2023-12-28 09:00:00 ET
Summary
- Lowe's Companies is the second largest home improvement retailer, underpinned by a wide economic moat.
- The company continues to execute its strategy and gain market share in the Pro segment.
- Mr. Elison, the CEO, has deep industry experience and is highly incentivized to create value for shareholders.
- Using a discounted cash flow analysis, I arrived an implied share price of ~$242, making this a buy.
Investment Thesis
I'm overweight Lowe's Companies (LOW) because it is the second largest home improvement retailer, it is underpinned by a wide economic moat, and I believe the company is well positioned to deliver growth and market share gain in the foreseeable future. Using a discounted cash analysis, I arrived at an implied share price of $246, translating into a 9% return from the price of this writing, $221.
What's The Moat?
It is not easy for a new company to enter the home improvement retail industry for two reasons: scale and brand recognition. Home Depot (HD) and Lowe's Companies are the leading firms, with HD first and LOW second. Their business models are very hard to replicate for a few reasons.
First is the scale. It requires a lot of capital to open thousands of 112,000-square-foot stores (the average size of a LOW store) and maintain them. LOW began operations in 1946, and being one of the first players in the market, it has amassed a store footprint of more than 1700 locations. Second is the relationship with vendors and suppliers. LOW is able to leverage both its store locations and brand equity to get favorable deals and offer attractive prices to customers, which is hard to do for a new player trying to break into the industry.
The third is the customer. A big part of LOW's brand reputation has been built on top-notch customer service and understanding their needs. According to LOW , 50% of the customers in the home improvement industry are do-it-yourself, and 75% of LOW's customers are DIY. When a customer walks into a Lowe's store, They don't necessarily know what they are looking for, so training workers using the knowledge the firm has gained over 77 years of operations is critical to its success. I can't speak for others, but for me, once I have a positive experience with a brand, it is very hard to switch to another company unless something major occurs.
I believe the combination of scale and intangible assets earn Lowe's Companies a wide economic moat in my book. Plus, LOW has averaged a 19% return on invested capital over the past five years, which further supports my wide moat assessment.
Growth & Market Share Gain
According to LOW, the home improvement market is worth around $1 trillion. I expect the company to gain a share in the future because of two things. The first is that the market is very large and highly fragmented. With an annual revenue of $97 billion, LOW only commands about ~10% of the market and Home Depot 15%. Leaving the firm with more room for expansion. The second reason is LOW's strategy, which includes accelerating online business, attracting pro customers, not just DIY, and driving localization.
I believe they will be successful at executing this strategy due to management's deep industry knowledge and experience. The CEO (Marvin R. Ellison) has deep skin in the retail game. He served as the CEO of J. C. Penney Company, held multiple senior roles at Home Depot, and served in a variety of operational roles with Target Corporation ( TGT ).
Additionally, Mr. Ellison is highly incentivized to create value for shareholders given that he holds a significant amount of stock value at +$50 million, and his 2023 compensation was $17.4 million, 73% of which was in the form of long-term incentives. In other words, stock options, shares, restricted stock, and other forms of equity compensation. Other named executives on the board also had a similar compensation plan.
25% of LOW's customers are Pro; the company has said they are trying to penetrate this segment more, given that it makes up 50% of customers in the home improvement market. An industry tailwind I believe the company should benefit from is that more than 50% of homes in the U.S. are 42 years old, which means they will soon need to be replenished or improved if they haven't already.
As home prices keep rising like they have for the past decade and mortgage rates remain elevated, it will serve as an incentive for people to stay in their homes instead of moving out. Plus, buying tools for a few bucks to improve your home and increase its value is a deal that any homeowner would take.
Recent Earnings
LOW reported Q3-23 earnings on November 21, 2023. I looked at the company's results, and there are good and bad ones. Let's start with the bad first. The company missed on revenue estimate by $385 million because of pressure on consumers in the DIY market. This news shouldn't just be brushed off. LOW is seriously dependent on the DIY market; a minor slowdown can cause it to lose billions. The CEO had this to say:
Given our 75% DIY mix, the DIY pressure disproportionately impacted our third quarter comp performance. At the same time, our investments in Pro continue to resonate, resulting in positive Pro comps again this quarter.
