Lowe’s Companies, Inc. (NYSE:LOW) Goldman Sachs 29th Annual Global Retailing Conference Call September 8, 2022 1:00 PM ET
Company Participants
Marvin Ellison – Chairman, President and Chief Executive Officer
Conference Call Participants
Kate McShane – Goldman Sachs & Co. LLC
Kate McShane
Okay. Thank you for joining us today. We are starting the afternoon session here with Lowe’s. I’m very happy to introduce Marvin Ellison, CEO of Lowe’s, who is going to start us off with some prepared comments.
Marvin Ellison
Good evening, everyone. So let me start out by just acknowledging that in this challenging retail landscape, Lowe’s is very fortunate to operate in a sector that serves a resilient DIY homeowner and our Pro customer that’s in high demand. Looking out over the next few years, Lowe’s is focused on growing both Pro and DIY through our continued execution of our total home strategy to deliver continued topline and productivity. And as a reminder, home improvement is a $900 billion marketplace in the U.S. And if you combine Lowe’s and our largest competitor, we equate to roughly $250 billion of the marketplace. So as a result of this fragmented environment, we see a tremendous opportunity for continued growth in both Pro and DIY.
And since time is money for Pros, we are focused on enhancing fulfillment capabilities, getting them out fast with a simple digital experience and personalizing our offer through our new Pro MVP loyalty program. And for DIY homeowners, we are trying to make projects easier by upgrading our digital experience with them on Lowes.com, investing in a broader set of direct-to-home fulfillment capabilities and enhancing all of our product assortments with new innovative easy-to-use products. And we are also focused on our continued productivity unlock with our perpetual productivity improvement or PPI initiatives.
Look, we are pleased with our intense focus on productivity and operating margin and our PPI initiatives combined with supply chain, optimization will continue to enable us to improve operating margin to substantially close the gap with our largest competitor. So in conclusion, if you think about the four years that I’ve been the CEO of Lowe’s, we are on track to improve our sales by roughly $25 billion increase return on invested capital from 11.2% to over 36%, and improved operating margin about 450 basis points from 8.6% in 2018 to approximately 13% this year. Again, our additional approach will continue to unlock additional long-term value for shareholders and take market share.
So Kate, with that, happy to take some questions.
Question-and-Answer Session
Q – Kate McShane
Okay. Sounds great. Thanks again for joining us.
Marvin Ellison
Absolutely.
Kate McShane
We thought maybe you could start with the macro. And I guess if you could maybe reiterate and talk through again, how you are viewing a higher interest rate environment and its impact on the housing sector and what it means for your business?
Marvin Ellison
Yes. Well if you think about home improvement, the home improvement backdrop remains really constructive. So if you think about interest rates for a second, 90% of our customers have a fixed interest rate. So even though the Fed has taken quite a bit of action, our homeowners and our customers are not impacted directly with higher mortgage payments because they are in a fixed interest rate environment and most of their interest rates are sub 3%. So if you consider the impact of a customer deciding to stay in their existing home because of a low interest rate for – on a fixed rate, and because of the fact that we estimate, yes anywhere from 1.5 million to 2 million homes that are short versus the demand that’s currently in the marketplace, it incentivizes customers to actually stay in their existing home and invest in that home.
So if you think about just a couple of factors relative to home improvement, you have home price appreciation, that’s at record levels, you have roughly $2.6 trillion and increased savings versus pre-pandemic. And roughly 70% of that is in the pockets of homeowners. And that’s our core customer. Roughly 50% of the homes in the U.S. over 40 years old, and that’s probably the largest number since World War II. And we are seeing a cycle where the big home building phase that took place in the early 2000s, those homes are now turning 20 years old, which means you are getting ready to hit a whole different investment cycle. And so I can go on and on and on, but the general headline is although you are in a high-interest rate environment, the backdrop of home improvement remains incredibly constructive and we believe that it gives us a great opportunity to continue to take market share.
Kate McShane
Okay. Thank you for that. I think aside from the macro, the question that we get asked most is just the ongoing demand period for home improvement just because of what we’ve seen in the last two years. Can you talk a little bit about what’s driving consumers to continue to engage in remodeling at this point; aren’t they pretty much done with their home renovations and what they wanted to improve after the last two years?
