2023-06-26 20:23:06 ET
Summary
- Lowe's has delivered decent alpha for close to a year, but we are revising our rating from a buy to a hold.
- Home improvement is unlikely to flourish in this environment, and forward valuations don't reflect that.
- We highlight a few other structural drawbacks.
- Lowe's technical chart also shows an unattractive risk-reward position, suggesting it may be better to buy at lower levels.
Introduction
Almost a year ago, we had initiated coverage on the home improvement retailer Lowe's ( LOW ), with a BUY rating. Since the publication of the article, LOW delivered decent returns of +13%, but crucially also witnessed steady outperformance, not just against its largest peer- Home Depot ( HD ), but also the broader markets.
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Nonetheless, we decided to revisit Lowe's story once again, and this time we are revising our rating to a HOLD. Here’s what’s driving our new rating.
The Outlook And The Fundamentals Are Not In The Best Shape
Firstly, we'd like to start by saying that at this juncture, the US discretionary sector isn’t the most opportune place to be dabbling in. For the second successive month, we’ve now seen real consumer spending growth decline.
In addition to that, do also consider that the broader US Conference Board’s Leading Economic Index ((LEI)), a useful forward-looking gauge of 10 sub-metrics, continues to plummet and suggests a recession may be on the anvil during the next 12 months.
Some of you may be perpetually inclined to stick to the discretionary sector and rotate within; in that case, we'd point you to a McKinsey survey published earlier this month which showed that going forward, US consumers will likely spend on categories such as restaurants, groceries, and travel. Home improvement wasn’t even part of the conversation, whilst spending on home goods was less of a priority
Lowe’s management already acknowledged difficult conditions last month by flagging a “higher-than-expected pullback in home improvement spending” and noting that arenas such as travel, groceries, etc. were taking a larger share of consumer wallet at the cost of home improvement. LOW is particularly vulnerable as the DIY (Do-It-Yourself) customers account for 75% of the business, and this is the segment that has demonstrated the greatest degree of spending pullback.
All in all, comp sales for Lowe’s were already down by -4% in Q1, and whilst there could be some timing-related shifts in some of the quarters ahead, eventually comp sales for the FY are still expected to be lower by - 4% (as per management outlook). As far as reported sales are concerned management is guiding to a range of $87-$89bn which would represent a YoY decline of -9% .
What investors also need to consider is that even though LOW will likely witness revenue growth in the years ahead (based on the low comp effect), on an absolute basis, by FY26, it will still be a smaller business at a revenue run rate of $93bn (FY22 revenue was over $97bn). Also note that LOW’s earnings will likely decline by -3% this year.
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All in all, declining revenue and earnings growth doesn’t feel like a great pitch for a business that is currently priced at a forward P/E multiple of over 16x, a 10% premium over its long-term average.
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Structurally, there are other issues as well that we don't find too appealing. Granted, Lowe does a good job of rewarding its shareholders via buybacks and dividends, but we don’t believe it is a good practice to resort to this when you don’t generate ample FCF to cover those shareholder distributions.
Firstly, it’s worth noting that LOW is not particularly adroit at converting its inventory to sales. Even though they may have spent ample cash to boost the inventory in recent quarters to prepare for the Spring season, do also consider that the pace at which LOW translates this to sales has trailed that of Home Depot’s for a long time now.
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When your inventory management is not tip-top, it tends to leave an adverse mark on FCF generation. Whilst LOW has been generating $6bn of positive FCF on a trailing twelve-month basis, that is certainly a long way off from covering both the dividend and the buyback outlays, which account for less than $15bn of cash on a trailing twelve-month basis.
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This means you’re looking at a business that will be inclined to inundate its capital structure with excess debt so that it can meet its shareholder distributions (besides funding the core operations). Note how Lowe's long-term debt continues to just grow over time, with its debt-to-capital ratio at staggering levels of 167%.
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At the end of Q1, Lowe’s adjusted debt to EBITDA stood at 2.6x, and this will likely pick up and hit levels of 2.75x by the end of this year (as per management’s guidance).
Closing Thoughts- Risk-Reward On the Charts Look Unappealing
Even on the technical front, there isn’t an awful lot to get excited about. The chart below measures how LOW is positioned relative to its peers from the broad discretionary sector. Even though there's been a pullback in the ratio from lifetime highs, we don't believe LOW will benefit from ample rotation momentum, given that the ratio is still around 25% away from the mid-point of the long-term range.
Then on LOW's weekly chart, we'd like to highlight how the risk-reward position looks unappealing at this juncture. Since March last year, the stock has been chopping along within a narrowing range, but whenever it hits the $215-$221 levels, one tends to witness additional supply (area highlighted in purple) which limits further upside. We saw this happen in late March 2022, August 2022, and Nov 22-Feb23. Once again LOW has breached those levels, and whilst we are not dismissing the probability of a breakout from here, we don't think it's prudent to bet your money at these levels. Rather the preference would be to get in somewhere close to the upward-sloping support which is currently around the $200 levels.
For further details see:
Lowe's: Limited Incentive To Maintain The Bullish Stance (Rating Downgrade)