Lowe's: An Undervalued Dividend King Strongly Positioned In 2021
Summary
- Lowe's delivered blistering 24.2% YoY revenue growth and 54.4% YoY adjusted diluted EPS in 2020.
- With home sales expected to rise 10% in 2021 amid continued low interest rates and favorable demographic trends, Lowe's is positioned to benefit once again in 2021.
- In addition, I estimate that Lowe's shares are trading at a 5% discount to fair value based on my inputs into the DDM and DCF model.
- Between its 1.5% yield, 8.0-9.0% annual earnings growth, and 0.5% annual valuation multiple expansion, Lowe's is positioned to meet my 10% annual total return requirement over the next decade.
While 2020 was a year that resulted in a hit to the operating results of many businesses, an industry that particularly benefited was home improvement retailers.
As a result of over 5.6 million existing home sales in 2020 (a 5.6% increase from 2019), Lowe's (NYSE:LOW) was able to generate impressive double-digit revenue and adjusted diluted EPS growth during the year.
When taking into consideration that home sales are expected to increase by 10% in 2021 due to a continuation of relatively low interest rates and favorable demographics (i.e. increased Millennial first-time buyers), and that there is a strong correlation between the strength of the housing market and spending on furniture and home improvements, I believe that Lowe's is positioned for yet another strong year in 2021.
Lowe's Dividend Remains Very Safe
Even though Lowe's 1.51% yield is roughly in line with the S&P 500's 1.52% yield, and this indicates that the financial markets view Lowe's dividend as safe for the foreseeable future, I will examine Lowe's FCF and adjusted diluted EPS payout ratios to gauge the safety of Lowe's dividend.
Lowe's generated $11.049 billion in operating cash flow against $1.791 billion in capital expenditures during 2020 (according to data sourced from page 7 of Lowe's Q4 2020 earnings press release), for FCF of $9.258 billion.
When measured against the $1.704 billion in dividends paid out during that time, Lowe's FCF payout ratio equates to 18.4% for 2020.
This represents a marked improvement over the 57.5% FCF payout ratio during 2019 (as per data sourced from page 7 of Lowe's Q4 2020 earnings press release).
Additionally, Lowe's generated $8.86 in adjusted diluted EPS during 2020 (as per page 9 of Lowe's Q4 2020 earnings press release) against $2.30 in dividends/share paid out during that time, for an adjusted diluted EPS payout ratio of 26.0%.
When compared to the 37.1% adjusted diluted EPS payout ratio in 2019 (as per data sourced from Lowe's Q4 2020 earnings press release and dividends page), Lowe's significantly improved its adjusted diluted EPS payout ratio in 2020.
When I factor in that Yahoo Finance is forecasting a 9.1% increase in Lowe's average adjusted diluted EPS to $9.67 in 2021 and that I'm anticipating a ~10% increase in dividends/share paid out during the year ($2.30 in 2020 versus $2.52 in 2021), I believe that Lowe's adjusted diluted EPS payout ratio will remain steady around 26% in 2021.
Since this payout ratio leaves plenty of room for expansion over the long-term and Yahoo Finance is forecasting 13.7% annual earnings growth over the next 5 years, I believe that Lowe's is positioned to deliver 8.5% annual dividend growth over the long-term.
After A Jaw-Dropping 2020, Lowe's Is Again Positioned Well In 2021
Image Source: Lowe's Q4 2020 Earnings Press Release
In a typical year, I would consider Lowe's operating results to be impressive, but given the challenges faced by many businesses in 2020 due to the impact of COVID-19, I believe that Lowe's delivered downright jaw-dropping operating results in 2020.
Where many businesses were negatively impacted by COVID-19, Lowe's was arguably a beneficiary as Lowe's CEO Marvin Ellison noted in Lowe's Q4 2020 earnings call "during the pandemic, the home has come to serve four primary purposes: a residence, a home school, a home office and the primary location for recreation and entertainment."
Because COVID-19 forced most in the U.S. to stay at home throughout the year to help curb the spread of the virus, a home was transformed into so much more than a residence in 2020, which prompted tens of millions of consumers to take on DIY projects or hire contractors to aid in the transformation of their home into whatever their needs may have been to adapt to their circumstances.
This allowed Lowe's to increase its comp sales 26% in 2020, which resulted in a 24.2% YoY increase in the company's revenue from $72.148 billion in 2019 to $89.597 billion in 2020 (page 4 of Lowe's Q4 2020 earnings press release).
On top of Lowe's massive surge in revenue during 2020, Lowe's benefited from cost control measures, which boosted its operating income margin over 200 basis points from 8.75% in 2019 to 10.77% in 2020.
Further adding to Lowe's impressive operating results is the fact that the company repurchased $4.7 billion of its stock during the year (or nearly 4% of its outstanding shares in 2020).