Marvin Ellison
It’s a great question and it ties in some regards to what I just outlined. Again, for us, it’s very straightforward in the midst of arguably some really challenging macro environment with inflation and interest rates. If you are a homeowner, you are in a unique position where you have a strong balance sheet, you have home price appreciation, you have an environment where you have a shortage of homes in the marketplace that incentivizes you to stay [indiscernible].
And then you have other factors that we think are sustainable. Things like, boomers deciding to stay in their existing home and make investments in that home versus going out and going maybe to a retirement community or transition to a smaller living space. That trend was starting to occur pre-pandemic and since the pandemic is overridingly leading us in a direction where boomers are decided to stay in place, we call it aging in place. And we actually developed a program called [Luwa Home] that addresses that. I think a lot of people were surprised by the millennials and the household formation trends we are able to see in that age cohort, and we think that’s equally sustainable.
And even though the work-from-home phenomenon is subsiding somewhat in certain sectors, I don’t think any of us believe they will ever get back to pre-pandemic levels of people working in the office and not using their existing residence for home offices. And so if you take all of those things in addition to the macro tailwinds that I talked about, we think it creates sustainable demand. We think it creates demand on the Pro side and on the DIY side. And in the midst of, again, a unique set of macro factors, we think home improvement is uniquely positioned that there are a lot of tailwinds that actually support our business and we think the support is something that’s going to be sustainable.
Kate McShane
I’m going a little off script here, but I think something that you and I’ve talked about before is prior to the pandemic that millennial housing formation wasn’t even really happening at the time. So it’s kind of kickstarted a whole new generation if you will and homeowners. And so if you had to parse out, what you’re seeing is the biggest opportunity with any kind of secular change, what would you say it is within home improvement?
Marvin Ellison
Well, if you go back just more specifically to the millennial formation trends, I mean, you can go back just a few years and you would read the [indiscernible] that the millennials would be so affected by the financial crisis and what happened to their parents and grandparents in the high foreclosure environment that created that they would steer away from home ownership and be more focused on renting and the opposite occurred to your point. I mean, we saw this and our data supported that that was going to happen. So we were actually not surprised by it. But again, as we think about what other trends that we believe are sustainable, I’ll just kind of repeat what I’ve said. We think that millennial formation trend is here to stay. We think boomers living longer and aging in place is here to stay and they’re making investments in their homes to meet their changing mobility needs.
And we also believe that it’s going to be really difficult, it’s going to take a significant amount of time to close the supply demand gap that currently exists in the marketplace for homes. Irrespective of the interest rates, you currently have anywhere between 1.5 million to 2 million homes short of current demand. And it’s going to take a while for all the building activity to catch up that. And you could argue that the interest rate environment is actually slowing that down.
And as counterintuitive as that maybe in some ways that actually benefits home improvement, you can go back to the 1990s and you can see examples of where home improvement was able to perform really well in an environment of high interest rates and low housing turnover. And so it’s one of these unique sectors that we can operate well when housing turnover is robust and we can operate well in an environment when the housing turnover slows. And I think we’re proving that with what you’re seeing over the last couple of years and what you are seeing even in 2022.
Kate McShane
Okay. Thank you. So we’ve been dealing a lot with things of pandemic and the macro, which has taken up actually a good amount of your tenure at Lowe’s.
Marvin Ellison
Yes, it has.
Kate McShane
So when you think about the last four years, since you’ve been there, what have you been able to change that you’ve wanted to change? And do you think there’s still a pretty significant runway left just given what we’ve – the blocking and tackling you have had to do in the last couple of years?
Marvin Ellison
Well, I would say first and foremost, it starts with the people. And when I think about being able to put a team together of experienced retail leaders that have operated through a variety of macro backdrops, it helped to pivot a really large business and be very agile. When I think about the leadership in merchandising, store operations, supply chain, information technology, these were all areas that we really did not have depth of experience and we did not have leadership that had the capabilities and the experiences to operate a company, the size of Lowe’s and growing at the rate. So it always starts with, do you have the right team in place that can create the transformation that needs to happen. And so it starts with the team, and then it pivots to understanding the root causes of kind of why are we not performing at the levels that we should.
