you think for you, Ryan?

What do you think is your bear case? I guess it's that. I think if there is enough ties to the housing market here that People, Burry called it whatever, slow plane crash. Basically, if there's less movement for homes or housing in general, it could just lead to, I think, lackluster DIY sales growth. Now, I still think regardless of the amount of transactions or home sales, I think people are still going to be improving their home more and more every year. So I think it's muted in terms of cyclicality relative to real estate as a whole, but it could lead to lackluster growth, especially relative to the last 10 years, which would lead to more like mid-single digits, maybe a high single digits earnings per share growth as opposed to double digits. Yeah. And that's mine as well, where all those things, those factors that we talked about, when they

come together, they can create really, really strong double-digit returns that are durable. But like Ryan mentioned, if they see comp sales kind of stagnate, that's probably going to impact margins. And that has a compounding effect. So they could see margin compression there. And that's really what happened. It seems like one, and again, this is just like AutoZone with some of these great share cannibals with durable businesses.

It seems like it's hard to lose money over a long enough time period, because I think over the next 10 years, they can probably generate close to their entire, at least market cap, not enterprise values, entire market cap in cash. But I don't know if this is the best entry point. More or less interested, Ryan, as we close things out, what are your final thoughts here? More interested. i don't know if i'm a buyer right here but this is something i would be really interested in owning it's same i think maybe even more so than auto zone because i with auto zone there was kind of lingering ev concern which is maybe going to eat away over time that's 15 years 15 years i know but eventually it starts to hit the top line maybe maybe i don't know if it's 15 years

before they start to see less cars coming through anyway that's a different discussion but i think there's less terminal concerns for lows here and it trades at a similar price they're just as committed to the buyback management's very competent and the growth seems similar really yeah i'm more interested as without his own i'm looking for the earnings multiple to be lower for share cannibals. They're something that I think people underrate is a share cannibal trading at 10 times earnings, where it gives you an incredible amount of margin of safety. That business is durable. So I'd look for them at a trough earnings multiple of 10. Now, that may never happen or it might not happen for a long time, but it's got to stick on the

watch list. And unless something drastically changes with this business and they come up with some boneheaded strategies, it is an incredibly easy buy at 10 times earnings. with their competitive advantage and it could happen. And they're not too far away. It'd be a 30% drop from here or something like that, but that's what I'm waiting for. Okay. The EV to EBIT for Lowe's in 2015 was basically 17 times.

yeah since that point returns are 450 percent total returns yeah and what are their margins i mean less less less and not the housing boom yet like beginning of a housing boom like two three years into a housing boom after a terrible crash yeah but this is a business that's 50 years old. There's been a housing boom for the last 100 years. I think it's probably more likely that continues. I mean, there's a lot more

variables there. I don't know. I think they just have a ton of... If you have a really ultra long-term portfolio, I could see Lowe's getting in there right now. Yeah.

Like I said, I don't think you can go wrong with it. What's the biggest holdup for you to owning it today? I think it's just that the housing market right now is just incredibly uncertain. What do they say? It's like unprecedented, you know? Like all the stuff, all the factors.

We don't know what's going to happen. I think that's just something that's holding me back. And like with these companies, with competitive managers, Autosun's the same. I want to buy them during a procession. If you're confident that the competitive advantage is there when there's a recession in the economy, I want to buy the stock. Trying to find their EBIT in 2008.

Well, it'd be more 2010 when the actual numbers came through, but yeah. It dipped like- But here's the thing, the numbers aren't going to look that good then, right? right what i mean like their earnings multiple might not it's the you know they're going to be earning less so their earnings multiple might not look that attractive no i'm that's what i'm i'm looking at there 2010 and it was down it looks like maybe 20 from the 2008 highs beauty let's have that happen again what is do they have a better business today

would say uh yeah yeah for sure especially the new management team eb to ebit right before 2010 got down to eight uh maybe that doesn't happen again but i just want to be extra picky all right well more interested for me stock for next week discover no this is a weird one this one people either love or hate because they they look at the brand but i think we'll get into a big time share cannibal might even you know i think this one's trading at less than 10 times earnings but a little more hair on the bone than both autozone and and los yeah this one has actually last like three years i think it's probably taken out the most shares of anything i've seen let me see all right well that's a good little teaser don't don't get maybe give the

number if uh if you give it but i'll go through the disclosure and we'll get out of here all right you have it in the last since 20 in the last three years shares are down 18 and a half percent yeah that's solid yeah okay i was thinking more like 30 but yeah still pretty good and that's a nice little tease for next week kind of an interesting company all right let's hit the disclosure and get out of here we are not financial advisors anything we say on the show is not formal advice or recommendation we are general partners at arch capital and clients may hold securities discussed in this podcast. Thank you everyone again for tuning in. We're closing out the share cannibal month. AutoZone was last week, this week Lowe's, next week Discover Financial,

and the week after Sprouts Farmer's Market. We'll see you next time.