Lowe's Companies: Strong Cash Flow And 10%+ Return Potential

|
About: Lowe's Companies, Inc. (LOW)
by: Passive Income Pursuit
Summary

Lowe's Companies is a Dividend Champion with 56 consecutive years of dividend growth. Shares currently yield 1.90%.

Lowe's Companies is the second largest hardware and home improvement store in the United States.

Lowe's cash generation is strong; however, I do have one big concern about the company.

If management delivers on the expected growth, Lowe's should generate 10%+ annual returns over the next decade.

Lowe

The first Lowe's Companies (LOW) store opened 98 years ago in North Carolina. It now operates 2,015 home improvement and hardware stores in the United States, Canada and Mexico. I've owned Lowe's for nearly 2 years now and the results have been solid, if not spectacular with nearly 13% internal rates of return.

A few weeks ago, I was getting things ready for our daughter to move into her own room so our newborn could take over the nursery next month. With several trips to the local Lowe's, and Home Depot (HD) (you can read my analysis here), I wanted to dig into the second largest hardware and home improvement store in the United States to see if it deserved more of my investment capital.

Dividend History

Whenever I invest my savings into a business I want management to treat me as I am, an owner of that business. If I owned a business 100% I would want to return excess cash that isn't needed by the business to myself and other owners. There's no sense in keeping excess cash in coffers if there's not a good use for it within the business.

Lowes Companies Dividend History Passive-Income-Pursuit.com

Image by author; data source Lowe's Companies Investor Relations. An interactive version of this chart is available here.

According to the CCC list, Lowe's had paid and increased dividend payments to shareholders every year for 56 consecutive years. That gives them the title of Dividend Champion which they share with just 131 other companies.

While some companies amass a lengthy streak of increases with small raises that hasn't been the case for Lowe's. Dividend growth has fluctuated greatly from year to year; however, the longer term trends look solid with the worst 10-year dividend growth rate coming in at 7.0%.

The 1-, 3-, 5- and 10-year rolling dividend growth rates since 1984 can be found in the table below.

Year Annual Dividend 1 Year 3 Year 5 Year 10 Year
1984 $0.010 12.36%
1985 $0.011 9.00%
1986 $0.012 11.01%
1987 $0.013 7.44% 9.14%
1988 $0.014 7.69% 8.70%
1989 $0.015 8.57% 7.90% 8.73%
1990 $0.016 7.89% 8.05% 8.51%
1991 $0.017 3.66% 6.69% 7.04%
1992 $0.018 3.53% 5.01% 6.25%
1993 $0.020 13.64% 6.84% 7.39%
1994 $0.021 6.00% 7.64% 6.88% 7.80%
1995 $0.023 8.96% 9.49% 7.09% 7.80%
1996 $0.025 9.09% 8.01% 8.19% 7.61%
1997 $0.028 9.52% 9.19% 9.42% 7.82%
1998 $0.029 4.35% 7.63% 7.57% 7.48%
1999 $0.030 4.17% 5.98% 7.19% 7.04%
2000 $0.035 17.33% 8.45% 8.79% 7.94%
2001 $0.038 6.82% 9.29% 8.33% 8.26%
2002 $0.040 6.38% 10.06% 7.70% 8.56%
2003 $0.053 31.25% 14.25% 12.76% 10.13%
2004 $0.070 33.33% 23.02% 18.47% 12.69%
2005 $0.100 42.86% 35.72% 23.22% 15.78%
2006 $0.160 60.00% 44.98% 33.59% 20.30%
2007 $0.260 62.50% 54.87% 45.41% 25.14%
2008 $0.330 26.92% 48.88% 44.43% 27.62%
2009 $0.350 6.06% 29.81% 37.97% 27.85%
2010 $0.400 14.29% 15.44% 31.95% 27.51%
2011 $0.500 25.00% 14.86% 25.59% 29.53%
2012 $0.600 20.00% 19.68% 18.20% 31.10%
2013 $0.680 13.33% 19.35% 15.56% 29.19%
2014 $0.820 20.59% 17.93% 18.56% 27.90%
2015 $1.020 24.39% 19.35% 20.59% 26.14%
2016 $1.260 23.53% 22.83% 20.30% 22.92%
2017 $1.520 20.63% 22.84% 20.43% 19.31%
2018 $1.780 17.11% 20.39% 21.22% 18.36%

Table and calculations by author; data source Lowe's Companies Investor Relations. An interactive graphical version of this data can be found here.

