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Hardware retailer Lowe's (NYSE:LOW) reported third quarter results that were roughly in-line with consensus expectations. Revenue grew a paltry 1.9% year-over-year to $12.1 billion, slightly better than expected. Earnings improved tremendously thanks to higher gross margins and cost cutting, nearly doubling year-over-year to $0.35 per share. Lowe's results continue to improve, but they're still lagging those of Home Depot (NYSE:HD)

Economic Profit and Valuation

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Lowe's 3-year historical return on invested capital (without goodwill) is 10.2%, which is above the estimate of its cost of capital of 9.8%. As such, we assign the firm a ValueCreation™ rating of GOOD.

Our discounted cash flow model indicates that Lowe's shares are worth between $20.00 - $30.00 each. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $25 per share represents a price-to-earnings (P/E) ratio of about 17.3 times last year's earnings and an implied EV/EBITDA multiple of about 7.8 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 3% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 1.3%. Our model reflects a 5-year projected average operating margin of 8.2%, which is above Lowe's's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.4% for the next 15 years and 3% in perpetuity. For Lowe's, we use a 9.8% weighted average cost of capital to discount future free cash flows.

Recent Performance

Same-store sales growth didn't fare any better than company-wide sales growth, increasing 1.8% in both the US and company-wide, though we expect some acceleration due to Hurricane Sandy in the fourth quarter (management agrees). Still, the pace of expansion doesn't compare favorably to Home Depot, which has been growing same-store sales closer to 4.2% due to its superior execution, in our view.

Gross margins ticked up 25 basis points to 34.3%, despite the company's highly promotional environment throughout the quarter to clear inventory. Management foreshadowed that clearing this inventory and moving to better product during the fourth quarter should lift margins. However, margins have been secondary, as the true story at Lowe's is management's commitment to reduce costs. SG&A tumbled $210 million on an absolute basis, or a 200 basis point year-over-year reduction as a percentage of sales (29.1%). We expect to see continued cost containment success going forward.

The company continues to generate plenty of cash flow, with $3.5 billion in operating cash flow year-to-date, which has been utilized to repurchase $3.6 billion in stock during the past 9 months. The company intends to repurchase approximately $550 million worth of additional shares during the fourth quarter, which is a slower pace than normal, but reflective of working capital increases.

Outlook

Looking ahead, the company raised its full-year same-store sales growth guidance to 1% (was 0.5%) and its full-year sales growth figure to 2% (was 1%) on a comparable 52-week fiscal year. The firm didn't raise its full-year earnings guidance of $1.64 per share, but we wouldn't be too shocked to see the company exceed the figure by a few cents.

Our Take

While we remain bullish on the housing market, we're less optimistic about Lowe's. Given it current valuation, we aren't interested in adding shares to the portfolio of our Best Ideas Newsletter. In fact, since the name scores a 4 on the Valuentum Buying Index (our stock-selection methodology), we would need to see a substantially lower price before getting interested in the retailer.

Source: Lowe's Shares Are Expensive