I mean, I have cited in the prepared comments that we ended 2018 with operating income of 8.6% when our next competitor was north of 14%, and we will end this year at 13%, but we see that as just a milestone and a stepping stone where we can continue to get better. And that meant focusing on what we call retail fundamentals. And I categorize these things as elements of the retail business that all world-class retailers are good at supply chain, merchandising, operational productivity, information technology and omnichannel, the marrying of digital and physical stores. And we were very fortunate that the investments we made in those retail fundamentals gave us the ability to meet the outsized demand that was created by the pandemic.
But the good news is, is the $24 billion to $25 billion in revenue growth that occurred during the pandemic, we are not giving those sales back. And as we grew those sales, we grew those sales while also driving outsized productivity from an operating margin and return on capital. I mean, again, our return on capital in 2018 was a little over 11%, and we’re going to end this year closer to 36%. And so we’ve made investments the right way, not just growing unprofitable topline, but taking market share growing topline, generating productivity and creating a much more healthy balance sheet by the allocation and the management of capital and those things we believe are sustainable.
So it’s not so much as what didn’t get accomplished as kind of what’s a continuation and what is a cycle of things that always occurs and one is supply chain. You never complete your supply chain transformation because customers buying patterns change, and any retailer will tell you that if they ever think that they finish with their supply chain and transforming their supply chain, then they’re going to quickly find out that that’s not the case because you have to build a supply chain to meet the needs of how customers desire to shop, not the way you choose to serve customers.
One of the biggest mistakes that Lowe’s made is that everything we did was store centric, everything we shipped, every system and every type of technology because we desired to serve the customers from our stores first. But when the customers decided that they wanted curbside and they wanted lockers and they wanted to bottom line, pick it up in store, we had to pivot. And at the time, we didn’t know how to do it. And so now we’ve created a flexible agile model that we can easily or more easily pivot to the needs of the customer.
So supply chain is ongoing, information and technology, development enhancement is ongoing. And all the things that we do is really more customer-centric and we feel like we’re in a great position and the good news there’s a lot more to do. And as we do these additional things, we think there’s a lot more value that we can create. And we look forward to in December at our Analyst and Investor Conference outlining our next multi-year strategy of our financial plan and some of the key initiatives we think that would create a lot of value for our shareholders.
Kate McShane
Great. One of the things you mentioned was supply chain, and I know that you’ve been investing in market delivery and the building out of your coastal holding facilities. So could you maybe talk through the impetus for that and where you are and within that, where do you see the supply chain today, especially when it comes to delivering for the Pro?
Marvin Ellison
Yes. So if you go back and start with where were we back four years ago, our supply chain was totally store-centric. So what do I mean by that? It means that anything that was delivered to a consumer had to be delivered from a store. And the only way the store could get credit for the sale, it had to occur from the store in which the customer consummated a transaction. So as an example, you could live in Buffalo, New York, but if you purchase an appliance in Newark for your home in Buffalo, the only way the Newark store could get credit for the sales, they had to ship it from Newark to Buffalo. And trust me stores did that.
And if you think about the inefficiency created in the cost of that for the company, it was something that we were really constrained because our systems and our supply chain was driven by the store-centric model delivered from store for the store to get credit for the sale, irrespective of the inefficiency that created. And so obviously we had to take a step back and say, we need a market delivery model and so we’re in the process of building that out, starting with appliances, where now you make the purchase either online in the store and the delivery happens to the closest market delivery point to the consumer’s home, which is the modern way to do it. But that was really difficult to do for a company our size that had a technology system hardwired to be store-centric.
And so now we’ve redesigned the technology platform. And at the end of next year, we’ll have market delivery rolled out to every geographic area of the company, not only to support appliances, but to support anything big and bulky. So think patio furniture, think grills, think outdoor riding equipment. So it literally transforms how we deliver to customers and how we leverage the entire network of our stores and distribution centers.
But then the question is, how do you serve the Pro? And so we’re creating a fulfillment network of different nodes, including market delivery that will enable us to deliver products directly to the job site for the Pro. And we’ve tested quite a few things from Pro Fulfillment Centers in Charlotte to leveraging the gig network, to try different things, to do same day, next day delivery options for our Pro customers. We feel really good about where we are.
