2023-07-28 13:54:59 ET
Summary
- The record increase in mortgage rates in 2022 has caused a slight decline in home prices and a small slowdown in the construction and building sector.
- The housing market and general economic strength vary widely between geographical areas and demographics, creating complex issues for home improvement and construction companies.
- Lowe's appears likely to face a sales decline over the coming two years due to weakening economic trends; however, there may be significant variation in its store performance across geographies.
- One significant risk facing Lowe's is a potentially sharp increase in transportation costs, which it will struggle to pass on to customers, given the economic slowdown.
- Lowe's appears significantly overvalued based on my EPS target and even that of more bullish analysts, but the company's managers have some options to mitigate potential recession exposure.
An emerging theme in my research in recent weeks has been the apparent overvaluation of the construction industry . Since 2019, I have been very bullish on the homebuilding and construction industry due primarily to the growing homebuying trend among millennials. Combined with the interest rate reductions in 2020, that trend saw solid performance through 2021 as single-family home construction finally boomed amid a sharp increase in sales and home prices. However, a record increase in mortgage rates in 2022 has put a damper on that trend, causing home prices to generally decline since then, leading to a sharp slowdown in most stocks within the sector.
More recently, stocks in the construction and building sector have caught a "second wind" as most beat previously poor expectations. This potential "double top" pattern appears to be forming across the industry. A surprise home price increase and a slight sales improvement over the past month support the rebound. Indeed, my view regarding single-family homes is not nearly as bearish as my outlook for commercial property construction. For one, single-family homes do not face as direct a burden from higher interest rates as those properties bought primarily for investment potential. Secondly, home inventory levels remain extremely low, particularly in attractive geographical locations, supporting a positive trend in the property market that could continue despite the extremely sharp increase in financing costs.
While some fundamental positive factors influence the residential property market, that does not necessarily mean investors should buy stocks in the sector. One interesting example is Lowe's ( LOW ), which has risen nearly 20% this year after losing a quarter of its value last year. LOW is now reaching close to its previous all-time high, which could either signal a much larger bullish rally or a "double top" reversal that could push it much lower.
Fundamentally, the stock faces a sharp contrast of positive and negative factors. Its most significant positive factor is the company's strong momentum in recent years and its partial resilience in economic headwinds. That said, Lowe's is a very cyclical company, and its fundamentals likely lag other critical economic trends (interest rates, consumer spending power, etc.) by a great deal of time. Additionally, Lowe's is a retail company and, like virtually all, faces increased strains from theft and related issues, potentially exacerbating the tension in its performance across geographical locations. Overall, I believe this situation warrants a closer look at Lowe's and its exposure to emerging economic trends.
Economic Health Is Location Dependent
Nationally, home prices are roughly flat year-over-year and remain much higher than before 2020. From 2020 to early 2022, tremendous price growth was fueled primarily by a sharp improvement in affordability due to the decline in mortgage rates (stemming from the Fed's purchases of MBS assets via QE). Now that the Fed is selling mortgage assets, mortgage rates are much higher, causing home affordability to sink below the "bubble peak" level of 2005-2006. See below:
From a national perspective, the housing market is fueled by strong momentum and low inventory levels. Existing home sales are also about as low as during the 2008 recession, meaning the market is certainly not as hot as it was in 2021. Importantly, in the 2008 crash, it took around two years for the property market to crash after affordability reached a minimum ~2006, so investors should expect a significant lag between market fundamentals and price changes.
There are also notable demographic trends impacting the market. For one, retiring people selling homes at a profit and buying all-cash are major positive factors influencing prices, mainly due to their lack of exposure to mortgages. However, first-time buyers have virtually disappeared due to high mortgage rates. The younger generation's high non-mortgage debt levels and low family formation rates will likely also play a negative long-term role in the single-family home market, particularly after the current positive trend from baby boomers ends, with it probably peaking around the 2021-2024 timeframe.
Further, there is a tremendous geographical discrepancy between home price changes across the country, with the east coast generally seeing flat-to-positive changes and the west coast facing sharper losses. See below:
Homes in more expensive areas are falling while those in less pricey regions are not. Indeed, this is logical considering the economy appears to be falling for higher-income earners while it is rising for low-income earners - an abnormal trend dubbed the " richcession ."
However, from a national standpoint, it is pretty clear that the manufacturing strength boom is ending, as seen in the manufacturing PMI:
In my view, this is a firm indication that the national property market has reached its peak and will continue to face negative pressure due to interest rates and general economic stagnation. However, this shift's impact on Lowe's is atypical as the company may soon face significant earnings declines in some geographical regions, with relative strength in others.
