Lowe's Stock Pops On Earnings; Creating A Selling Opportunity

Summary

• Lowe's is a great business, and the stock appears cheap on the surface, but there are big hidden risks over the medium-term.
• Pandemic stimulus and low interest rates created an unsustainable boom in earnings.
• It's highly likely earnings growth declines significantly over the next two years.
• I do much more than just articles at The Cyclical Investor’s Club: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »

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Introduction

I last wrote about Lowe's stock (NYSE:LOW) on April 18th, 2022, when I warned investors "Lowe's Is Probably The Biggest Value Trap In The S&P 500". And that it would be wise to sell the stock. Here is what I had to say in the conclusion of that article:

In order for a stock to be a "value trap", it needs to 1) look very attractive to investors, and 2) have a high likelihood of falling deeper than one might expect given the current valuation metrics. I think Lowe's meets both of those standards because of unusual "boom/bust" dynamics caused by government stimulus and unique pandemic activities. It looks attractive on the surface, but management's dividend policy (along with some common sense) tells us not to trust the current earnings trends, and not to extrapolate those out far into the future. I think it's reasonable to think Lowe's stock could still fall another -35% to -40% from here if we have a bear market. So, even though Lowe's is getting close to the high end of fair value, it likely isn't "cheap" at today's price and has further to fall at some point over the next 1-3 years.

I'm going to reexamine Lowe's stock again today in light of the recent earnings report in which they beat expectations. But I suspect that the same dangers I warned investors about in April are still present for the stock. Since that article was published, here is how Lowe's has performed:

Data by YCharts

While the total returns have been negative most of the time, the past week, better-than-expected earnings have pushed the stock into positive territory. This seems like a good time to review my medium-term value trap thesis to see if anything has changed.

My Standard Valuation Approach

I'm going to begin this analysis using my standard valuation approach for Lowe's to first show why the stock might look attractive on the surface, then, after that, I'll examine the risks. As part of the analysis, I calculate what I consider to be the two main drivers of future total returns: Market Sentiment returns and Business returns. I then combine those expected returns together in the form of a 10-year CAGR expectation and use that to value the stock.

Before I begin this type of analysis, I always check the business's long-term earnings patterns in order to ensure that the business is a proper fit for this sort of analysis. If the historical earnings 1) don't have a long enough history 2) are erratic in nature, or 3) are too cyclical, then I either avoid analyzing the stock altogether or I use a different type of analysis that is more appropriate.

FAST Graphs

Lowe's has a long earnings history on the FAST Graph, so there is plenty of data to work with. Over this time, it has had only three years where EPS declined. They were all during the Great Recession in 2008, 2009, and 2010. The cumulative decline over these three years was roughly -40%. My approximate threshold for categorizing a business's earnings as "cyclical" is that it tends to experience earnings drawdowns of -50% or more during down cycles. Lowe's is shallower than that, so I would not categorize this business as "deeply cyclical". For that reason, it is okay to use earnings and earnings growth, along with other traditional metrics, as a guide for valuing the stock. (This is what I will do in this article.) However, it's worth noting that a -40% earnings drawdown is still higher than average and this is what I would describe as a moderate-to-deeply cyclical business. That means it's wise to be careful when we are late in the economic cycle (as we likely are right now).

Because its earnings history is not too cyclical and earnings have shown solid growth, Lowe's meets all of the basic requirements for the Full-Cycle Analysis I'm about to share.

Market Sentiment Return Expectations

In order to estimate what sort of returns we might expect over the next 10 years, let's begin by examining what return we could expect 10 years from now if the P/E multiple were to revert to its mean from the previous economic cycle. Since we have had a recent recession (albeit an unusual one), I'm starting this cycle in fiscal year 2015 and running it through 2023's estimates.

FAST Graphs

Lowe's average P/E from 2015 to the present has been about 20.70 (the blue bar circled in gold on the FAST Graph). Before the recent earnings announcement, analysts expected EPS of $13.53 for this year's earnings. But after the earnings beat, management guided higher to $13.65 to $13.80, with one quarter remaining in the year. So, I am going to use the very high end of that range for my earnings estimate. It should be noted that is up from the $13.48 analysts expected back in April.

Using 2023's forward earnings estimates of $13.80, Lowe's has a current P/E of 16.01. If that 16.01 P/E were to revert to the average P/E of 20.70 over the course of the next 10 years and everything else was held the same, Lowe's price would rise and it would produce a 10-Year CAGR of +2.61%. That's the annual return we can expect from sentiment mean reversion if it takes ten years to revert. If it takes less time to revert, the return would be higher.

Business Earnings Expectations

We previously examined what would happen if market sentiment reverted to the mean. This is entirely determined by the mood of the market and is quite often disconnected, or only loosely connected, to the performance of the actual business. In this section, we will examine the actual earnings of the business. The goal here is simple: We want to know how much money we would earn (expressed in the form of a CAGR %) over the course of 10 years if we bought the business at today's prices and kept all of the earnings for ourselves.

There are two main components of this: the first is the earnings yield and the second is the rate at which the earnings can be expected to grow. Let's start with the earnings yield (which is an inverted P/E ratio, so, the Earnings/Price ratio). The current earnings yield is about +6.25%. The way I like to think about this is, if I bought the company's whole business right now for $100, I would earn $6.25 per year on my investment if earnings remained the same for the next 10 years.