And so as we outlined the next phase of our supply chain transformation, it’s going to be in large part about fulfillment, about creating quick, efficient low cost fulfillment capabilities that currently don’t exist, whether it is purchased digitally or in a physical store or otherwise. And we’ll lay this out in a lot more detail. The good news is, is that we’ve been able to create a lot of operating leverage and productivity in an environment where our supply chain is still being built out. And so as we start to get a fully developed supply chain, and we start to leverage that on a more continuous basis, we see nothing, but improvement in upside and we’re really excited about the progress we’ve made, but even more excited that there’s a lot in front of us that we’ve yet to do and we know that’s going to open up even more value.
Kate McShane
And so supply chain is one way that you talk about being able to cater to that Pro customer, which I would imagine drive more sales and maybe more mix going forward. But can you talk a little bit about how you’re viewing the opportunity for Pro, it’s about 25% of sales today? Is there a lot more runway to increase that and how do you approach that?
Marvin Ellison
So if you think about our current makeup, to your point, roughly 75% of our sales revenue is driven from the DIY or do-it-yourself customer, 25% to Pro. And you may think, well 25% doesn’t seem like a lot. In 2018, it was 19%. So we’ve increased about 600 basis points since 2018. And so we’re on the right trajectory. And when you think about where does the next 600 basis points come from, and how do we continue to grow it. It’s going to be the foundational things we put in place. The first thing we had to do was to get the service levels in our stores corrected. Stores were poorly staffed, associates were poorly trained and Pros didn’t trust the fact that if they showed up to make a purchase that we would have trained staff there to help them. So that was step one.
Step two was get the inventory levels right. We call it job like quantities. There’s a different inventory commitment you have to make for a Pro versus do-it-yourself customer. And then the third thing was making sure that we had the right prices and the right brands. And over the course of the past 15 years, Lowe’s exited a lot of the national brands that Pros really, really migrate to. Pros are extremely brand loyal and a lot of those brands had left for a variety of reasons and we’ve been bringing those brands back and now getting price right. And so those things were foundation. Those were retail fundamentals that I talked about.
So the next evolution was now we need to create stickiness. We need a reason for a Pro customer to bypass a competitor shop at Lowe’s, so we rolled out and enhanced CRM platform and a new loyalty program that we call MVP Pro Rewards, which allows Pros to spend more, accumulate points and it gives them a reason to come back and shop over and over again. And what’s great about our loyalty program that we rolled out chain wide this year is for customers engaged in our loyalty program and our credit program. They spend three times more per year than a customer not. So it’s actually exceeding our expectations and it’s driving – the loyalty that we hope was also driving additional trips and new customers.
And now the next iteration is what we discuss. It’s fulfillment. We need enhanced flexible fulfillment. We believe doing all of these things consistently in doing them well; we will continue to grow their Pro penetration. We purposely not set a penetration target because I’ve learned in my years in retail, if you set a target, sometimes you get too focused on the target and you lose sight of your focus on the customer. And so we have a general idea of where we want to be, and we feel like we’re making great progress. So our goal is grow our Pro penetration while still you’re maintaining strength and dominance in the DIY categories which we think we can do both. And we think this $900 billion marketplace gives us a chance to do that.
Kate McShane
And I guess that 25% too is on a much bigger sales base than it was in 2018. So you have the 600 basis points, and then just the more dollars. Is it right to think that the small medium size Pro is still your core constituency? And is that where you want to grow market share or do you want to expand the opportunity?
Marvin Ellison
That’s exactly – it’s exactly where we will grow market share for the next couple of years. I ran the Pro business for over six years with my largest competitor. And the one thing I learned in that timeframe is that you have to get the core Pro experience right first before you try to extend your business to the larger Pro because there are more demands for the larger customer. And so rather than overreaching or getting over our [SKUs] so to speak, we’re going to be really intense on the small and medium Pro for a couple of reasons. Number one, we have the ability to service that Pro through our stores and through our current supply chain infrastructure.
