2023-10-28 08:20:39 ET
Summary
- Lowe's shares have been falling for two months, but the market is overly negative on the company's prospects.
- Lowe's business has slowed but remains strong, and normalization does not mean ongoing declines.
- Consumer demand for housing projects should remain stable, supported by rising disposable incomes and homeowners' equity with a surprising tailwind from higher interest rates.
Shares of Lowe’s ( LOW ) have been essentially falling for two straight months, erasing all of the year’s gains to now trade about 6% lower than 12 months ago. While the price momentum is unfavorable, I believe the market is becoming too negative on the company’s prospects. At less than 15x earnings and with several favorable macro data points, shares are beginning to look attractive. I would begin to add shares, though given the negative momentum, I would dollar cost average in rather than building a full position at one time.
To begin, it is clear that Lowe’s has seen its business slow. There was a boom in all things housing related after COVID, which boosted Lowe’s sales and profits. That has been unwinding. I think it is important to remember though that while its business has softened, it remains strong. It also is important to emphasize that normalization from unsustainable levels to more normal ones does not necessarily mean ongoing declines to weak levels. Markets can be too quick to assume linear trends continue, getting both overly optimistic and overly pessimistic. I believe that may be part of LOW’s ongoing share decline, and for several reasons, I believe we are in the “normalization” not “outright decline” environment.
In the company’s second quarter , Lowe’s earned $4.56, down about 2.5% from last year as same-store sales declined by 1.6%. While sales were lower, gross margins expanded by 40bp to 33.66% as input price pressure has faded, which helped to mitigate some of the revenue decline. Alongside these results, management reaffirmed its outlook for same-store sales declines of 2-4% and EPS of $13.2-$13.6.
While earnings are down year over year, it is worth bearing in mind that in just the quarter, Lowe’s earned more than it did in any calendar year prior to 2020. As I said, results have moderated, but on an absolute level, they remain strong. The elevated EPS run-rate is partly because Lowe’s has bought back 45% of its shares over the past nine years. Before COVID, Lowe’s issued long-term debt, locking in low rates, to repurchase stock, which has proven to be a very accretive capital allocation policy. Since COVID, Lowe’s has been generating substantial free cash flow, which it has been returning to shareholders.
Lowe’s did $2.2 billion in buybacks during the quarter. Its $4.2 billion in H1 purchases is substantial but down from $7.9 billion last year as “boom” conditions have moderated. This level of repurchase activity is supported by underlying free cash flow. Excluding working capital, Lowe’s generated $5.4 billion of H1 free cash flow. Now, I expect its cap-ex spending to be weighted to the second half, but this is a $10 billion free cash flow business. Over the past year, its share count is down 8.5%, and with free cash flow, it can reduce the share count ~6% per year on top of 2.4% dividend yield.
Now, the stock has lost momentum since CEO Marvin Ellison spoke at a Goldman Sachs conference in September. In his Q&A, he said “the DIY [do it yourself] consumer, although healthy, is cautious.” This, combined with rising interest rates over the past two months, has added to concern about a harsher downturn in housing-related spending. Lowe’s is also particularly sensitive to consumers’ spending habits. LOW gets 75% of its business from do-it-yourself work and 25% from professionals, giving it more of a skew towards consumers’ spending habits than rival Home Depot ( HD ). Now, I would note that pro has been growing more quickly, rising from 19% of sales 5 years ago, but this is an ancillary part of the business.
There are several reasons why I expect consumer demand for housing projects to remain fairly strong. While we may not see a significant surge in spending over the next year, I expect it to be stable around current levels over the next twelve months, which given a 14x P/E and 9.5% free cash flow yield is a sufficiently constructive environment to begin building a position in Lowe’s. First, management has highlighted that home equity and disposable income are the two primary drivers of consumer demand. Ultimately, consumers need to have money to spend, and when they are “in the money” on their house, they are more willing to invest in it.
First, despite all the bearishness around consumption, real disposable incomes are rising, up 3% from last year (timing of government stimulus checks drove outsized moved in 2020-2021). This is actually somewhat faster than just before COVID. As inflation has slowed, wages and employment have risen, giving consumers more purchasing power. Clearly, the absolute level of prices is weighing on consumers’ mindset, but there is a capacity to grow spending. And as of now, there are no clear indicators the jobs market is materially weakening.
