A reader recently passed along a link to a recent Barron’s interview with Steven Romick of First Pacific Advisors’ “contrarian value” Crescent Fund, suggesting that I might be interested in reading what Mr. Romick had to say, given our shared interests in Microsoft (NASDAQ: MSFT) and Cisco (NASDAQ: CSCO). The reader was correct, and I enjoyed reading the interview. It appears that Mr. Romick saved the best for last, ending the interview with these tantalizing tidbits of information about Lowe’s Companies, Inc (NYSE: LOW), the home improvement retailer:
Lowe’s doesn’t have a big international presence and trades at 12 times earnings in a low economic ebb. They own 90% of their stores. They have a 3% dividend yield. They’ve bought back 13% of their shares over the last 15 months.
Sounds pretty good, so I thought I’d give it a closer look. First, let’s look at the company’s returns over the last fifteen years.
Lowe's Companies - Returns, 1996 - 2Q 2012
We see that the company enjoyed returns in the high teens up until the recession. As expected, the combined effect of a broken housing market and weakened consumer was not kind to LOW, resulting in a dramatic decline in returns. We do see some signs of life as the company's returns appear to be at the early stages of a rebound. Let’s turn to revenues and margins.
Lowe's Companies - Revenue and Margins, 1996 - 2Q 2012
Here we see a dramatic increase in the company’s revenues from 1996 on, with a leveling off and ever-so-slight dip during the recession. The company sustained aggregate revenues as a result of increasing store count (we see this in declining operating and net margins, as the added costs of running more stores took a slight toll. This is also a big part of the decline in returns noted above). What’s interesting is that the company has done a remarkable job increasing its gross margins, accomplishing gains nearly every year. I find this impressive for a company with commoditized products and strong competition.
Lowe's Companies - Sales per Store, 1996 - 2011
Here we see the decline in sales per store. The store count increased from 1385 at the end of fiscal 2007 to 1749 at the end of fiscal 2011, for a total increase of 26% in just four years. I see a remarkable opportunity here. We are at a low point in the business cycle, and at some point in the future, as the housing market recovers and consumers begin home renovations and other projects that are currently on hold, sales per store will return to historical levels. As this occurs, the effect will lead to a drastic increase in revenue (and profitability, as the company’s business has significant economies of scale) given the new store count.
Let’s turn to free cash flows.
Lowe's Companies - Free Cash Flows, 1996 - 2Q 2012
Here we see that LOW’s free cash flows have increased dramatically in recent years. The result has been a slowdown in the pace of the company’s growth, lending some support for the idea that its historical capital expenditures have largely been driven by its increasing store count (growth capex), rather than maintenance capex. For readers of Bruce Greenwald’s Value Investing: From Graham to Buffett and Beyond, you will know that companies that have low maintenance capex demands can be great investment opportunities, because once growth slows, free cash flows increase dramatically (since the capital expenditures for growth, which were the bulk of total capital expenditures, are no longer required, freeing up cash flow). I believe this is what we are seeing with LOW. Over the last two years, store count has increased only slightly (the figures I noted above were driven largely by growth from 2007 to 2009). As soon as the pace of new store openings slowed, free cash flow skyrocketed.
Let’s look at the company’s capital structure.
Lowe's Companies - Capital Structure, 1996 - 2Q 2012
Here we see a potential concern with LOW. The company’s debt load is quite high relative to its cash balance (keep in mind, most of my other investments have cash balances that exceed their indebtedness – though Supervalu (NYSE: SVU) is an exception). However, the company’s debt is a small portion of its capital structure (as you can see from the red line in the chart above, indicating the company’s Debt to Equity ratio). Additionally, the company’s net interest expense is extremely low relative to earnings and free cash flow, so I believe there is little reason to worry here.
Two housekeeping items for those of us who have read Financial Shenanigans (Read my in-depth multi-part review here). First, let’s look for any trends in the difference between the company’s reported comparable store sales and a calculated ratio of revenues to total ending store count.
Lowe's Companies - Same Store Sales, 1997 - 2011
I don’t see anything to worry about here (though I would have been concerned in the late 90s!). Now we’ll turn to the company’s cash conversion cycle to look for any trends that could indicate future problems with inventories.
Lowe's Companies - Cash Conversion Cycle, 1997 - 2Q 2012
Ok, now let’s turn to valuation. Using a multi-step discounted cash flow analysis, I looked at possibilities of a recovery at different points in the future, with different assumptions about when sales per store will return to normal levels. Additionally, I considered the effect of continued expansion of store count. My conclusion is that the company is cheap and represents a good margin of safety.
Furthermore, even though the company is currently cheap on an absolute basis, there are many opportunities for future growth (either on an absolute or per share basis). First, as the company’s sales per store improve once again, there will be a dramatic increase in the company’s profits, even without an increase in store count.
Second, the company has barely touched international growth. While we could expect some growth in the US, the real future growth will be in international markets, continuing with Canada and Mexico and then overseas.
Finally, the company has rapidly been repurchasing shares, to the tune of $5.56 billion over in the last eight quarters, reducing share count by nearly 15%. And there’s more to come!
I am a big fan of LOW. What do you think?
Disclosure: No position, but may initiate within 72 hours.
