SHW announced preliminary, unaudited sales and earnings results for 4Q18 before the market opened today (1/15/19). Sales were lower than expected across all three segments, and our research suggests that weather drove a significant portion of the revenue miss in the Americas Group (TAG). Leaving weather aside, we are reducing our 2019 estimates as SHW continues to be over-indexed to new home construction and has a higher industrial end-market revenue base post the Valspar acquisition – both these factors could make comps and earnings more volatile if an economic slowdown were to materialize. That said, we continue to view SHW’s scale and vertical integration as a key differentiator and see SHW as a core hardlines-retail holding for investors that are looking for cyclical exposure. Even with a reduced target multiple reflecting the earnings uncertainty, we see a compelling risk/reward opportunity in the equity and are maintaining our Outperform rating.
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With bankruptcy proceedings ongoing since October, we have seen reports that CEO Eddie Lampert’s hedge fund ESL is continuing negotiations with a bid greater than $5bn. While we do not know when a resolution could be finalized, we view liquidation or continued asset disposals as likely outcomes. In this note, we analyze the potential impact to what we view as the four key beneficiaries from our coverage (HD, LOW, WMT, TGT) from a potential total liquidation of Sears and Kmart. While liquidation would likely be a headwind temporarily, it would likely drive incremental sales longer-term. The estimates below are representative of the high-end of the potential benefit and are not specifically included in our current forecasts, as many of the sales could be outright lost, could shift to other retailers not considered in this analysis (private or public), or could move online. Also, liquidation sales could serve as a headwind in the near-term as these locations close and discount merchandise
The calendar may have turned, but the challenges impacting the Food Retail and Food Producers industries remain unchanged. The groups are marred by slow sales growth, higher costs, falling returns and subpar balance sheets. We do not believe 2019 will see any deviation from these difficulties as they appear largely systemic and, as such, we continue to advise investors to underweight Food Retail and Food Producers. In our opinion, while a sharp economic slowdown would clearly hurt if it were to materialize, the Hardlines Retail industry still appears poised to see robust sales growth fueled by a strong consumer, stable margins, and higher ROIC. These companies also have solid balance sheets and a penchant to return cash to shareholders. With valuations reasonable, we continue to suggest investors overweight Hardlines Retail. Finally, the Broadlines Retail industry is seeing sales grow rapidly, in part due to the strength of the economy, but with labor expenses increasing and with the need for omnichannel investments, EBIT growth and better ROIC remain elusive for some. While this causes us to advise market weighting the Broadlines Retail industry, we do believe there are opportunities for outperformance (AMZN, DG) and underperformance (BJ) within the group.
Our key takeaway from new CEO Marv Ellison’s first investor day was that while there is an enormous opportunity for Lowe’s, the amount of work that needs to be done to realize the benefits is equally large. Store execution, merchandising, logistics and IT systems, all are in need of overhaul, but the revamped and motivated senior management team are well-positioned to drive operational improvements, in our opinion. Moreover, better capital allocation, a sharpened focus on ROIC, and a simplified incentive compensation structure that the team is set to propose to the Board, should all benefit Lowe’s over the long-term. The only missing link we see is a clearly articulated, differentiated go-to market strategy that, in our view, is key to improving sales and ultimately driving returns. Putting it all together, the sheer number of improvement projects does involve some execution risk, but we continue to believe that the risk-reward for LOW remains very favorable. As such, we are re-iterating our Outperform rating.
We had the opportunity to host SHW management on the road this week. In attendance from the company were Al Mistysyn, SVP – Finance and Chief Financial Officer, and Bob Wells, SVP – Corporate Communications & Public Affairs. From our meetings, it appears that the important topics of relevance for the equity are the near-term housing market trends, the need for price increases, cost inflation, and SHW’s industrial business.
Today (12/6/18), Home Depot hosted a sell-side lunch with CEO Craig Menear and CFO Carol Tomé in attendance. The management team highlighted a continued focus on capturing more share of the Pro market, improving associate productivity, and enhancing its omnichannel capabilities, particularly in the B2B category. Further, the team acknowledged an aggressive stance on share buybacks, raising the company’s share buyback target for the year to $10bn from $8bn, which was just raised from $6bn in the company’s most recent earnings (11/13), as management believes the equity is currently trading below intrinsic value. The stock is down ~0.3% today.
Best Buy’s 3Q19 results last week, while ahead of Consensus, missed our estimate for U.S. sales, and the mid-point of the U.S. 4Q comp outlook was slightly below our expectations as well. Indeed, if we have a concern it is around the slowdown being seen most visibly in the housing market, and the potential that it could start to depress sales in important areas of the store such as appliances and home theater systems. Add in the possible impact of tariffs and the recent swoon in the equity markets, and we believe that the risks around the equity have increased. With that said, the current economy remains very strong, core middle income households are experiencing good wage growth, and the future is far from written around tariffs and the equity markets. Balancing a solid holiday outlook and reasonable valuation against rising uncertainty for 2019, we remain Peer Perform rated on the equity.
Lowe’s 3Q18 results were highlighted by weaker comps, in-line EPS, and slightly reduced guidance. Near-term results, however, are less important in our minds than the longer-term plans by new management. While the team appears to be taking appropriate steps to rationalize the asset base, we expect 2019 will be a year where this strong new management team puts in place the building blocks for the future. In doing this, there is likely to be organizational friction that could lead to some sales headwinds. Given this backdrop, it is important, in our opinion, for CEO Marvin Ellison to simply frame-out the strategic vision for Lowe’s employees and shareholders. Our research suggests there are three big buckets that should be focused on: 1) improving store execution, 2) gaining labor efficiencies, and 3) differentiating the go-to-market strategy. We see significant opportunity in all three of these areas which should lead to much higher earnings over time, and as such, we are reiterating our Outperform rating.
Target reported 3Q18 comp sales of 5.1% (vs. Wolfe 5.8% and Consensus 5.5%) and Adj. EPS of $1.09 (vs. Wolfe $1.09 and Consensus $1.11). Sales were ahead of the company’s previous guidance for 4.8% but appear light of expectations. Guidance for 4Q18 comp sales is approximately 5%, in-line with our 5% estimate and ahead of Consensus 4.4%. Guidance for full year Adj. EPS of $5.30 to $5.50 is unchanged and implies 4Q18 Adj. EPS of $1.42 to $1.62, bracketing our $1.47 and Consensus at $1.52. The significant takeaway from the quarter is that gross margin declined approximately 90 bps, well in excess of what we were forecasting. While there are multiple contributing factors, it is clear to us that Target’s omni-channel initiatives are pressuring margin significantly. The challenge as we see it, and one of the major reasons we downgraded the equity to Peer Perform after last quarter, is that any sales slowdown from the current pace is likely to meaningfully pressure results. Call at 8:00am ET.
Home Depot reported a better-than-expected third quarter yesterday morning (11/13/18) and lifted its outlook for the year. However, the equity continues to flounder as concerns mount around the economic cycle generally, and the health of the housing market specifically. We recognize that the housing-related data has weakened over the last six months, with the down mortgage applications this morning representing “Exhibit A” in this trend. The challenge when evaluating HD is that the future is far from written whether we see an economic downturn in the near term. With that said, Home Depot is a best-in-class retailer, with an equity valuation that is below historical norms, both absolutely and relative to the S&P. Balancing the uncertainty around the macro backdrop and the strength of Home Depot’s franchise, we continue to believe the risk/reward is favorable for owning HD shares.
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