DA Davidson downgrades Lowe's on performance against Home Depot

Lowe's (LOW) has received a downgrade from D.A. Davidson, lowering its rating on the stock from Buy to Neutral. The firm cited expectations for a potential pause in the company's momentum. D.A. Davidson Managing Director and Senior Research Analyst Michael Baker joins Market Domination to discuss the call.

Baker notes Lowe's has been "a great stock," adding that the company has outperformed its close rival, Home Depot (HD), significantly closing the margin gap between the two companies. However, he expresses skepticism about Lowe's ability to narrow the rest of the margin.

Baker praises Lowe's current management team as "brilliant," crediting it for the company's success since CEO Marvin Ellison joined in 2018. However, he notes the company is now becoming a "victim of their own success." Baker recommends that Lowe's shift its focus to the Pro segment, an area where Home Depot currently holds a stronger position.

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Editor's note: This article was written by Angel Smith

Video transcript

JARED BLIKRE: Long-term bulls on lows are simmering down on expectations for the stock. D. A. Davidson downgrading the company to neutral from a buy. Noting that shares are due a pause.

Here for more on this is Michael Baker, D. A. Davidson Managing Director and Senior Research Analyst. Thank you for joining us here today. Just give us your big picture overview of your call on Lowe's.

MICHAEL BAKER: Sure. Yeah, it's been a great stock. I find it really interesting that Lowe's is outperformed Home Depot six years in a row and 7 if you include 2024 year-to-date. Much of that is because they've been able to close the margin gap. Six years ago in 2018, it was 600 basis points.

Now, it's about 90 basis points. So it's 85% of the way narrowed. And we just don't think it's going to be that easy for them to narrow the rest of it. In fact, we think the margin gap might even widen a little bit more towards Home Depot's favor this year.

And so if that outperformance has been driven by we think, Lowe's ability to close the margin gap. If that's no longer the case, then we don't see Lowe's necessarily outperforming Home Depot as much this year.

JOSH LIPTON: And Michael, to be clear, too, it's not like you seem to have any kind of issue with CEO Marvin Ellison or the leadership team? In fact, you still sound like you remain a fan.

MICHAEL BAKER: Brilliant. Absolutely brilliant. They came in 2018. Lowe's was a good concept from a consumer standpoint, but arguably was not as well run as Home Depot. Marvin Ellison, of course, came from Home Depot. A stop at JCPenney. But spent 12 years at Home Depot.

Sort of knew the playbook we think on how to turn Lowe's around, brought in a very talented management team around him, and has really succeeded tremendously again. Closed 85% of the margin gap. It's been quite remarkable.

And we're still huge fans of Marvin Ellison and his team. It's just that a little bit of a victim of their own success, again, having closed 85% of that gap. The rest is going to be a little bit more difficult.

Now there's still a pretty big sales productivity gap primarily on the pro-business. And that's the next thing what we think they work on. But our view is, A, that'll be harder, and, B, the valuation sort of reflects that a little bit more now.

Lowe's at 21 times forward earnings. That multiple has expanded by 400 basis points year-to-date. And it's towards the high end of where Lowe's usually trades.

JARED BLIKRE: And so you talked about a couple of things that they need to work on. Is the strategy now the big turnaround winding down? And now, they just have to execute in various areas, just kind of cleaning up.

I'm just wondering what the strategy here is. And is there going to be some kind of retooling for another grand strategy that appears in the next few years? I guess, what's the next big thing for Lowe's?

MICHAEL BAKER: Yeah, it really is that pro-business. It's about 25% of their business. It's about 50% of Home Depot's business. So if you do the math on sales per store, and then break that up into DIY sales per store, and pro sales per store, the entirety of the productivity gap between the two companies is on the pro side. In fact, Lowe's leads Home Depot in DIY sales per store.

But the opportunity is in the Pro initiative. And we do think they're making strides there. There's just a long way to go.

And again, we think that's just a little bit harder than improving the internal operations on the margin side plus you have that valuation, which to us is looking a little bit toppy right now for Lowe's.

JOSH LIPTON: And so, Michael, so you moved to a neutral. You moved to the sidelines. Where could you be wrong, Michael? What are the kind of upside risks to your call?

MICHAEL BAKER: Yeah, sure, fair question. Housing. Housing is the answer. So housing seems to us to have bottomed.

Therefore, we think same store sales have bottomed. We do think same store sales will be negative for both Home Depot and Lowe's in the first half of 2024. But less so than they were in the second half of 2023.

So you're getting less worse. And then eventually, positive. And we think that'll sort of lag what we think is a bottom in housing by a couple of quarters. So comps will get better from here.

The call, though, is that we think that's well known both on the terms of the sell side, i.e. it's already in the estimates and also well known by the buy side i.e., it's already in the valuation.

JOSH LIPTON: And, Michael, what about rival Home Depot? Because you're neutral there as well. Why are you neutral, Michael? And what would you need to see before getting more bullish?

MICHAEL BAKER: There, the valuation is certainly much higher. So part of our whole rating or neutral rating on Home Depot has been that it is one of the more expensive stocks that we cover. But they too have had a little bit of a difficulty on the margin side.

So as Lowe's has closed the margin gap, a lot of that is because Home Depot's margins have been flat to even down the last couple of years. We do think they'll be down again in 2024. But less so than Home Depot-- than Lowe's. Sorry.

We'd love to see that margin turnaround, couple that with maybe some better comps. And we think there could be an opportunity for Home Depot at some point. And again, after 6 and 1/2 years of Lowe's outperforming Home Depot, maybe it is time for Home Depot to take the leadership again.

JARED BLIKRE: I got to ask you about the Fed here because everything ties back to the Fed. And we did take talk a little bit about the impact of home prices influenced by mortgage rates. But anything with respect to Jay Powell and Cole and Co that might move the needle for the housing sector and might affect some of these home improvement plays as well?

MICHAEL BAKER: Sure. Yeah, again, housing is a big part of it. Home price appreciation, more than turnover. But, of course, turnover is tied to-- or sorry, pricing is tied to turnover.

One of the things we put in our note is that the gap between the Fed funds rate and the 30-year mortgage rates is pretty narrow right now, about half of what it usually is. What that means to us is that as the Fed funds rate falls. We think mortgage rates might be more sticky and fall less.

In other words, that gap widens to where it's been over the last 30-plus years. Right now, it's at about 170 basis points. It's usually about 350 basis points.

So if that's the case as the Fed drops rates, we think that will happen. And mortgage rates are a little bit more sticky. We do think housing is bottomed. But that might mute the recovery in housing a little bit.

JARED BLIKRE: All right, sticky mortgage rates. That sounds almost like my gas prices. They don't seem to come down as fast as they go up. Really appreciate you stopping by here. Michael Baker, thank you.

MICHAEL BAKER: Sure.