2023-08-24 10:08:25 ET
Summary
- Lowe's Companies, Inc. shows impressive resilience in the first half of the year, driven by a strong home improvement industry and growth in its Pro and online sales.
- The company's focus on the Pro customer segment and online channels contributes to its resilience and supports its growth trajectory.
- The company has shown incredible improvements in its margin profile over recent years and I see plenty of room for further improvements over the next several years.
- Lowe's is well positioned for solid sales and EPS growth once the macroeconomic environment normalizes.
- I believe shares are valued at 3.5% below their fair value.
Investment thesis
I maintain my Buy rating on Lowe's Companies, Inc. ( LOW ) stock following the company’s Q2 results, which came in roughly in line with the consensus. Lowe’s has shown impressive resiliency in the first half of the year, driven by a strong home improvement industry and growth in its Pro and online sales.
Lowe's Companies, Inc., a prominent player in the American home improvement retail sector, holds a resilient position in the market, marked by its expansive store network, digital presence, and robust customer base. Boasting over 1700 stores across North America, Lowe's serves as a one-stop destination for home improvement essentials for both DIY enthusiasts and professionals. The company's unwavering commitment to customer satisfaction is evident as it caters to over 19 million customers weekly, solidifying its position in the industry.
A key strength for Lowe's is its focus on the Pro customer segment. Historically skewed toward the DIY market, Lowe's has been methodically increasing its share of Pro customers, leading to more balanced revenue streams. This strategic shift, reinforced by investments in Pro-friendly tools and services, contributes to the company's resilience and supports its growth trajectory despite market challenges.
Additionally, Lowe's commitment to enhancing its online channels has yielded positive results, with online sales growth and efficient order pickup mechanisms contributing to customer satisfaction and revenue growth.
Lowe's margin expansion further underscores its prudent management and operational efficiency. Despite the macroeconomic headwinds, the company has expanded its gross and operating margins, reflecting its ability to navigate a challenging environment. Looking ahead, Lowe's ambitious plans for productivity improvements, including technological advancements and supply chain enhancements, signal further potential for margin growth.
While near-term challenges persist due to the broader economic landscape, Lowe's demonstrated adaptability, strong margins, and growing Pro and online segments position it for future success. I believe double-digit EPS growth over the next several years and sales growth in the 5% to 6% range are likely in a normalized macroeconomic environment. Based on these expectations, I believe Lowe’s is currently valued at 3.5% below its fair value.
In this article, I will take you through the latest developments and financial results and update my estimates and view on the company accordingly.
Showing impressive resilience
Lowe’s released its Q2 earnings report earlier this week, on August 22, and reported revenue of $24.96 billion, which sat in line with its guidance and that of Wall Street . Revenue was down 9.2% YoY as was anticipated following the blowout results over recent years and the sale of the Canadian business, which in the year-ago quarter still brought in $1.7 billion. Comparable average ticket was up 0.3% YoY and was helped by high inflation.
The company saw significant tailwinds driven by the COVID-19 pandemic as this caused people to sit more at home, which caused increased home investments and DIY activity. Now that these tailwinds have disappeared, the company is seeing lesser demand and weakness in the DIY market, also partly fueled by a challenging macro environment.
As for the challenging macro environment, it is important to know that the two strongest demand drivers for Lowe’s are real disposable personal income and home price appreciation, and both aspects are impacted by negative changes in the macro environment. This then negatively impacts demand for the products offered by Lowe’s.
However, while both of these are far from their peak reached in recent years, there are definitely also positives today. For example, home price appreciation, while decelerating over the last year, is still up 35% from pre-COVID levels, which is part of the reason why Lowe’s is still able to report revenue relatively close to its Covid highs. These levels now seem structurally higher, even staying resilient in these challenging times, which benefits Lowe’s due to increased consumer confidence and higher home equity, allowing for an increase in home improvement projects.
Furthermore, while real disposable income has been pressured by decade-high inflation and high-interest rates, there was an improvement in the latest quarter, supporting demand for home improvement products.
The resilient and bottoming trends in these crucial demand drivers for Lowe’s support its high covid-driven revenue level to remain as management guides for a YoY decrease of “just” slightly over 9% at the midpoint, which, considering the extremely challenging operating environment and incredible covid highs, is absolutely nothing to complain about. For comparison, the current FY23 guidance still sits 22% above the 2019 level.
Also, as these crucial demand indicators improve further, which is likely over the next couple of quarters, assuming interest rates don’t go much higher and unemployment does not skyrocket in the US (a soft landing seems likely to me), I even see more room for outperformance by Lowe’s in the second half of the year.
