2023-08-01 21:40:31 ET
Summary
- Lowe's Companies has greatly benefited from the home improvement boom since the pandemic, with the trend increasingly likely to normalize.
- The company's weaknesses include an increase in inventory turnover and a long-term liability that has exceeded its long-term asset by the largest share in its history.
- Although despite fluctuations in housing starts, the home improvement market demand will provide a long term resilience for the company.
Investment Thesis
Company Overview
Lowe's Companies (LOW), founded in 1921 with the opening of its first hardware store in North Wilkesboro, North Carolina, is the world’s second-largest home improvement retailer. Its home improvement retail operations represent a single reportable segment.
Strength
In Q1, Lowe's delivered 5% increase in EPS, excluding the positive impact from the sales of its Canadian retail unit. The company saw a 75 bps increase in operating margin but a 35 bps decrease in gross margin. Its online sales grew by 6.9% YoY, but total sales volume decreased by 4% comparably. Overall, it's a mixed bag.
Lowes' prides itself as a multi-channel retailer. The company differentiates its services by focusing on different stages of home improvement activities of the so-called Professional Customer (Pro Customer), while pairing its physical retail store operations with online selling channels. In doing so, it is able to single out business acceleration through online offerings for customers to do research on large projects before setting foot in the stores.
Lowe's Pro Customer Strategy's Five Pillars (Company 2022 10K )
In effect, its ability to sell products in-store, online, on-site, or through its contact centers increases the leverage of its existing infrastructure, and the omnichannel capabilities turn into an integral experience for the customers. This not only enhances its customer retention rate but also helps drive down the cost of sales. It is a win-win strategy.
Lowe's OmniChannel Network and Experience (Company presentation)
Although it is still in the transition from a legacy system to this omnichannel system that started in 2019, the process is expected to finish by 2024.
Lowe's Enterprise Technology Support (Company Presentation)
With a highly fragmented market and customer base, Lowe serves Pro Customers, individual homeowners, and renters that make up a do-it-yourself (DIY) and do-it-for-me (DIFM) spectrum. Although the company's Total Home strategy serves both Pro and DIY customers, it is the Pro Customer that drove the broad-based with positive comparable sales. The DIY category tends to have seasonal and demand cycle fluctuations. Therefore, it is not surprising that it continues the investment in partnership with the Pro customer in Q1 with more loyalty programs and rewards.
Lowe's: Pro Customer Overview (Company Presentation)
Lowe's is further enhancing its efficiency by better-managing labor and inventory with its Perpetual Productivity Improvement initiatives. It is also converting 11 geographic areas to market-based delivery for bulky products that bypass stores altogether, strengthening front-line and on-site assistance at the stores when directly facing customers. The sales of its Canadian retail units were also meant for it to be laser-focused on the US markets, making up over 95% of its revenue, to simplify its business models and facilitate the deliveries. It is also transforming its knowledge of home price appreciation, age of the housing stock, real disposable personal income, and housing turnover, combined with demographic trends into its AI machine learning models to upgrade its supply chain and customer satisfaction. Overall, the company is making efforts on all fronts to strengthen operating margins and productivity.
Lowe's: Supply Chain Transformation (Company Presentation)
Since the pandemic, home improvement enthusiasm has greatly benefited Lowe's bottom line and cash flow which both have been at elevated levels in the past three years. Although its free cash flow seems to be on its way back down to the pre-pandemic levels, the company still has one of the highest earnings on a TTM basis.
low (Calculated and Charted by Waterside Insight with data from company)
Weakness/Risks
Lowe's net operating working capital excluding inventory has reached one of the lowest levels, while its inventory accounted for the greatest proportion.
Lowe's Net Working Capital (Calculated and Charted by Waterside Insight with data from company)
Lowe's also has the lowest inventory turnover in at least ten years. There is short-term seasonality at play for its current level, but unless there is an upcoming big swing for the next season, it remains to be in one of the lowest turnovers for its inventory.
Lowe's Inventory Turnover (Calculated and Charted by Waterside Insight with data from company)
Its long-term liability has exceeded its long-term asset by the largest share in its history. Its total equity was relatively stable before 2020, but has been dropping deeper into negative since 2021. Although the sales of its Canadian retail unit this year have seen about $2.5 billion of loss on sale and long-lived asset impairment, the rise of debt was the main driver behind the negative equity. Its current ratio is at 1.2x but its cash-to-debt ratio swings at less than 10%.
Lowe's Total Equity (Calculated and Charted by Waterside Insight with data from company)
Against the backdrop of strong market demand and earnings, Lowe's management hasn't been able to engineer a more solid balance sheet. While now faced with slower sales compared to the recent highs, the company will be hard-pressed to deal with its inventory and debt levels for the medium term. It will be facing pressure from both sales normalization and balance sheet normalization in the coming earnings quarters. The question is how fast and by how much - will it revert back to the pre-pandemic level or stay within the new range reached post-pandemic? We explore this in the valuation section.
Big Picture
As we can see, while the US housing starts' peak-to-trough behavior has a high correlation with monetary tightening cycles, the home improvement markets tend to have more resilience. The expenditures spent on owned dwellings tend to have a smooth upward trajectory over the long term. This will underline steady support for Lowe's business growth on a macro level.
US Housing Starts vs Fed Fund's Rate vs Dwelling Units Expenditures (Fred)
Financial Overview
Lowe's Financial overview (Calculated and Charted by Waterside Insight with data from company)
Valuation
Based on our analysis above, we utilize our proprietary models to assess the fair value of Lowe's with a ten-year forward projection. Although we believe the intrinsic market demands will still be supportive of it in the medium term, the company needs to make efforts in normalizing the balance sheet dislocation incurred during the past two years on the back of slower sales trends. We assumed its cost of equity to be 6.71% and a WACC of 6.9%. In our base case, it has a double-digit free cash flow decline this year and anemic growth for next year, while its cash flow reverts back to its pre-pandemic level in subsequent years; it is priced at $200.51. In our bullish case, its growth next year performs better than expected while its general slower trend growth remains for the medium term; it is priced at 237.42. In our bearish case, the slowdown extends to the next two years when fully pricing in not only the slower market demand growth but also its balance sheet risks, it was priced at $154.19, retesting the previous low reached last year. The current sentiment from the market appears to still be bullish on the stock but has reached our top estimates.
Lowe's Fair Value (Calculated and Charted by Waterside Insight with data from company)
Looking ahead to Q2, we expect the company to continue seeing softness in its sales volume and spending-per-ticket, especially in the >$500 category. Its free cash flow will continue to trend down, extending its drop of 16% YoY in Q1, although earnings should still hold up from an increase in efficiency and decrease of cost after the sales of its Canadian retail unit.
Conclusion
Lowe's has its biggest strength in tapping the high-fragmented US home improvement market and the company has a highly effective system to drive margin by category and simplified logistics. This system's strength was highlighted by the boom of home improvement trends in the past three years. But all signs are pointing to demand normalizing currently while the company has a highly leveraged balance sheet that also needs to regress to its average level. Although history shows that macro support is long-term, it will need to further lean into its strength to avoid a more dramatic slowdown. We will recommend a hold at the present levels.
For further details see:
Lowe's: Facing Pressure Of Normalization