2023-12-29 14:56:27 ET
Summary
- Lowe's stock has a sharp rebound after a 20% drop, but it's perhaps not justified.
- The company has been using its multichannel platform to target specific consumer bases amid revenue slowdown, and it has improved efficiency to generate rising net income.
- However, the company's net working capital is weakening, inventory is still high, and its free cash flow conversion has declined.
- The negative total equity remains a concern with no signs of easing.
- Without notable improvement, the rebound is not fundamentally driven, and further normalization is yet to come.
Investment Thesis
Preview
We initiated our coverage of Lowe's (LOW) in "Lowe's: Facing Pressure of Normalization " in August with concerns that the pandemic boom to the company's performance is receding, and it is facing the pressure to re-adjust to a normalized growth pattern and trajectory. The stock fell by 20% in the next four months from $229.76 to $183.62. In the past two months or so, it has recovered just as much and is now back up to $222.21. Is this FOMO or a reflection of the fundamentals? We dig in for some updates.
Updates
We previously highlighted Lowe's advantage of using its multichannel platform in gauging consumers' preferences regardless of which channel they use. The company has been actively turning this knowledge into a useful marketing strategy. It targeted gardeners and pet owners in the 1H by offering workshops and partnering with Petco , in addition to its several existing private brand partnership, such as Kobalt, Bosch, DeWalt, Rubbermaid, and Scott's. Encouraged by the initial results, the company in 2H continued its efforts of bringing shoppers in by targeting a specific consumer base, one at a time. It renewed NFL partnerships to help homeowners' DIY projects, and then promoted to the Millennials how to make basic home improvements. Overlaying this targeted marketing, it implements loyalty programs such as MVP pro-rewards program with CRM to win back more professional users, such as electricians and HVAC professionals. The proactive attitude to "earn the business" with a more sophisticated strategy is the new changes it brought about.
These changes came about amid the slowdown of its revenue growth YoY. Although it is still at almost twice the level compared to pre-pandemic, its revenue is no longer growing but declining on a TTM basis. The company improved its efficiency by cutting down both the cost of revenue and operating expenses in Q3 to stem the downward trend from the topline from impacting earnings. It still produced rising net income and EBITDA in Q3.
LOW: Revenue, Net Income vs Earnings (Calculated and Charted by Waterside Insight with data from company)
But as we pointed out before, Lowe's net working capital weakened while inventory rose. The difference between its account receivables and payables has had no notable improvement since then, while its inventory, although it has been reduced, is still at 85% of its revenue in the last quarter, the highest historical levels. Although the strategies it implemented so far this year are on the right path, their effects are not strong enough to shift the trend yet.
LOW: Inventory (Calculated and Charted by Waterside Insight with data from company)
Even though its net earnings have improved by 22% YoY in Q3, its operating cash flow has been lower, mostly due to paying down operating liabilities of about $2.1 billion in the quarter. It explained its 10Q that this is mostly from paying down the deferred federal tax in Q4 2022 permitted due to the impact of Hurricane Ian. But on a TTM basis, its operating cash flow has been on the decline secularly, starting even before the revenue started to drop. So far it is still higher than pre-pandemic, but not by much.
LOW: Operating Cash Flow (Calculated and Charted by Waterside Insight with data from company)
The same cannot be said for the free cash flow conversion rate. Both from its EBITDA and revenue, its converted free cash flow has turned lower to a level below in 2019. From this perspective, the pressure of normalization has come in more than we expected. Despite the record earnings, only 40% converted into free cash flow. If we disregard the volatility during the pandemic, this level was last seen only in 2010. If these levels continue to decline, it will constrain its future expansion plans in additional hiring or acquisition, not to mention diminishing its ability to continue rewarding shareholders.
LOW: Free Cash Flow Conversion (Calculated and Charted by Waterside Insight with data from company)
Lowe's rising earnings per share is a sharp contrast with its continued declining negative total equity. Its total liability has reduced by 3%, but its total assets also have fallen by 9.5%, resulting in a further decline in total equity since we pointed it out in the last article.
LOW: EPS vs Total Equity (Calculated and Charted by Waterside Insight with data from company)
Lowe's pushed down its negative cash flow in financial activities since 2020 and hasn't meaningfully slowed the pace yet. The persistent leveraging up is still at one of the highest levels in the past twenty years. It usually doesn't keep more than $2 billion cash on hand by the end of the period, which is about a quarter of its quarterly financing needs. So this gives little room for its cash flow from operating activities to decline. It is unlikely the negative total equity will be reversed any time soon. The burden to discount on its future cash flow will continue.
low (Calculated and Charted by Waterside Insight with data from company)
For the year ahead, Lowe's emphasized on its survey results from the professional customers, whose response showed that about 70% of them still have a backlog in their project lineups, but are held back due to the macro environment concerns. And most of the houses in the US aged 40 or older give rise to more reasons for DIY home improvement. However, DIY pro or starter home improvement projects tend to be fragmented in nature. Lowe's heavy debt burden, declining trends in cash flow, and continued leveraging are not going to help it capture the opportunities ahead. Being more efficient and customer-targeted is the right way to generate more organic growth for Lowe's, however, until the management decides to seriously tackle its debt problem, the pressure of transition back to normalization from the pandemic boom is still there. This should be paid attention to as much as the earnings and bottom line, as a 2.75x debt-to-EBITDA ratio just won't cut it to be a growth company.
Financial Overview and Valuation
LOW: Financial Overview (Calculated and Charted by Waterside Insight with data from company)
We updated the fair value assessment with our models. Its 2023 whole-year free cash flow is set to be lowered by about 20%, in line with our previous expectation of a double-digit decline in the base case, and we were giving it this year and the next to adjust back to the normal previously. However, in the past five months, Lowe's challenging situation hasn't improved much, and we didn't hear the management's intentions to tackle some of the hard problems head-on. We have lowered all three scenarios to discount further on its cash flow on top of a continued weakening trend in the next year, to the point of another high single-digit to a low double-digit decline in free cash flow. The current price has become higher than our top estimate.
LOW: Fair Valuation (Calculated and Charted by Waterside Insight with data from company)
The risk to our thesis could come if Lowe's top-line growth significantly raised in the next 12 months. Given that the weakening free cash flow conversion came when the secular trend of its operating cash flow was still above the pre-pandemic level, and its earnings were pulled back up to an all-time high in Q3, we think it will take a strong double-digit revenue growth to make a difference. When asked about 2024, the management gave a cautious outlook citing DIY customers' "discretionary spend is still something that we're managing through" since they were impacted by their disposable income and the housing market. If the housing markets were to rise significantly higher next year, it is safe to say inflation would not come down, and the Fed would be back in action. So we think the upside risks are not high at this point because the market seems to have fully factored in strong growth and more for next year in its current price. Any disappointment will send its price lower.
Conclusion
For the last five months or so, Lowe's has continued its strategy of targeting specific consumer bases to generate more organic sales while strengthening various name-brand partnerships. Along with efficiency improvement, the company is on the right path in seeking growth. However, there hasn't been a decisive measure in tackling its debt burden while its cash flow is weakening. The future constraints will not ease, and we expect further normalization is still on its way. We consider the premium in its current price too high and will recommend a sell at the moment.
For further details see:
Lowe's: Further Normalization On The Way