When adjusting for a $0.06/share cost associated with restructuring Lowe's Canadian operations and $1.05/share loss on the extinguishment of debt, Lowe's generated $8.86 in adjusted diluted EPS, which represents a staggering 54.4% YoY growth rate compared to the $5.74 in adjusted diluted EPS reported in 2019 (according to data sourced from page 9 of Lowe's Q4 2020 earnings press release).
While 2020 was a great year for Lowe's, as investors, we don't invest in where a company has been, but where it is heading.
Fortunately, I believe Lowe's is positioned for another strong year in 2021.
Image Source: Lowe's Q4 2020 Earnings Press Release
Although Lowe's is forecasting sales will be slightly lower in 2021 ($86 billion at the top end of its $82-$86 billion forecast), the company is forecasting a 40 to 120 basis point expansion in its operating margin (from ~10.8% in 2020 to 11.2-12.0% in 2021 as per CFO David Denton's opening remarks during Lowe's Q4 2020 earnings call).
In addition to steady expansion in its operating margin forecasted during 2021, Lowe's maintains a great deal of flexibility with roughly $20 billion remaining on its share repurchases authorization (according to CFO David Denton's opening remarks in Lowe's Q4 2020 earnings call).
Accordingly, Lowe's anticipates that it will repurchase $9 billion of its shares during 2021, which equates to an astonishing ~8% of its outstanding share count based on the current share price. Since I believe that Lowe's is trading at a discount to fair value at this time (as I'll delve into in further detail below in the valuation section of the article), I am particularly pleased with this decision by Lowe's management team.
Image Source: Lowe's Q4 2020 Earnings Press Release
And based on Lowe's strong ability to generate free cash flow (as evidenced by the $9.3 billion during 2020 referenced in the prior section of this article), as well as Lowe's $4.7 billion in cash and cash equivalents as of January 29, 2021, it's clear that Lowe's won't be impairing its liquidity to execute this meaningful share repurchase endeavor in 2021.
What's more, Lowe's interest coverage ratio significantly improved from ~8.1 in 2019 to ~9.1 in 2020 (as per data sourced from page 4 of Lowe's Q4 2020 earnings press release), and is positioned to be relatively stable in 2021 based on the forecasts provided by management. This indicates that Lowe's faces no issues whatsoever in covering its interest expenses.
From purely a fundamental standpoint, Lowe's strong results in 2020 and the likelihood of continued momentum heading into 2021, suggest the stock is worthy of further consideration from investors at this time.
Risks To Consider
Even though Lowe's has delivered strong total returns in the duration of its time as a publicly traded company, it is important for prospective and current Lowe's shareholders to consider Lowe's risk profile as the manifestation of key risks could significantly alter the long-term investment thesis of the stock, which is why I will be outlining several risks associated with an investment in Lowe's based on its previous 10-K.
The first risk to Lowe's is that as a company that collects, processes, and stores sensitive information about its customers, employees, and vendors, it is of utmost importance to Lowe's reputation and long-term investment thesis to protect that data at all costs and prevent it from being compromised via a security breach of its information systems (page 11 of Lowe's previous 10-K).
Even though Lowe's spends a significant amount of resources each year to improve its cybersecurity, there is no guarantee that Lowe's won't some day find itself the victim of a significant cyber breach. If this does occur, not only could Lowe's face significant fines, government investigation, and lawsuits (which could adversely impact its near-term financial results), but Lowe's could also suffer from irreparable damage to its reputation, which could negatively alter its long-term operating results.
Another key risk to Lowe's is that in an increasingly digital retail environment, it will be important for the company to continue working toward making its omni-channel sales platforms (i.e. Lowes.com and Lowesforpros.com) as helpful and user friendly as possible to enhance the e-commerce customer's shopping experience (page 12 of Lowe's previous 10-K).
Even though Lowe's is likely to continue to allocate significant capital to its omni-channel sales platforms in the years ahead, there can be no assurance that customers will continue to favor Lowe's platforms over that of its competitors.
An inability to stay ahead of its competitors in delivering the best e-commerce shopping experience possible could negatively impact Lowe's online retail sales and market share.
The final risk facing Lowe's is that as a home improvement retailer, the company is highly dependent on macroeconomic indicators, such as consumer confidence levels, home appreciation, and unemployment rates (page 16 of Lowe's previous 10-K).
Given that the current outlook for 2021 includes a complete recovery in real GDP to pre-pandemic levels in the first quarter as a result of economic stimulus and continued business reopenings, it appears as though Lowe's is positioned for another strong year from an operational standpoint.
However, it's worth noting that the major structural headwind of elevated unemployment will remain for the foreseeable future as even with the strong February jobs report, the U.S. labor market has nearly 10 million less jobs than it did before COVID-19 arrived in the U.S, which will take several years to fully recover.