But number two, we think there’s an opportunity where that Pro is available for us to serve if we can be consistent with our staffing service levels and our in-stock. And so that has been the kind of the fuel behind our basis point improvement thus far. And we think there’s a lot of room to grow with that customer. After we feel good about the consistency and the sustainability of the growth there, you’re going to see us extend to the larger customer.
Kate McShane
Okay. Thank you. If we could maybe pivot to inventory. Lowe’s has been able to manage inventory very, very effectively, and it sounds like you can continue to do so as the year progresses. Could you maybe update us on where you feel like maybe you’re still understocked versus maybe any areas where maybe you have too much inventory? And I’ll ask my next question after that. Sorry, go ahead.
Marvin Ellison
Okay. Well one of the areas that I’m most pleased with when you think about the difficulties in planning in this environment is how well we’ve managed inventory. I would argue to say that we’re probably one of the only large retailers in America that can actually say that our inventory units are down versus last year mid-single digits. That took an incredible amount of work and an equal amount of collaboration between the merchandising team, supply chain and finance. And so as we go into the back half of the year, we feel that we’re in a great position, you are relative to what we had planned.
And as we think about areas of opportunity, we really don’t have pockets of opportunity that come close to reflecting how tough it’s been in the pandemic. I mean, I would argue to say that we’re probably in the best in-stock position today that we’ve been in and over three years because we had quite a few challenges as most retailers have had in managing through the global supply chain, even though a significant amount of our supply base is domestic, a lot of those domestic suppliers are still part of the global supply chain because they source in and import component parts. And so the global supply chain still challenges domestic as well as import suppliers.
Having said all of that, I can’t give you a specific category that I’m concerned with that we are not in a position to meet the needs of our customers. As I think about the first half of the year for home improvement, the first six months of the year is our most seasonal parts of the year because that’s where most of your outdoor purchasing activity takes place, grills, patio furniture, lawn and garden type products. And so you’re highly dependent on mother nature cooperating with you. And if your DIY penetration is as high as Lowe’s, then we are disproportionately impacted by weather and weather being seasonal.
We had some challenges in the first half, but the good news is, is that we are managing through that inventory the way we always have, and we have no concerns that we have significant overhang in any category going into the back half of the year or going into next year. Again, I mean, I feel really good and the work that we put in place to plan inventory in 2022, we’re putting those same efforts in place as we set our financial plan for 2023. We’re understanding where we believe demand will come from.
And the good news is, is that we’re seeing customers respond aggressively to innovation and to newness. And as we discuss on our second quarter earnings call since July 4, we have seen a positive step change in DIY demand. Our Pro business has been double-digit sales comps for nine straight quarters. And coming out of July 4, we start to see our do-it-yourself customer pick up momentum and we’ve been fortunate for the last 10 weeks that momentum has sustained. So now we have the DIY performing at a higher level side-by-side with a double-digit Pro growth. And so we feel really good about the back half of the year.
Kate McShane
Great. And then I just wanted to ask a couple of quick questions on pricing. Ticket has been strong at Lowe’s, part of it has to do with mix and the innovation you talked about, but also I think you’ve been successful in passing some price through. How do you manage the cost inflation when it comes to pricing? And do you worry at all about any kind of negative elasticity response?
Marvin Ellison
We have developed really robust processes, systems and dedicated teams to really manage cost, price and our supplier relationships. I mean, I just think back to three years ago, we had such limited visibility to what was happening in the marketplace. And when we would receive a cost increase, it was virtually impossible for us to determine the relevancy of the cost increase and if it was driven by wage inflation, if it was driven by energy costs or driven just by commodity inflation. And so when you don’t know what’s driving the cost elements, then it’s really difficult to determine if the cost increase is relevant or not, so now we’ve created this robust processing system where we literally can break down component costs of most of our categories and we can understand specifically if a cost increase is justified or not. And then because we operate in more of a portfolio type of a process, we determine what and how much of that can be passed on to the end consumer.
Now part of that determination is driven by the marketplace because our number one objective is to be competitively priced. And so we’re not going to do anything that’s going to put us in uncompetitive position either on the high or on the low. So we focus really on being competitively priced, but we also focus on making sure that we work with our suppliers and that we’re not accepting or taking a cost increase that is not justified based on our current modeling and our processes. And conversely, when we take that cost to increase, we monitor all those commodity costs really closely. So when we see those prices and those costs go down, we in turn want to make sure that we get a cost decreased. And that’s something that we didn’t have the capabilities to do as recent as two years ago.