Also important to note here is that home improvement projects are typically postponed instead of canceled, which means that while Lowe’s might be reporting negative growth rates today, these investments are still expected to be realized once the macroeconomic environment improves. Add to this the aging housing stock will also draw remodeling and repairs combined with other favorable trends like millennial household formation and persistent remote work, and the mid to long-term outlook for the underlying industry for Lowe’s remains quite strong.
However, do expect continued weakness in the second half of the year, with a more meaningful recovery starting by the first quarter of 2024. So, while the home improvement industry definitely is a cyclical one, it seems to be doing just fine through this cycle, supported by several factors and supporting Lowe’s.
As a result of these industry tailwinds, comparable sales declined by just 1.6%, topping the consensus of a 2.6% decline, due to a very strong spring recovery and continued strength in Pro and online, which was able to partially offset the impact of lumber deflation and a struggling DIY market. Apart from a relatively resilient home improvement market, the company’s investments in Pro and online are also helping it further outperform the overall industry and offset headwinds in other segments like DIY.
The focus on Pro and online drives its resilience
Historically, Lowe’s has been primarily focused on the more sensitive and cyclical DIY market, with about 75% of its sales coming from this customer segment over the last few years, whereas its largest and only real competitor Home Depot ( HD ), is more focused on the Pro customer segment.
Yet, Lowe’s has been working on expanding its Pro customer base to increase this as a share of total sales. This is what I previously wrote regarding this transition:
improving penetration in the Pro segment is a focus point for Lowe’s as it has been over the last couple of years. It plans to leverage Pro CRM to expand its wallet share and use a data-driven method. Where Pro grew by 76% over the last three years, growth so far stands at 6% YoY, outpacing other company segments. Lowe’s targets to grow the Pro segment by 2x the market rate.
By focusing on this, Lowe’s tries to transition to a more stable sales mix between DIY and Pro. This should make the company less sensitive to consumer spending. The current sales mix for Lowe’s is 75% to DIY and just 25% of revenue comes from Pro, leaving plenty of room for improvement.
Lowe’s has been focusing on increasing its efforts in the Pro segment through expanded national brands, MVPs Pro rewards program, and enhanced online tools. Late last year, the company introduced Apple Pay in its physical stores and online platform to improve the customer experience and allow for an easier checkout process for Pro customers.
In the latest quarter, Lowe’s released its same-day delivery option on its online platform, enabling pro customers to receive their products within hours on the Pro job sites through a delivery network partnership and Lowe’s excellent presence across the US. Lowe’s has the ability to leverage its excellent nationwide store footprint to enable these services.
Furthermore, developments like these are powerful today and should further boost the company’s popularity among Pro customers and allow it to increase its ability to fight with Home Depot.
In Q2, Lowe’s continued to see resilient demand among Pro customers, highlighted by a recent survey showing that 75% of Pros report healthy backlogs, up from 70% in Q1. Also, the company continued to report positive comparable growth in Pro, highlighting the success of these efforts. This positive growth comes after already recording double-digit growth in Pro sales over the previous 11 quarters. Pro continues to be a growth driver for Lowe’s and I expect this to remain over the next several years as well.
Meanwhile, comparable online sales growth increased by 6.9%, up from 5.1% in Q1, despite the challenges the company is facing, which is a clear indication that the company is seeing solid improvements in its online channels.
Crucially, half of those orders are still picked up from the stores as stores are most often close to the customer and Lowe’s has been able to lower the time to pick up these orders by 70% over recent years, increasing customer satisfaction. The improvements in its online channels are increasing the company’s visibility and customer satisfaction rates, which were up 100 to 200 basis points YoY.
Lowe’s continues to report bottom-line improvements
Moving to the bottom line, Lowe’s did once more outperform despite a declining top line. Lowe’s was again able to expand the gross margin, this time by “just” 42 basis points. While this might not sound very significant, considering the company’s investments in several areas and a challenging operating environment, this is a promising indicator of further improvements to come, especially as growth returns.
As indicated in the earnings call, while Lowe’s has seen significant productivity improvements over recent years, the company still sees room for further improvement over the next several years. This includes developments like replacing their 30-year-old operating systems and other technology improvements to drive efficiency. Management gave the following example during the earnings call :
One example of this is in our supply chain where we are driving greater throughput with new mobile applications combined with automation and robotics to improve productivity, maximize speed, and minimize damages.
The gross margin in Q2 sat 160 basis points above 2Q19, which is solid but not overly impressive. More impressive is the performance in the operating margin, which expanded from 11.3% in 2Q19 to 15.6% in the most recent quarter.