Although I have discussed multiple key risks facing Lowe's at this time, the above discussion of Lowe's risk profile shouldn't be interpreted as exhaustive. For a more complete discussion of Lowe's risks, I would refer interested readers to pages 10-16 of Lowe's previous 10-K and its newest 10-K that will be released in a couple weeks.
Lowe's Is An Undervalued And Underappreciated Dividend King
While Lowe's has established itself as a high-quality business with its reputation as a Dividend King, it remains crucial for investors to avoid overpaying for shares of the stock to lower the risks of a lower starting yield, valuation multiple contraction, and lower annual total return potential.
Fortunately for those considering purchasing shares of Lowe's, Lowe's is trading at ~16 times 2021's forecasted adjusted diluted EPS of $9.67, which suggests that Lowe's is trading at a discount.
In order to further support my belief that Lowe's is undervalued, I will be using two valuation models to determine the extent of Lowe's undervaluation.
Image Source: Investopedia
The first valuation model that I'll utilize to arrive at a fair value for shares of Lowe's is the dividend discount model or DDM, which considers the sum of future dividend payments, and discounts them back to present value. The DDM is comprised of the following 3 inputs.
The first input into the DDM is the expected dividend/share, which is another term for the annualized dividend/share. Lowe's current annualized dividend/share is $2.40.
The next input into the DDM is the cost of capital equity, which refers to the annual total return rate that an investor requires from their investments. While this typically varies from one investor to the next, I require 10% annual total returns on my investments because I believe that offers ample reward for the time and effort that I dedicate to researching investment opportunities and monitoring my investments.
The final input into the DDM is the annual dividend growth rate over the long-term or DGR.
While the first two inputs into the DDM require minimal effort to find a stock's annualized dividend/share and to set an acceptable annual total return rate, accurately predicting a stock's long-term DGR requires an investor to weigh multiple variables, including a stock's payout ratios (and whether those payout ratios are positioned to expand, contract, or remain the same over the long-term), future annual earnings growth, industry fundamentals, and the strength of a stock's balance sheet.
When I consider that Lowe's is positioned to deliver high-single digit annual earnings growth over the next decade and that there is room for expansion in the adjusted diluted EPS payout ratio, I believe it is reasonable to anticipate 8.5% annual dividend growth over the long-term.
Upon plugging the above inputs into the DDM, I am left with a fair value of $160.00 a share, which indicates that Lowe's is trading at a 0.6% discount to fair value and offers 0.6% upside from the current price of $158.98 a share (as of March 7, 2021).
Image Source: Money Chimp
The second valuation model that I will use to estimate the fair value for shares of Lowe's is the discounted cash flows model, which calculates the fair value of an investment by finding the present value of future earnings. The DCF model is also composed of 3 inputs.
The first input into the DCF model is the TTM adjusted diluted EPS figure, which is $8.86 in the case of Lowe's.
The next input into the DCF model is growth assumptions, which are very important to accurately forecast as even the smallest of errors in the growth assumptions can significantly skew a stock's fair value.
I believe that factoring in a 5 year annual earnings growth rate of 7% (or roughly half of Yahoo Finance's estimates) and a long-term annual earnings growth rate of 4% (or half of my long-term 8% estimate) is an appropriate assumption for Lowe's.
Finally, the third input in the DCF model is the discount rate or required annual total return rate, which I set at 10% because that is in line with the S&P 500's historical average annual total return rate.
When I put the above inputs into the DCF model, I arrive at a fair value of $174.55 a share, which implies that Lowe's is priced at a 8.9% discount to fair value and offers 9.8% capital appreciation from the current share price.
Averaging the two fair values above, I compute a fair value of $167.28 a share, which means that Lowe's shares are trading at a 5.0% discount to fair value and offer 5.2% upside from the current share price.
Summary: Lowe's Offers An Attractive Blend of Value And Growth Potential
Lowe's consecutive annual dividend increase streak of 58 years places it prominently among the Dividend Kings. While Lowe's dividend increase streak is impressive, it's also worth noting that due to its forecasted adjusted diluted EPS payout ratio around 26% for 2021, I believe Lowe's has many more years of strong dividend increases in its future.
Lowe's double-digit revenue and adjusted diluted EPS growth in 2020 was impressive, but even more importantly, the outlook for 2021 is also promising as Lowe's is forecasting roughly flat sales and a significant expansion in operating margins, which will lead to high-single digit earnings growth in 2021.
When considering that Lowe's is trading at just over 16 times this year's forecasted earnings and that Lowe's is trading at a 5% discount to my estimated fair value based on my inputs into the DDM and DCF model, I believe Lowe's offers a mix of value and growth potential.
Between its 1.5% yield, 8.0-9.0% annual earnings growth, and 0.5% annual valuation multiple expansion, Lowe's is positioned to meet my 10% annual total return requirement over the next decade.
Due to the preceding points, I am reiterating my buy rating of shares of Lowe's that was initiated in January 2019.
This article was written by
Analyst’s 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.
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