So all that being said, we feel really good about the response that we’re receiving from our consumers. We noted on our earnings call that one of our best selling outdoor power equipment SKUs was a EGO battery operated mower that reach out over $700. We could barely keep it in-stock. And so what that means is that customers have a different definition of value. Value is not always just focus on price. It is focused on many other elements and we believe that if we stay closely engaged with our customers, we will always find the right level of elasticity from a pricing standpoint and we’ve done a really nice job so far this year.
Kate McShane
Okay. In these last few minutes, we’ve been asking the companies that sit up here with us for common questions. We’ve touched on a lot with them already. But with regards to the consumer just with – compared to where you see the consumer now versus 2023, do you think it will be weaker or stronger or about the same?
Marvin Ellison
So I’ll answer by saying that all we can do is look at the macro indicator specific for home improvement. And when we look at home price appreciation, it’s positive tailwind. When we look at the age of homes, it’s a positive tailwind. When we look at the balance sheets of consumers, you get $2.6 trillion of increased savings versus pre-pandemic levels, 70% of that is in the pockets of homeowners, we see that as a positive. When we look at boomers desiring to stay home and in agent place, we see it as a positive millennial household formation trends. And the fact that interest rates in the home shortages we’ve discussed is incentivizing homeowners to stay put and invest in existing homes. So when we look at all of those macro indicators, we see nothing happening, in 2023, that’s going to dramatically change any of the things I just rattled through.
Having said that, we also operate with a high and an adequate degree of paranoia, so because of that, we have different playbooks and different modeling so that we can be agile and we can be flexible. And if something dramatically shifts in the marketplace, we have the ability to shift accordingly, so that we can make sure that we are where we need to be to serve our customers well. But based on everything that we see in home improvement, we think that there are no signs pointing to a dramatic step down in our consumer going into next year.
Kate McShane
Okay. Thank you. The next question is on margins, we talked about before about how you now have these tools to monitor costs and what’s happening on the cost side. If we were to enter into a period of more moderate inflation or even deflation, what is your view on what would happen to average selling price and what it would mean for your margins?
Marvin Ellison
Look, we think at some point you’re going to see a normalization of unit and ticket. Since the start of the pandemic, or especially within the last 12 months, you’re seeing ticket up and that’s driven in some part by inflation. And in the other parts just by overall cost increases that, that we are strategically managing as best we can, but we’re going to start to see at some point a normalization of units and ticket.
Having said that, we again are remaining really agile and we have to remain really flexible. And we have to manage our business as that moderation takes place. Even with all that being said, we still believe that we have opportunities in any environment of ticket or transactions to still run our business really well, and to deliver continued operating margin leverage while taking market share. So in either environment, we have the leverage and the ability to manage the portfolio to manage the business well.
Kate McShane
Okay. The next question was on unit versus price. So we got that one. So the last question I have is just on promotions. It’s not something we’ve talked too much about. Again, inventories is in good place, your EDLP, so it’s not really driven by promotions, but the whole retail environment sounds like it’s getting more promotional versus what we’ve seen in the last couple of years. What is your view on that for 2023?
Marvin Ellison
You know, home improvement has historically been a very rational promotional environment. We think that will persist into next year, we see no reason or no indication that the marketplace is going to become more promotional. What I can tell you quite certainly is it will not be driven by Lowe’s. We have no desire to create an aggressive promotional environment. We’ve spent the last 3.5 years unwinding a high, low promotional strategy that we inherited, that we quickly wanted to get to a normal everyday competitive price environment and away from the high, low. And so we’ve gone through the really difficult transition period to get out of that high, low environment. We have no desires to go back. So in our retail segment, I don’t have any real concerns that you’re going to see an overly promotional environment.
Kate McShane
Okay. And with that, we’ll wrap up our chat. Thank you for joining us.
Marvin Ellison
It’s my pleasure.
Kate McShane
Nice to see you.
Marvin Ellison
Yes.
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