Lowe's (LOW) and Home Depot (HD) have been on quite a bull run since I pitched them a few months back. Actually, in the last six months, they have both gained around 60% in value. In this article, I will run you through my DCF model on Lowe's and then triangulate the result with an exit multiple calculation and a review of the fundamentals compared to Home Depot and even Costco (COST). Despite its recent surge from the bottom, I find that Lowe's is still reasonably discounted to intrinsic value.
First, let's begin with an assumption about the top-line. Lowe's finished FY2011 with $50.2B in revenue, which represented a 2.9% gain off of the preceding year. I model revenue trending from 7.5% to 5% over the next 6-year period.
Moving on to the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I estimate cost of goods sold at 65% of revenue versus 24.5% for SG&A and 3.2% for capex. Taxes are estimated at 37% of adjusted EBIT (ie. excludes non-cash depreciation charges to keep this a pure operating model).
We then need to subtract out net increases in working capital. I estimate that this will hover around 0.4% of revenue.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 9% yields a fair value figure of $40.45, implying 19.9% upside. In finance theory, there is a heated debate over what should be the discount rate. One area of consensus is that it should measure the stock return threshold, so to speak, in which company is able to compel opening long positions. Over time, I believe this will decline to 8.5% as the economy improves - implying 32% upside.
All of this falls within the context of a challenging business environment:
"Given uncertainties surrounding the competitive environment in the fourth quarter, we forecasted a flat to 1% comp. This level of growth was similar to third quarter results and actually implied a slight improvement on a multiyear basis. In fact, we successfully executed our plans and drove significantly higher comps than forecasted in tools, appliances, building materials, lumber, flooring, fashion electrical, paint and nursery".
From a multiples perspective, Lowe's has plenty of room to appreciate and little downside. It trades at 21.9x past earnings but only 13.9x forward earnings versus 20.2x and 15.5x for Home Depot and 26.4x and 20.7x for Costco. Assuming a multiple of 16x and a conservative 2013 EPS of $2.19, the rough intrinsic value of Lowe's stock is $35.04.
Consensus estimates for Home Depot's EPS forecast that it will grow by 16.2% to $2.87 in 2013, and then by 12.5% and 13.3% in the following two years. Assuming a multiple of 16x and a conservative 2013 EPS of $3.19, the firm is roughly at fair value. The company has been able to edge out Lowe's at store locations, which indicates a stronger brand. Home Depot is also led by strong management that has taken aggressive actions to keep down union organization, thus allowing for better operational predictability.
Consensus estimates for Costco's EPS forecast that it will grow by 17% to $3.86 in 2012 and then by 13% and 12.8% in the following two years. The stock is valued at 18.5x 2014 EPS expectations, which means investors are really waiting a long time to see the justification of the valuation. Unlike Home Depot and Lowe's, Costco offers a variety of products beyond home improvement. This diversification significantly reduces risk, especially when one considers the prospects of a weak housing market juxtaposed against an otherwise strong economy.
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