2023-11-27 04:35:56 ET
Summary
- Lowe's is a strong performer with a high Return on Capital Employed, consistent buybacks, and experienced management.
- Bill Ackman still owns a significant stake in this compounding machine.
- The long-term growth factors for the industry, including demographic growth and increased demand for repairs and maintenance, remain robust.
- Management incentives are well aligned with those of shareholders.
- A 7% Free Cash Flow yield compounder is a rare occurrence, and the current price provides us with an opportunity.
My Thesis
Lowe's ( LOW ) has emerged as a significant winner in recent history, attracting notable investors like Bill Ackman, who holds a significant stake in the company. I firmly believe that this retailer possesses the essential elements for long-term outperformance, including high Return on Capital Employed, robust growth, consistent buybacks, experienced and high-quality management, management incentives aligned with shareholders, a sound strategic plan, and more.
Finding a robust brand with a combination of high and growing ROCE/ROIC at a reasonable price, coupled with a 7% Free Cash Flow yield, is quite rare. It's a bet you won't often win, as businesses with such high ROCE at a 7% FCF yield typically reveal flaws in their operations. While Lowe's may not be a flawless business and may lag behind its main competitor in certain metrics, I believe it remains a solid choice for long-term investment.
The Business And The Industry
Lowe's operates in the vast home improvement market, with a total addressable market valued at $1 trillion. The company offers a comprehensive range of products catering to both the "do it yourself" ,DIY, customers and professional customers, including plumbers and Painters. The market is evenly divided, with each customer type constituting about 50% of the industry.
In the past, Lowe's faced a challenge in the professional segment, which happens to be the faster-growing market. Its main competitor, Home Depot ( HD ), provided superior service in this segment, resulting in a greater market share. Under the leadership of Marvin Ellison, the current management has actively addressed this situation, successfully expanding Lowe's professional business to approximately 25% of revenue in Q3 , up from 19% in 2019.
The Home Improvement Research Institute projects a 5% growth in 2024 for the industry, with growth expected to average 4.1% in the years 2025-2027. In contrast, the DIY segment is projected to have a growth rate of 0.8% next year and 3.6% from 2025 to 2027.
While the recent decline in revenue was anticipated due to the impact of the COVID-19 surge, the long-term growth factors for the industry remain robust, driven by demographic growth, signifying an increase in the customer base for the industry.
In the US, there is a lack of housing; this means there is an increasing demand for more repairs to current housing, read this quote from the HIRI report:
The US is estimated to have roughly 5 million fewer homes than it needs and there is no skilled labor solution in sight to address this. Given the large contribution of housing-associated costs to inflation, the Fed has a tremendous challenge of solving for inflation without being able to fundamentally address the root cause of the issue: too few homes for those wanting to own them.
As houses continue to age, the demand for repairs and maintenance naturally increases. Lowe's is strategically positioned to meet this growing demand by offering a comprehensive range of tools and materials required for these essential home improvement projects. Quote from Realtor :
More than half of owner-occupied homes were built before 1980. About 38% were built before 1970. Meanwhile, new-home construction has not kept up the pace over the past nine years, with the share of new homes dropping from 15% in 2006 to 7% in 2019, according to the builders’ trade group.
The share of housing stock built 50 years ago or more jumped from 30% in 2009 to 37% in 2019.
Furthermore, there is potential for additional growth stemming from the escalating issues related to climate change. The heightened awareness and impact of climate-related issues are likely to drive increased spending on repairs, encompassing both regulatory requirements and the need for restoration after environmental disruptions. This presents another growth avenue for Lowe's, aligning with evolving market dynamics and the growing emphasis on sustainability and resilience. Another key insight from the Home Improvement Research Institute reinforces the potential opportunities in this aspect.
Seize opportunities in home decarbonization to expand remodelers’ offerings. There are around 125 million residential housing units in the US, and more than 90% will require upgrades to meet climate goals; of these, about 75 million units will require work that includes improving the building envelope.
Lowe's emphasizes operational improvements through its Total Home strategy, aiming to increase its 18% market share. The key elements of this strategy include:
1. Drive Pro Penetration: As previously discussed, Lowe's is focused on increasing its presence in the professional segment, targeting growth in this significant market.
