How Lowe Can You Go?

Lowe’s Companies (LOW), the second largest home improvement retailer, experienced a tough first quarter (see conference call transcript). Profits fell 18%, triggered by a weak housing market, slowing consumer spending and fuel and food inflation. All of these factors contributed to weaker than expected numbers and Lowe’s management lowered already-conservative earnings guidance for the full year by about 20%.

This is the fifth time in just over a year that Lowe’s has lowered guidance, which gives us pause as management has consistently overestimated the company’s forward-looking prospects. Springtime is usually a critical time for home improvement retailers as many homeowners embark on projects as the weather improves, but with many consumers uncertain about the near-term economy, fewer large projects than normal are anticipated. Prior to the announcement of today’s earnings news, the stock was up more than 10% year-to-date. However, following the bad news, the stock is off a modest 2.5% - 3%.

Weakness in the housing market has cost the retailer dearly, especially in those areas hit the hardest, specifically Florida and California. Overall, same store sales were off by 8.4%, and none of the 19 product categories experienced positive sales growth. Even after opening 150 new stores in the year, net sales for the franchise were down 1.3%. However, Lowe’s is not going to depart from its growth strategy as it expects to open 120 new stores this year. That is a slightly slower pace than in the past few years but still far more aggressive than more built-out Home Depot (HD), which plans to open 50 new stores this year. Lowe’s is hoping to grow its business through the troubling times, as smaller competitors may not be able to survive the slowdown as well as the two mega stores.

Unfortunately for Lowe’s, spending on home improvements may not pick back up again until 2009. The Harvard University's Joint Center for Housing Studies said in April that the second half of 2008 could be even worse than the first half. Lowe’s and Home Depot will be able to ride out the storm and perhaps even benefit from the loss of smaller, less well-capitalized competitors.

Ockham Research has LOW rated a Hold because—from a valuation perspective—the stock looks slightly undervalued compared to historically normal price-to-sales and price-to-cash flow. Given normal circumstances we would anticipate the stock would fetch between $26.70 and $34.10, given current revenue and cash flow. However, the stock will likely continue to struggle with the housing market weakness through the next quarter or two. If LOW and HD fall much further, the home improvement retailers will likely be a good long-term value play, as the housing crisis will not last forever. However, at this time, we think that HD has more appreciation potential than does LOW.

Disclosure: none

Comments

[CrossProfit]

Cute title!

We disagree with your $26.70/$34.10 valuation. Multiples tend to contract for sectors that under perform consistently and do not rebound until they are clearly out of the woods. This could take a while. A good forward indicator would be tenable improvement in consumer confidence.

See www.crossprofit.com/vi... for 2008 CrossProfit e-line.

CrossProfit (consensus)

[jimsep]

Too many stores being built into a downturn. Company is over-focused on market share.They need to put the breaks on.