- Lowe's has outpaced the S&P 500 over the last 5 years.
- However, sales growth has been moderate, and income growth trails P/E significantly.
- The stock is cyclical and highly susceptible to economic downturns.
- The peak of the cycle is not the right time to buy.
Lowe's (NYSE:LOW) has outpaced the growth of the S&P 500 (see chart below) over the last five years, particularly since 2013.
Over the past four years, the company has grown its sales at an annualized rate of 3.1% per year, from $47.2B in FY09 to $53.4B in FY13. Operating income and net income have grown faster at annualized rates of 7.5% and 6.45%, respectively, driven primarily by a slight increase in gross margins as well as by increased operating leverage. SG&A expenses declined from 24.8% to 24.0% over the same period.
Lowe's is the second largest home improvement retailer in the US, with 1832 stores at the end of FY13. Store count increased last year with the acquisition of Orchard Supply Hardware, and has grown from 1710 to 1832 over the last four years with the acquisition accounting for the majority of the expansion. Over the last three years, comparable store sales have grown at 1.3%, 0.0% and 4.8%, respectively. However, the nature of its business is cyclical and dependent on the housing market. The following chart shows the trend in comparable store sales during the period of the 2007-2008 recession, and comparing it to Home Depot (NYSE:HD).
The charts clearly show the impact of the recession on store comps for both LOW and HD, however, Home Depot's performance has been better since FY10.
Store growth and comp growth assumptions
Lowe's has grown its store count in fits and starts, with periods of rapid expansion followed by periods of relatively stable growth. In my model, I assume a growth in store count of around 15 per year, leading to a total store count of 1937 by the end of 2020. At this point, Lowe's would be more than 80% of Home Depot's size as measured by number of stores.
I am using relatively optimistic assumptions to model out same-store sales growth, and have used a growth rate of 4% for FY14 (in accordance with management guidance), growing to 5% through 2020. The chart below shows the store count and same store sales growth in my model:
(click to enlarge)
Gross margins for LOW have remained fairly stable at the 34-35% range over the last five years. In the model I assume stable gross margins at 35% - this is exactly in line with Home Depot's gross margins as well. I have also modeled SG&A expense to decline slightly each year to reach 23.4% of sales by 2020. The Home Depot spends only 21% of sales on SG&A, so there is an opportunity for LOW to become more efficient. A comparison of gross margins and SG&A expenses for LOW and HD is shown in the chart below.
To calculate cash flow, I have assumed the ratio of depreciation to capex remains relatively flat - net income for Lowe's is lower than cash flow (since depreciation has been higher than capex), and I have factored this into my analysis.
Using these assumptions and discount rates/terminal value growth rates of 10% and 3%, respectively, I get to a fair market value (FMV) of $44 for Lowe's, which is around a 7% discount to current prices. This suggests that the company is modestly overvalued even with my aggressive assumptions on sales growth (6.0 % annually in my model, against 3.1% over the last 4 years). I am also assuming some operating leverage, through a reduction in SG&A expenses as a percentage of sales. Hence, I believe that my valuation model is fairly conservative. The one area of upside would be if Lowe's were able to reduce its SG&A expenses to the level of HD without a corresponding reduction in sales growth - this would push the FMV to $55, which would be a 17% upside to today's price. The complete valuation model is attached below.
In my last article, I wrote about how Home Depot was meaningfully overvalued at current prices relative to its growth outlook. Based on my analysis of Lowe's, it appears to be in the same boat, albeit the extent of overvaluation is not as much. It needs to meet a high bar to justify its current price, and investors should wait for a more opportune time to buy.
Additional disclosure: I am short LOW $30 puts.