The company also adjusted its guidance, but not in a way an investor would like, with FY2023 revenue expected to come in at $86 billion vs. previous guidance between $87 billion and $89 billion. ADJ EPS is expected to come in at about $13.00 vs. the previous guidance of between $13.20 and $13.60.
As for the good news, LOW did beat EPS estimates by $0.03 despite top-line pressure due to margin improvement. Gross margin improved by 40 bps and ADJ operating margin by 47 bps year-over-year. Management cited that the improvement was mainly due to the ongoing perpetual productivity improvement initiatives ("PPI").
LOW also experienced an uptick in Pro customer comp sales, indicating their strategy to gain more share is working. But moving forward, I will keep an eye on the DIY market. If there is more weakness without much improvement in the Pro segment, I might downgrade LOW, given that my thesis depends on the company to continue gaining share in the Pro market.
Valuation
LOW is trading at a forward PE of 17.12x the FY23 consensus of $13.02 and 16.81x the FY2024 consensus of $13.26. The company does trade at a discount compared to its peer HD (23.15x FWD P/E) given that Home Depot has more scale and better margins. But if the company continues to improve its margins, then I believe this gap could close.
In my discounted cash flow analysis, I looked at some consensus estimates and some industry growth rates to arrive at my assumptions. I estimate revenue to compound at an annual rate of 3.5% from 2024 to 2032. For FY2024, I decided to use management's revenue guidance of $86 billion.
As for margins, LOW's COGS as % of sales has hovered around 66% for over three years now, so I estimated it to stay around 66.70%. As for SG&A as % sales or margin, it has declined, as you can see below, but I was a little conservative and assumed it would decline by 40 bps year-over-year, yielding an average of 17.95% of net sales. Other assumptions include a 1.82% D&A margin, 1.8% of revenue allocated towards CapEx, and a 22% tax rate.
Margin Analysis | FY2019 | FY2020 | FY2021 | FY2022 | FY2023 |
Cost of Sales | 67.88% | 68.20% | 66.99% | 66.70% | 66.77% |
SG&A | 24.42% | 21.30% | 20.68% | 19.01% | 20.95% |
D&A | 2.07% | 1.75% | 1.56% | 1.73% | 1.82% |
Using a growth rate of 3% (aligned with the market and GDP) and an 8.30% WACC, I arrived at an implied price share of $234, translating into a 9% return from the price of this writing ($221). I used a 12.50x EV/EBITDA multiple (in line with the current FWD and TTM multiple) and got an implied price target of $248.92, representing a 15% upside from the current price.
Taking the average of both methods, I arrived at an average implied share price of ~$242, representing a 9% return. See below for all assumptions, calculations, and sensitivity analyses for my discounted cash flow:
Key Risks
Obviously, the biggest risk facing LOW is competition; Home Depot is still the leading home improvement retailer by revenue and store count (almost double LOW's). The company does carry a lot of leverage on its balance sheet, with a total debt of $40.1 billion, $1.5 billion in cash, and a TTM EBITDA of $13.4 billion, yielding a 2.87x net debt to EBITDA.
However, the maturity date for most notes is 2027 and up, so for now, LOW is safe from a leverage standpoint, in my opinion. As we witnessed in the previous quarter the dependency on the DIY market can put pressure on the company in-times of economic hardship. This why I believe it is important to monitor LOW's progress on expansion into the Pro segment.
Takeaway
To sum it all up, Lowe's Companies is a leading firm in an industry that is hard to penetrate. I believe the company will benefit from industry tailwinds and continue gaining market share as it keeps executing its strategy. My DCF valuation implies a 9% upside. The combination of the great business model and attractive valuation makes this a buy.
For further details see:
Lowe's Companies: Undervalued And Has Great Prospects