The bears piled on Lowe's (LOW) in the weeks leading up to its 3Q10 report, marking down EPS forecasts and issuing ratings downgrades. Such sentiment was well-founded. Although retail sales have shown signs of a pulse in recent months, measures used to track home remodeling activity have continued to be soft.
With renewed pressure on home values post tax credit nationwide, the homeowner has less impetus to invest in a depreciating asset. Homeowners continue to engage in smaller ticket permanent refurbishments or seasonal sprucing up rather that the McMansion type upgrades synonymous during the housing boom.
Second, the foreclosure mess has added a variable not accounted for by many; no foreclosures moving through the pipeline, no need to buy the tools and materials found at Lowe's. I must say, however, that I was pleased by Lowe's 3Q10 report as it fit squarely with my takeaways from analyst day in the summer.
Nevertheless, I sensed an interesting story emerging at Lowe's. That story is basically one of a retailer finding ways through technology to do more on the earnings front while getting less, or inconsistent, trends on the top line. As such, consensus may not only be questioning the validity of the indeed ambitious 4Q10 guidance (calls for sequential comp acceleration), but where the numbers stand to fall in FY11.
Lowe's management, in my view, sounded incrementally cautious on the housing market recovery relative to the 2Q10 earnings calls and NYC analyst day, and now thinks its revenue fortunes are tied to unemployment and increases in income than housing turnover. I tend to agree with this assessment. However, the debate will rage on as to whether Lowe's can grow earnings in line or ahead of consensus next year against pockets of weakness in important areas of the stores and sluggish broader housing trends. (See 3Q10 conference call transcript here.)
With Lowe's trying to push through prices increases to combat inflationary pressure a hit to the positive comp trajectory experienced in FY10 shouldn't be ruled out. I believe that Lowe's increasingly granular approach to inventory planning and pricing are powerful tools that are like to foster upside earnings in FY11, provided comps do not slip back into negative territory to a large degree (if they were to do so, share repurchases could be scaled back).
I am comfortable with my 4Q10 and FY11 EPS modeling. Presently, the stock trades at a P/E multiple of 12.3x my unchanged FY11 EPS estimate of $1.80 (assumes 25% YOY growth), a 22% discount to the 9-year P/E mean multiple and a 10-% discount to Home Depot (HD) when applying my internal estimates. This is a compelling valuation for Lowe's from absolute and relative perspectives.
While Lowe's shouldn't trade on the 9-year P/E mean multiple given top line considerations and an operating margin will be sub 2006 peak, I expect multiple expansion as operating margins expand in the context of zone pricing and base optimization, and a leaner US store footprint. Compared to Home Depot, Lowe's tools to extract efficiencies is slowly steering the debate in its favor (Home Depot had been driving efficiency gains at a strong pace in 2009 and early 2010), and should at least trade on par with Home Depot.
- For Such a Large Sales Mix, $0.01 Beat Not Too Shabby: Lowe's reported 3Q10 sales of $11.59 billion, missing consensus for the second consecutive quarter, this time by $150 million. EPS ex. items (it was interesting see charges taken to future store openings...) was $0.31, in line with my modeling, supported by a gross margin beat of 58 bps to consensus and $560 million in share repurchases. Comps and EPS were towards the upper end of guidance, but the former did continue to pullback from the 1Q10 peak (less tax credits). The market may be slightly disappointed by 4Q10 EPS guidance of $0.16-$0.19 (below consensus EBIT margin guidance). But, again, given the muted sentiment on the stock pre-earnings, I wonder if relatively in line guidance is a positive thing.
- Inside the Business: Comp traffic and ticket were positive; comp ticket +$500 up 1%; 20 bps of unit share gained; comp trends by month were flat August, -5% September, +1.2% October.
And the Charts Say...
Lowe's has delivered three consecutive quarters of positive comps following over three years of declines (tough to imagine huh). The gains are slowing, however, as Lowe's benefits less from government tax credits for energy efficient products and appliances, and consumers remain steadfast on small scale housing upgrades. The work that Lowe's has done on gross margins has been impressive, bringing the rate to levels not seen during the housing boom. In other words, Lowe's is generating more profits on a lower base of sales, which suggests strong earnings power once sales return some sense of normalcy.
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Disclosure: No position