Our upgrade rests on 4 key points:
1. Risk reward compelling. We see 40% upside and 15% downside. Assuming ‘07 is the trough and ‘08 is a recovery year, we get to $2.40 in ‘08. We believe the stock could get back to an 18x multiple in that scenario considering prior cycle recoveries, implying a $43 stock, or 40% upside.
If we assume a worst case of flat earnings of $1.96 through 2008 [an unprecedented flat to down comps for 3 years] and a 13x trough multiple we get a $25-$26 stock, implying 15% downside.
2. Fundamentals may not have bottomed, but it looks like valuation has. In most cycles, LOW’s P/E has moved coincident with peaks and troughs in housing turnover. In the current cycle the P/E anticipated the peak of the cycle, and we think it has done the same with regards to the trough.
Home improvement stocks have recently gone up despite weak sales and housing data points. That suggests embedded expectations are low and it will take a significant negative catalyst or prolonged downturn to move the stock lower.
3. There are some signs of optimism in the home improvement macro environment. These include a peak in interest rates at relatively low levels,  inflation figures have been more benign recently, and  easier year over year housing turnover comparisons begin in November. Given all of the above, if housing continues to weaken we believe there would be increased odds of Fed rate cuts in early 2007.
4. We believe LOW is capable of weathering the downturn given market share gains and cost discipline. LOW is showing steady market share gains across several product categories we track. We had been concerned about LOW’s optimism of late, but that capitulated in 3Q06 with a decidedly more realistic macro outlook. LOW has identified $200m+ of corporate incentive expense reductions.
With over 50% of SG&A in payroll, their ability to cut non-essential labor hours without adversely impacting customer service levels should provide cushion in a weak sales environment.
LOW 1-yr chart