These solid margin improvements, even today, drove a solid performance in EPS as this came in at $4.56, beating the consensus by $0.08 and down 2.3% YoY. Also, following the solid margins reported by Lowe’s, the company generated $3.5 billion in FCF, which nicely covered the $2.8 billion in shareholder distributions, including dividends and share repurchases.
Shares currently yield a very respectable 1.94% and the dividend payout ratio still stands at a very healthy and conservative 30%, leaving a lot of room for further increases. Lowe’s has been growing the dividend at a 5-year average growth rate of 20%, but as the company’s top-line growth has now eased off, this has fallen to 5% with the most recent increase.
Still, I believe the dividend of this rare dividend king is still nothing to complain about as the starting yield is decent and the dividend is extremely safe due to solid cash flows reported by Lowe’s. Also, as the industry outlook is still solid, I expect the dividend to keep growing by mid to high-single digits over the remainder of the decade, still offering plenty of value to dividend investors.
Finally, the company’s balance sheet at the end of Q2 also remained in good health with a total cash position of $3.9 billion and long-term debt of $35.8 billion, which is up significantly from $28.7 billion. All in all, with a BBB+ financial rating, the company remains in good health, although I would prefer it to focus on lowering its debt position somewhat and to stop funding its share repurchases through debt, which the company has often done over recent years.
Outlook & LOW stock valuation
Lowe’s predicts the home improvement market will decline by mid-single digits in the second half of the year, but the company will be able to outpace the market by 100 to 200 basis points.
This resulted in the company reaffirming its FY23 guidance, expecting to report revenue in the range of $87 billion to $89 billion, representing a comparable sales decrease of 2% to 4%. In part due to a tough comparable quarter last year, Lowe’s does expect some weakness in Q3, with the growth rate expected to come in at the low range of the FY23 guidance and to show a better performance in Q4.
Management expects the operating margin to sit in a range of 13.4% to 13.6%, resulting in EPS of between $13.20 and $13.60.
Following these results and the reaffirmed outlook, analysts now expect the following financial results through FY26.
Wall Street consensus through 2026 (Made by Author based on data from Seeking Alpha)
These estimates look fair as these sit at the mid-range of Lowe’s management’s guidance. The home improvement industry will likely continue to struggle in the second half of 2023 and going into 2024. I expect to see a more meaningful improvement by the second half of FY24, which still drives positive growth for Lowe’s and an acceleration in FY25 and FY26.
EPS should remain more resilient in FY23 as Lowe’s keeps its margins relatively stable driven by efficiencies and lowering investments as long as the top-line performance continues to show weakness. Meanwhile, the long-term outlook for EPS remains strong in the low double digits, driven by a solid top-line performance and continued share repurchases. However, the most significant contributor to EPS growth is the improving margin profile, for which I see a lot of room for upside over the remainder of the decade. Therefore, I think double-digit EPS growth should be no problem for Lowe’s.
I do believe the long-term estimates above leave some room for upside as I think, driven by strong growth in Pro and online sales, Lowe’s should be able to report sales growth of around 5% to 6%.
Moving to the valuation, shares of Lowe’s are currently valued at a forward P/E of 17x, which sits 5% below its 5-year average and significantly below the 21x multiple for Home Depot. Meanwhile, the outlook for Lowe’s is slightly better when looking at the current analyst estimates.
Also, as Lowe’s has shown impressive resiliency over the last couple of quarters and continued strong margin performance, in addition to a solid growth outlook, I believe a valuation of slightly above its 5-year average at 18x is justified.
Based on this belief and the FY24 EPS consensus, I calculate a target price of $264 per share. (Please note, this target price is solely based on its forward P/E and is only for indicative purposes.) Going with an annual return of 8% (10% including the current dividend yield), I believe a current fair share price sits around $235 per share, meaning shares are currently valued 3.5% below their fair value and leaving an upside of 16% to my target price.
Conclusion
Lowe’s delivered a very solid Q2 earnings report which led to it reaffirming the FY23 outlook. The company remains in excellent financial shape and the medium to long-term outlook is solid. The company remains poised to report double-digit EPS growth over the next several years and offers a respectable and well-protected dividend yield. In my eyes, Lowe’s offers everything a conservative investor can wish for.
Therefore, I continue to view Lowe’s as an excellent investment that offers both stability and very decent returns while currently being discounted by 3.5% to its fair value. So, while the share price is up 16.5% since I last covered Lowe’s after its FY22 results, expectations have come up as well, following the company’s resilient performance in the first half of the year, allowing me to maintain my buy rating. I calculate an 18-month target price of $264 per share, leaving an upside of 16%.
Therefore, I rate Lowe’s shares a Buy .
For further details see:
Lowe's: Showing Resiliency And Operational Stability