2. Accelerate Online Business: Recognizing that 37% of the Home Improvement market comes from e-commerce, with Amazon ( AMZN ) being a major player, Lowe's management has revitalized its website, making it more modernized and responsive to the evolving online market.
Market Share in the HI market (HIRI)
3. Expand Installation Services: While installation services currently contribute a relatively small segment of revenue, strategic improvements in this area have the potential to capture a larger share of the market.
4. Drive Localization: Lowe's is already positioned within 20 miles of 90% of its customers. However, the company remains committed to enhancing efficiency and further localizing its services to meet the diverse needs of its customer base.
5. Elevate Assortment: Addressing past concerns from professional customers about a lack of brands and inventory, Lowe's management has detailed transformative changes in the supply chain and store appearance in its 2022 presentation . This commitment to elevating the assortment aims to provide a more comprehensive and appealing range of products for customers, especially in the professional segment.
Management
In my view, under the leadership of Marvin Ellison, Lowe's management is commendably adept at identifying the long-term factors that will contribute to future growth and operational efficiency. Marvin Ellison brings extensive experience in the retail sector, with a background that includes pivotal roles at Target and Home Depot. His leadership has been recognized by multiple magazines, earning him a reputation as one of the best CEOs in America.
Furthermore, the alignment of management incentives with shareholders is a notable strength. With only 9% constituting the base salary, Lowe's compensation structure is heavily weighted towards performance-based elements. Approximately 73% of the CEO's and 68% of other named executive officers' average annualized target compensation is contingent upon the achievement of performance objectives or relative and absolute share price performance. Additionally, a significant portion—73% for the CEO and 69% for other NEOs (Named executive officers, including the CFO, VP of Stores, VP of Merchandising, VP of Digital and Information)—of the average compensation is in the form of long-term incentives. This structure underscores a commitment to linking executive compensation with the company's performance and shareholder value.
compensation structure (Lowe's Proxy)
Incentives within Lowe's are primarily tied to the performance metrics of sales and operational profits. Additionally, factors like sales growth and inventory turnover contribute to shaping these incentives. What particularly appeals to me is the emphasis on average Return on Invested Capital in determining 50% of the long-term incentives. Recognizing the importance of ROIC aligns with my perspective on the critical role it plays in ensuring the sustained success of the business over the long term.
While there isn't a significant level of insider ownership among Lowe's executives and directors, it's noteworthy that Bill Ackman has benefited from the stock's appreciation over the last five years. Holding a stake of more than 7.5 million shares, it's worth mentioning that he recently reduced his stake by 5% in the latest quarter.
The Important Numbers
While we are currently navigating the aftermath of the COVID surge, the long-term growth factors I presented earlier remain pertinent. Despite historical challenges in metrics like professional penetration and supply management, Lowe's has achieved a robust top-line growth, posting a solid 5.5% CAGR over the last decade, slightly trailing Home Depot. Analyst expectations, however, forecast a slightly diminished growth trajectory, with a projected CAGR of just under 3% for the next five years. I find these projections reasonably accurate, considering the historical alignment between actual revenue and analysts' expectations.
Lowe's reports do not indicate any plans for global expansion, potentially limiting avenues for further growth. Consequently, comparable growth becomes a focal point, alongside a strategic emphasis on the ongoing shift toward e-commerce.
The real potential for growth lies in per-share profits, driven by margin expansion with a targeted operating margin of 14.5%, a notable increase from the 11% average of the last five years. The compelling case for Free Cash Flow per share growth stems from Lowe's effective share cannibal program, particularly impactful given its low price offering a 7% FCF yield. Over the past five years, Lowe's has significantly reduced its share count, resulting in an annual reduction of approximately 5.6%.
An important development is Lowe's plan , initiated in 2022, to return $33 billion to shareholders over the subsequent three years. This represents 25% of the company's value at the time. If executed according to plan, this initiative is poised to be a major contributor to the total return in the coming years.
Lowe's maintains solid margins for a retailer, and while the company doesn't anticipate improvements in gross margins, its main peer, HD, exhibits similar margin trends. However, Lowe's has the potential to enhance efficiency and elevate its operating margins. The near-term goal is to achieve a 14.5% EBIT margin, with a long-term target of 15%. These margins remain notably stable, showing minimal fluctuations even in years with a downturn in the top line. This stability, coupled with the upward trajectory, suggests the company's ability to pass increased costs to the customer, indicating a degree of pricing power.