As you can see in the following graph the payout ratio has increased over the last decade although it's still at a very healthy and conservative level of 28% for FY 2018. Given Lowe's great cash flow, as you'll see below, future dividend growth should still be strong through growth of the business as well as the possible expansion of the payout ratio.

Lowes Companies Dividend Payout Ratios Passive-Income-Pursuit.com

Quantitative Quality

Businesses with strong fundamentals will show it in their numbers.

Lowes Companies Revenue Operating and Free Cash Flow Passive-Income-Pursuit.com

Image by author; data source Lowe's Companies SEC filings

Lowe's has managed to grow revenues 51.0% in total since the excess induced housing bubble. That's roughly 4.7% annual growth over the last decade with revenue growth accelerating starting FY 2014. Over that time revenue grew from $47.2 B in FY 2009 to $71.3 B for FY 2018.

The strong revenue growth from Lowe's has led to 52.8% growth in operating cash flow over the same period which is roughly 4.8% annual growth. Free cash flow has exploded higher growing 122.6% over the last decade or 9.3% per year.

It should come as no surprise to see that Lowe's free cash flow margin has made significant strides over that time improving from 4.8% in FY 2009 up to 7.0% for FY 2018. Unfortunately, it doesn't quite hit my 10% threshold, although that's not a hard limit due to margins being very industry specific. Lowe's average FCF margin over the last decade has been 5.9% with the 5 year average coming in at 6.6%.

Lowes Companies Cash Flow Margins Passive-Income-Pursuit.com

Image by author; data source Lowe's Companies SEC filings

Alternatively, I like to examine the FCF ROIC and believe this gives a better view of the efficiency and profitability of a company. The FCF ROIC is the annual return based on free cash flow that a business generates based on the capital invested in the business, both debt and equity. I also like to calculate the FCF ROIC "Net" value which nets out the cash held on the books from both equity and debt. A strong cash generating entity should have 10% or greater FCF ROIC.

Lowes Companies Free Cash Flow Returns Passive-Income-Pursuit.com

Image by author; data source Lowe's Companies SEC filings

While Lowe's FCF margin was a bit underwhelming, their FCF ROIC has been truly outstanding. In FY 2009 Lowe's FCF ROIC was 9.3% and has been above 10% every year since while improving to 25.3% for FY 2018.

To understand how Lowe's uses its free cash flow, I calculated 3 variations of the metric, defined below:

  1. Free Cash Flow (FCF): Operating cash flow less capital expenditures
  2. Free Cash Flow after Dividends (FCFaD): FCF less total cash dividend payments
  3. Free Cash Flow after Dividends and Buybacks (FCFaDB): FCFaD less total cash spent on share repurchases

Ideal investment candidates should maintain a positive FCFaDB a majority of the time since that would mean the business generates more cash than is needed to run the business as well as return excess cash to shareholders via dividends and buybacks and still have some left over to pad the balance sheet or increase future capital return.

Lowes Companies Free Cash Flows Passive-Income-Pursuit.com

Image by author; data source Lowe's Companies SEC filings

As we saw earlier Lowe's has done a tremendous job generating and growing FCF. Cumulative FCF over the last decade has totaled $34.1 B. That's allowed management to move up the capital allocation tree with paying and growing their dividend.

