With a stagnant macroeconomy and a poor housing market, Lowe's (LOW) and Lumber Liquidators (LL) are a worthwhile consideration. The theory is that these companies have bottomed out in disregard to the strength of the fundamentals. While both home improvement retailers are rated a "buy" on the Street, I have a more reserved outlook.
From a multiples perspective, both firms are trading at the high of end of peers and appear overvalued. LL trades at a respective 20.4x and 14.4x past and forward earrings while Lowe's trades at a respective 18.2x and 14x past and forward earnings. These figures are at a considerable premium to similar European and Japanese companies. LL is in a more unique situation, as it is the largest retailer of hardwood flooring with more than 220 stores in 46 states. Lowe's, on the other hand, has intense competition from Home Depot (HD) - a battle that, as I describe here, it is losing.
At the third quarter earnings call, Lowe's CEO, Robert Niblock, noted disappointing performance:
Sales for the quarter increased 2.3% while comparable store sales were positive 0.7%. Comp traffic increased 0.7% in the third quarter, and comp average ticket was flat. Gross margin contracted 99 basis points in the quarter. Bob Hull will provide more details regarding gross margin in a few minutes.
We had good operating expense control in the quarter third quarter, however, as detailed in today's release, we recognized charges related to store closings and discontinued projects, which in aggregate reduced pretax earnings for the quarter by $336 million and diluted earnings per share by $0.17. Including this charge, we delivered earnings per share of $0.18 in the third quarter. Excluding the charge, we delivered earnings per share that exceeded our guidance for the quarter.
As I said before, our performance is not at the level we expect relative to the market or, frankly, that we demand of ourselves as we define success, so we're taking action.
The firm will be closing 20 stores and opening upwards of only 15. Interesting, most of the closings were in the Northeast and near Home Depot stores - a sign that the firm is struggling in what is traditionally accepted as the optimal choice in game theory. Accordingly, I remain concerned about the firm's ability to grow market share sustainably. Moreover, Lowe's, with only 2 stores in Mexico, is not as diversified in emerging markets as its competitor is. Global exposure is seen as a plus due to it being a hedge against domestic economic stagnation.
Consensus estimates for Lowe's EPS are that it will grow by 11.8% to $1.61 in 2012 and then by 10.6% and 16.9% in the following two years. Assuming a multiple of 17x and a conservative 2012 EPS of $1.70, the rough intrinsic value of the stock is $28.90. This implies only 15.7% upside and, in my view, does not render the firm a value play at the present moment. At the same time, it is notable that 21 of the 23 revisions to estimates went up.
LL may have strong flexibility in operations that can boost margins, but management has thus far struggled with execution. It is now the third time that guidance has been lowered for the year. While what's past is past, fourth quarter guidance has been revised below expectations. On the other hand, the Sequoia acquisition will grow Asian sourcing and expand margins.
Consensus estimates for LL's EPS are that it will grow by 4.3% to $0.97 and then by 23.7% and 21.7% more in the following two years. Assuming a multiple of 18x and a conservative 2012 EPS of $1.15, the rough intrinsic value of the stock is $20.70 for 21.1% upside. If the multiple were to fall to 16x and 2012 EPS turns out to be 15.8% below consensus at $1.01, the stock would only fall 5.4%. Accordingly, I believe that the stock has favorable risk/reward. Even still, given macro headwinds and underperformance, I would recommend holding out until conditions improve.