How Diverging Economic Trends Impact Lowes
While there are sharp parallels between today's economic and property market circumstances and that of ~2007, it is far less monolithic today than it was then. Sunshine states, areas with more blue-collar workers, and non-urban areas generally see stronger economies and property markets, with the opposite being true in areas with the best performance since ~2010 (the west coast and the urban regions). Inflation is also a major economic issue that is particularly important for Lowe's due to its significant freight and labor costs. Although inflation has slowed, it may soon rise again due to the recent sharp increase in gasoline prices.
Interestingly, Lowe's COGS, gasoline prices, and retail hourly earnings have a robust relationship. See below
I believe the most significant underappreciated factor impacting Lowe's is transportation fuel prices. The company sells heavier items, so it pays significant amounts in freight for those items. The direct cost of those goods is also very energy-price sensitive due to producer shipping and materials costs. All retailers generally have high sensitivity to fuel prices, but Lowe's is much more significant due to the size and weight of construction and home improvement items. The unending shortage of retail workers is also causing a positive trend in its COGS as the company struggles to find enough workers.
In its last investor call, Lowe's managers had a positive outlook regarding costs due to the disinflation trend . In my view, that disinflation trend is not necessarily a strong signal because it is triggered by a decline in consumer discretionary spending levels . Further, for more complex reasons , I believe it is likely that fuel prices will rise much higher over the next two years and are unlikely to be sensitive to an economic slowdown. Accordingly, I expect Lowe's to face a sharp cost increase and a general sales decline. Indeed, this pattern already appears to have started. See below:
Like many firms, Lowe's has partially offset declining gross margins by reducing operating expenses. Looking forward, I expect its Opex-to-sales level will remain near its current depressed level while its sales and gross margins will decline. I believe a 15% sales reduction followed by long-term stagnation seems reasonable, given the economic trends impacting durable goods demand. Further, a more considerable gross margin decline to ~30% also seems likely given the many factors that I expect will push Lowe's direct costs higher, factors that cannot be easily made onto the consumer given the demand situation.
The company's inventory level is also slightly elevated, potentially triggering impending gross margin declines. Further, it is paying more in interest costs due to higher rates, currently around 1.6% per year (or 0.4% per quarter of annualized sales). See below:
Overall, these balance sheet factors are not alarming, but they point toward a negative trend in its profitability. Accounting for a 15% sales decline, a gross margin level of 30%, flat operating costs as a percent of sales, flat financing costs ($1.4B), and a 28% tax rate (its historical norm), I estimate the company's future income at ~$3.2B annually or an EPS of ~$5.50.
While that estimate is less than half of the current analyst consensus of $13.37 , that is close to its EPS two years ago and much higher than its pre-COVID EPS. Indeed, my assumptions are relatively conservative, assuming a relatively mild recessionary trend in construction and durable goods spending activity. A very sharp rise in fuel prices would trigger a more extreme decline in demand and a more significant cost increase, quickly pushing Lowe's EPS much lower than my estimate. However, since it is certainly not guaranteed that fuel prices will rise much higher, I only assume a smaller economic shock. Even still, a decline in its EPS to $5.50 by 2024-2025 would give LOW a very high forward "P/E" of ~43X. Even the current consensus outlook, which I believe to be unrealistic, gives LOW a forward "P/E" of 17.6X, a high figure for a cyclical firm. Accordingly, I firmly believe LOW is overvalued and due for a relatively sharp devaluation over the coming year.
The Bottom Line
The critical issue with my outlook is the diverging nature of the national economy. In some areas, the economy and property markets are relatively strong, while deteriorating quickly in others. Lowe's is also facing issues relating to higher theft in its stores, creating new costs for the company that should grow in geographical areas with more significant economic strain. Lowe's recently faced backlash after firing (later rehiring) an employee for trying to stop a theft incident and was violently attacked . Thus, should Lowe's act accordingly, it may benefit from closing stores in geographical areas facing underperformance and theft-related issues. Outside of a significant national economic problem (potentially another sharp fuel cost increase), I expect Lowe's stores in higher-demand areas to continue to perform well and may see greater profits over the coming year.
Typically, I only would bet against a company if its management team had little control to stop a downturn. While I firmly believe LOW is substantially overvalued based on my earnings estimate and even those of more bullish analysts, I would not bet against LOW because its managers have a strong historical track record. In my view, the company's managers likely have many choices that could mitigate its exposure to the growing economic divergence pattern. That said, I have a bearish outlook on LOW and believe it will decline in value due to overvaluation in light of a generally negative construction and consumer discretionary market trend, with its risk greatly dependent on potential changes in transportation costs.
For further details see:
Lowe's: Overvalued Amid Abnormal Construction Market Trends