Over the same period, Lowe's has paid out a total of $8.69 B in dividend payments to shareholders. That puts the FCFaD over the entire period at $25.4 B. The positive FCFaD has allowed management to continue to rapidly grow their dividend payment as well as return excess cash to shareholders via share repurchases.

Unfortunately, here's where things aren't as pretty. Lowe's has spent a total of $31.8 B on share repurchases over the last decade which puts the FCFaDB at a negative $6.4 B for the entire period. As we'll see later, that imprudent spending has led to a deterioration of the balance sheet and in turn erosion of the shareholders' stake in the business. The excess spending has slowed in recent years from the 2011-2015 period and for FY 2018 Lowe's managed a positive $0.5 B FCFaDB.

With that $31.8 B spent on share repurchases, Lowe's has bought in 44.6% of the shares outstanding at the end of FY 2009. That's an incredible 6.4% annual reduction. Lowe's managed to repurchase >9% of the shares outstanding in 2011 and 2012 with steady decreases in the percentage repurchased ever since. FY 2018 marked the smallest decline at 3.3%.

Lowes Companies Shares Outstanding Passive-Income-Pursuit.com

Image by author; data source Lowe's Companies SEC filings

The following chart shows the ratio of cash spent on share repurchase and dividends. Over the last decade Lowe's has spent roughly $3.50 dollars on share repurchases for every $1.00 paid out as dividends. As a dividend growth investor my preference is to see dividends be the primary capital return mechanism although buybacks are more tax efficient.

Lowe

Image by author; data source Lowe's Companies SEC filings

Since Lowe's has spent more cash on dividends and share repurchases than free cash flow I wanted to take a deeper look at the cash returned to shareholders. The following chart breaks out the share repurchases into cash and debt funded buybacks.

Lowes Companies Dividend vs Cash Buyback vs Debt Buyback Passive-Income-Pursuit.com Image by author; data source Lowe's Companies SEC filings

Cash funded buybacks have still accounted for the majority of share repurchases over the last decade. Since debt funded buybacks peaked in 2012 they've been on the decline as free cash flow has made significant improvements while the total spent on repurchases has remained relatively flat. For FY 2018 Lowe's had a positive FCFaDB potentially signaling an end to the debt funded repurchases.

Moving on to the debt and the balance sheet here's where things don't look quite as good. Starting in FY 2009 shareholders have lost roughly 7% of their stake in the business every year. Debt has increased from ~20% of the balance sheet in FY 2009 up to 82% at the end of FY 2018. This a big concern for equity holders as their ownership claim on the business has been diluted and the increased debt load will be a strain on future cash flows.

Lowes Companies Debt to Capitalization Passive-Income-Pursuit.com

Image by author; data source Lowe's Companies SEC filings

While the overall level of debt is a problem, the debt that is on the balance sheet is relatively cheap. In FY 2018 the interest expense was $0.624 B and with FCF of $5.02 B the free cash flow interest coverage comes to 8.0x. The entire debt load on Lowe's balance sheet could be paid off with 3.2 years of FY 2018's FCF or 4.6 years of FCFaD which is a bit higher than I'd like but is not a true burden at this time.

If management can resist the temptation to continue to increase the debt load then Lowe's will be just fine as there's plenty of cash being generated by the business to service and eventually pay down the debt. Although it will take a commitment from management to do so.

Valuation

To determine whether Lowe's would make a good investment I like to use the minimum acceptable rate of return or "MARR" analysis. A MARR analysis requires you to estimate the future earnings and dividends for a company and to apply an expected valuation on those future earnings. If the expected return is greater than your investment threshold then you invest, if not then you wait.

During Lowe's 4Q earnings release in February, management is guiding for $6.00-$6.10 in EPS for FY 2019 with further improvements in margins. On average analysts expect Lowe's to show 15.6% annual earnings growth over the next 5 years. I then assumed that earnings growth would slow to 6.0% per year for the following 5 years and that dividends will target a 35% payout ratio.

