Lowe's (LOW) has followed in Home Depot's (HD) footsteps with a pretty disappointing Q1 (Apr) earnings report this morning. Non-GAAP EPS rose 2.5% yr/yr to $1.22. It was good to see EPS growth, but the market had been expecting higher growth than that. Revenue rose 2.2% yr/yr to $17.74 bln, which was slightly better than expected. The guidance was disappointing as well, as the company lowered its full year adjusted EPS guidance to $5.45-5.65 from prior guidance of $6.00-6.10. The good news is that full year revenue guidance was reaffirmed at 2% growth.
Same store comps for the first quarter came in at +3.5% while US comps were +4.2%. Back in Q4 (Jan), comps came in at +1.7% total and +2.4% for the US home improvement business. This follows +1.5% and +2.0% for Q3 (Oct). So there definitely was some sequential improvement over the prior two quarters in the most recent quarter. On another positive note, LOW reaffirmed full year comp guidance at +3%.
Our overall sense is that it was not revenue and comps but gross margin that presented the main problem in Q1. In fact, we think the comps were quite good, and the acceleration of comps throughout the quarter bodes well for Q2 (Jul). If adjusted for inflation, LOW says US comps would have been +7.5% for the quarter.
A big reason for the comp improvement was LOW making progress on its goal of reducing out-of-stock items. LOW saw comp growth in 10 of 13 categories, with high single-digit comps in Lawn & Garden. Canada saw weaker comps due to a weaker housing market in Canada. Online comps were +16%, but the company wants to improve that further.
So, what happened with gross margin? CEO Marvin Ellison explained on the call that the shortfall was caused by cost increases that were agreed to in 2018 by prior merchants. Heading into its busy spring season, LOW had replaced a good number of its merchandising managers. This caused more disruption in Q1 than expected, and, frankly, the company did not fully anticipate the impact of cost increases.
Ellison went on to explain that LOW uses a FIFO inventory accounting system, so higher costs taken in 2018 were not offset elsewhere in 2019. Legacy systems had limited visibility until items hit the P&L, and that hurt margins. LOW has since upgraded its systems to mitigate this in the future. LOW is making changes to pricing and POS systems. LOW wants to prioritize those that have biggest impact on gross margin. Meanwhile, merchants are getting better at offsetting pricing pressures. Ellison said that its efforts to deliver improved margin performance are part of a multi-year transformation plan and that the company is in Phase 1 of a three-phase process. As a result of this, Ellison expects improvements in gross margins later in the year.
Overall, sales, demand, and comps do not seem to be the problem. LOW really needs to get a better handle on its gross margin, or there will be more EPS misses ahead. Based on the stock reaction today, investors are clearly skeptical about LOW's near-term ability to turn around its business and close the gap with Home Depot.