Next, homeowners’ equity is $10 trillion above pre-COVID levels. As home prices have rebounded over the past six months, this measure has ticked up, but if even prices were to moderate somewhat, because of appreciation since 2020 and the fact mortgage borrowing standards have remained tighter than pre-financial crisis, home equity values are likely to remain quite elevated. This should support the ongoing willingness and ability of consumers to spend on home-improvement projects.
This is where I am more fundamentally optimistic about Lowe’s. In fact, I actually think the company could see some benefit over time from higher interest rates. If you are a homeowner unhappy with parts of your house, perhaps the bathrooms and kitchen need to be update, and you decide it is time for a change, there are two options: sell and buy a house up to your standards or renovate the one you own.
For anyone who bought a home in 2021 or earlier, it is prohibitively expensive to move as they likely took out a mortgage below 3.5% or refinanced at some point in 2020-2021 at 3.5% or even lower. If they sell their house to buy another, they will have to take out a 7.5-8% mortgage on their new property.
The below table shows monthly 30-year mortgage payments at difference loan sizes and interest rates. It shows just how expensive that decision to move would be.
my own calculations
Someone who bought a roughly median home a few years ago may sit in the first highlighted box (a $325k mortgage at 3.75%). A median home in today’s environment is also highlighted (a $400k mortgage at 7.5%). That move will increase the monthly mortgage payment by $1,290, or over $15,000 per year. Even staying at the same price point would increase your annual mortgage payment by over $8,500 in all likelihood.
Higher rates are likely to trap people into their existing homes because of how much higher mortgage payments would be. Suddenly, doing a $10,000 home renovation project becomes much more appealing than in a world where interest rates are low and you can move at little increased cost. Low mortgage rates are like “golden handcuffs,” providing a windfall to owners but trapping them in their homes. This can be seen by the fact the inventory of existing homes for sales remains well below pre-COVID norms.
Now of course, homeowners can also choose to defer projects. Some repair work is nondiscretionary, but many DIY projects are cosmetic and can be delayed by a few months. At some point though, projects become less discretionary—few people want a 40-year-old kitchen. As you can see, the median age of a US house has been steadily rising, in part because home construction was fairly muted after the financial crisis. Older homes, all else equal, need more repair and DIY work, than new ones. The aging of the housing stock should be a fundamental tailwind over the long-term for Lowe’s.
Census Bureau
Finally, while Lowe’s primarily serves consumers, as noted it has a growing pro business. For all of the bearishness around housing, I would be remiss not to mention that in Thursday’s Q3 GDP report, it was reported that residential investment increased in the third quarter, rising at about a 4% annualized pace . As you can see below, residential investment has reversed most of its COVID boom but has seemed to find its footing, at levels similar to pre-COVID. This should provide support to Lowe’s current level of sales.
When I look across all of the data, I do not see evidence to support a “housing-related recession.” Last year when rates rose past 5%, some felt there would be one, but housing spending has held up because the US housing market is aging and under-supplied with consumers that have significant equity in their homes. Last year, we saw that sharp shocks in rates can cause home prices to dip as consumers step back but then recover as they acclimated.
The market has focused on the “cautious” element of the consumer and discounted the “healthy” aspect. As disposable income stays positive and the fundamental backdrop of people with mortgages being unlikely to move persists, I expect DIY projects to continue at a healthy pace.
I see Lowe’s being able to continue delivering results around current levels for about $13.5 in earnings power and $10 billion in free cash flow. With that cash flow, it can pay its dividend and reduce the share count 5-7%, meaning that EPS will be insulated from small downturns. I view fair value as an 8% free cash flow yield or a 16x P/E, given the cyclical business and secular tailwinds I see. That would be a fair value of about $215, for a ~20% total return opportunity. The market is growing too negative about the housing DIY market, and investors should begin buying Lowe’s here.
For further details see:
The Market Is Growing Too Pessimistic On Lowe's Outlook