For the expected multiple that Lowe's will trade at in the future, I start with what Lowe's has historically traded for in the past. As you can see in the following charts, Lowe's has typically been valued by market participants between 15x-25x TTM EPS. For the MARR analysis, I'll examine multiples ranging from 10x-25x.

Chart Data by YCharts

The following table shows the potential internal rates of return that an investment in Lowe's could provide with a purchase price near $102 under the assumption that the forecast growth rates play out. Returns include estimated dividend payments and are run through the end of calendar year 2023, "5 Year", and calendar year 2028, "10 Year".

Lowes Companies MARR Analysis Expected Returns Passive-Income-Pursuit.com Alternatively I like to figure out what purchase prices would generate a desired return based on the varying P/E ratios. The same assumptions from above apply to the following purchase price targets.

Lowes Companies Purchase Price Targets Passive-Income-Pursuit.com To justify the 15% return target I wanted to take a more measured approach. The estimated growth in earnings, using the above assumptions, over the next 10 years works out to 11.2% growth. The current dividend yield is ~1.9%. To find undervalued opportunities I want to see roughly 20% growth from valuation change over the next decade which would equate to ~1.8% annual growth. Add those 3 together and you get 14.9% and rounding up puts the discount rate at 15.0%.

Risks to an Investment in Lowe's

As a home improvement store, Lowe's is tied to strength of the economy. As the economy softens and household budgets get tight that means consumers will pare back all but necessary spending on home improvement projects. That being said I believe any issues will just delay spending as opposed to completely curtailing it.

Another big issue for Lowe's is why are their stores underperforming. During the 3Q FY 2018 earnings release management stated that it is completely exiting the Mexico market over time as well as 20 stores in the United States and 31 stores in Canada. This suggests that the domestic market, as well as Canada, is fully saturated and the easy growth of new store locations are behind them. Future growth will need to come from further improvements in operational efficiency as well as taking market share from its competitors.

Conclusion

Coming out of the housing bubble, Lowe's has shown strong growth in revenues and big improvement in free cash flow generation. Since Lowe's is primarily built out less capital needs to be devoted to capital expenditures and in turn the asset base has relatively flat. Those two have allowed Lowe's to significantly improve its free cash flow return on invested capital up to 25% for FY 2018.

However, not everything is rosy here as management has significantly reduced owners' stake in the business by taking on debt, primarily to repurchase shares. Over the last 10 years Lowe's has spent $6.4 B more than cash generated by the business which explains part of the $11.1 B increase in debt over the same period. The debt on Lowe's books is fairly cheap at with 8.0x free cash flow interest coverage and not onerous as it could be paid off with 3.2 years of free cash flow.

It appears that management has started to pull back from their debt binge as total debt on the books decreased $770 M in FY 2018. They also returned to having positive FCFaDB in FY 2018 for the first time since FY 2009. I'll be monitoring debt and cash flow closely going forward.

The valuation appears to be on the high side of fair value at $102 per share. With expected earnings growth of 11% per year, a nearly 2% initial dividend yield and looking for 2% growth from valuation expansion the purchase price would need to be in the low $90s to generate a 15% annualized return. Since the bulk of the returns in that scenario is from rapid earnings growth, Lowe's isn't undervalued here and it would require that the business fire on all cylinders to continue with 10%+ earnings growth over the next decade.

On the other hand, if you're content with a 10% annual return, then Lowe's should easily hit that mark if the growth plays out as forecast. That being said you have to realize what you're giving up in that scenario which is returns that lag behind the growth of the business.

I currently have a position in Lowe's with a much lower cost basis. While I believe Lowe's is a high quality company, I see no reason to rush into a purchase this time. Should the share price pull back to <$90, I would begin to start looking to add to my position.

I am not a financial professional. Please consult an investment advisor and do your own due diligence prior to investing. Investing involves risks. All thoughts/ideas presented in this article are the opinions of the author and should not be taken as investment advice.

Disclosure: I am/we are long LOW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.