The impact of these robust margins extends to impressive returns on capital. In my perspective, high, stable, and growing Returns on Capital stand as crucial factors alongside revenue growth. A recent study by Morgan Stanley highlights the significance of a high and expanding spread between ROIC and the Weighted Average Cost of Capital as a common factor in the outperformance of winning companies. Lowe's has set a long-term goal of achieving a 45% ROIC, aligning with management incentives tied to these targets, thus demonstrating a shared interest in pursuing and achieving these favorable numbers.
Solvency
While Lowe's does not boast the strongest balance sheet I've encountered, I don't perceive any imminent threats. The company holds $32 billion in net debt, which may appear substantial, but a significant portion is structured for the long term, with only $7 billion maturing in 2027. The interest coverage ratio stands at a healthy 7.8 , indicating the company's ability to comfortably cover interest expenses. Furthermore, the current ratio is above 1, suggesting the company's capability to meet its short-term obligations, and the Altman Z score, a measure of bankruptcy risk, stands at a reassuring 3.9.
For comparison, Home Depot exhibits a similar debt structure, albeit seemingly slightly stronger.
Lowe's management maintains a goal of retaining its debt rating at BBB+, underscoring their commitment to financial stability and creditworthiness.
Valuation
Starting with the main point: it's uncommon to find a business with a 7% Free Cash Flow yield, high Return on Capital Employed (ROCE/ROIC), and without major flaws. I believe Lowe's has a robust business, presenting a compelling opportunity. Excluding the PEG ratio due to expected weakness post-COVID, Lowe's stock is currently below its historical multiple averages of the last 5 years. This suggests the potential for multiple expansion, catching up to the historical average. Additionally, if Lowe's can emulate some of Home Depot's qualities, there might be an opportunity to approach Home Depot's current multiple of 19, with an average of 21.
Now, let's delve into a Discounted Cash Flow analysis. Using a 6% FCF margin (the 5-year average) and full-year revenue guidance of $86 billion, a 7.4% discount rate based on the WACC calculation, a terminal rate of 2%, and 8% FCF growth (in line with analysts' EPS forecasts for the next 5 years), the derived result is a stock price of $218, indicating a 9% undervaluation.
It's crucial to note that this is a conservative approach. It does not account for forecasted margin expansion or the higher past FCF per share growth. If we assume a 14% operating margin and 11% FCF per share growth, similar to the past, the intrinsic value jumps to $400, representing a 50% undervaluation.
For a more middle-of-the-road scenario with a 12.5% EBIT margin and 9.5% growth, the stock is still trading at a 33% discount, presenting a favorable opportunity given the strength of the brand and high returns on capital.
Risks
Despite being a stable and predictable company with a source of recurring revenue, I do identify some risks for Lowe's:
1. Failure to Expand Pro Penetration: If Lowe's cannot successfully expand its professional customer base, it could hinder future growth and impact potential Free Cash Flow and returns to shareholders.
2. Increased E-commerce Competition: The Home Improvement market is vast, but heightened competition in the e-commerce space, especially from established players like Amazon, poses a risk.
3. Decision to Halt Share Buybacks: If management decides to cease buying back shares, it could alter the outlook. Share buybacks are critical factors in long-term FCF per share growth.
4. Valuation Concerns: While Lowe's is priced well, it's not a no-brainer. It isn't at a steep discount from its multiple averages and lacks a substantial discount from a Discounted Cash Flow perspective.
Despite these factors, I believe Lowe's is the type of company that can deliver solid returns with relatively low risk. Past stock price movements indicate the potential for great returns, even in the face of uncertainties.
Conclusions
Considering the risk/reward opportunities that Lowe's presents, I believe the current price, with a 7% Free Cash Flow yield, is favorable. This positions the company with a high Return on Capital, effective management featuring compelling long-term incentives, a robust buyback program, and a well-known brand. These factors make Lowe's an attractive investment, offering potential investors solid returns at low risk or, conversely, great returns with low risks.
Of course, there are inherent risks, primarily from an industry and economic perspective. If you are inclined towards bargain hunting, this stock might not align with your strategy.
Taking all factors into account, I categorize Lowe's stock as a STRONG BUY.
What are your thoughts on this opportunity?
For further details see:
In This Price Range, Lowe's Is A Low-Risk, Strong Performer