The next step is to estimate the company's earnings growth during this time period. I do that by figuring out at what rate earnings grew during the last cycle and applying that rate to the next 10 years. This involves calculating the EPS growth rate since 2015, taking into account each year's EPS growth or decline, and then backing out any share buybacks that occurred over that time period (because reducing shares will increase the EPS due to fewer shares).

Data by YCharts

Over the past 8 or 9 years, Lowe's has bought back more than 1/3 of the company via share repurchases. These repurchases helped create that smooth EPS graph we saw in the FAST Graphs above and it also inflates the EPS growth over time. I will back these share repurchases out for my earnings growth estimate. After I do that, I get an earnings growth estimate of +17.68% over this time period.

Next, I'll apply that growth rate to current earnings, looking forward 10 years in order to get a final 10-year CAGR estimate. The way I think about this is, if I bought Lowe's whole business for $100, it would pay me back $6.25 plus +17.68% growth the first year, and that amount would grow at +17.68% per year for 10 years after that. I want to know how much money I would have in total at the end of 10 years on my $100 investment, which I calculate to be about $271.87 (including the original $100). When I plug that growth into a CAGR calculator, that translates to a +10.52% 10-year CAGR estimate for the expected business earnings returns.

10-Year, Full-Cycle CAGR Estimate

Potential future returns can come from two main places: market sentiment returns or business earnings returns. If we assume that market sentiment reverts to the mean from the last cycle over the next 10 years for Lowe's, it will produce a +2.61% CAGR. If the earnings yield and growth are similar to the last cycle, the company should produce somewhere around a +10.25% 10-year CAGR. If we put the two together, we get an expected 10-year, full-cycle CAGR of +12.86% at today's price.

My Buy/Sell/Hold range for this category of stocks is: above a 12% CAGR is a Buy, below a 4% expected CAGR is a Sell, and in between 4% and 12% is a Hold. That makes Lowe's a "Buy" at today's price using my basic analysis.

Next, I will try to poke some holes in my basic analysis and explain why I still think Lowe's stock is probably a value trap over the next 6 to 24 months, and why I wouldn't be a buyer at today's prices, and would instead take profits on the recent bounce if I were an owner.

Explaining The Dangers of Lowe's Stock

There are two very significant dangers to Lowe's stock that can easily go unseen by the casual investor. They both have to do with different types of cycles. And since I specialize in cycles (the name of my marketplace service is "The Cyclical Investor's Club" after all) I think I'm more apt to notice these dangers than other investors. The first danger comes from the fact that the US has not had a "normal" recession since 2009, and the housing market has experienced historically low mortgage rates for over a decade. This means that investors who examine Lowe's earnings trends are almost never baking in the effects of a recession:

FAST Graphs

Lowe's went into the 2008-2010 downturn with a 17 P/E ratio. Earnings per share fell from $1.99 in 2007 to $1.21 three years later in 2010. And the stock price dropped more than -60%. With a P/E near 16 right now, investors are not pricing in a single year of EPS declines, much less two or three years. So, absolutely no recession in 2023 is being priced into this stock, yet.

The second danger to Lowe's stock price is that we just had massive amounts of stimulus pumped into the economy, most of which will have ended, and in some cases reversed, in 2023. Lowe's was a huge beneficiary of this stimulus money and pandemic demand for housing.

FAST Graphs

You'll notice that the earnings growth estimate I used for Lowe's in my basic analysis was over 17%. But a great deal of that growth rate was due to stimulus-driven pandemic money that is temporary in nature. In the 4 years leading up to 2020, adjusted for buybacks, Lowe's EPS grew at about 9.73%. That's a pretty good earnings growth rate, but much lower than 17%. If we extrapolate out that growth rate as if stimulus didn't happen, Lowe's would have earned about $7.56 per share this year, much, much lower than the $13.80 they will likely actually earn.

Lowe's really hit the trifecta of stimulus, physical demand from people moving into more single-family homes in the suburbs during the pandemic, and record low interest rates. This caused a very big boom. Unfortunately, that boom will almost certainly end in 2023. And it might even get worse than just a reversal of stimulus growth, we will likely have a recession, and a recession for which a large part of the decline will be in housing. I don't see any way Lowe's avoids an EPS decline next year. Will it fall all the way back down to the previous trend line? Perhaps. But we likely need to include about 7% inflation over three years which will be relatively sticky since the stimulus money is still floating around the economy. If I add that in, we are probably looking at somewhere around $9 to $10 per share of earnings for next year if things normalize. That's about -35% less than the $14.35 analysts currently expect (which they lowered from $14.96 since my April article).

The upshot of all this is that while it's truly difficult to know how much earnings might fall next year, when the current estimates could be off by as much as 35%, it is just not a good set up for a stock, and the price has a very high likelihood to be lower during the next 6 to 24 months. And if interest rates stay elevated, it could be a fairly slow recovery from that decline as well. The best-case scenario is the stock price stagnates because there are a lot of buy-and-hold investors who are holding the stock for the dividend. But stagnation isn't typically what I aim for when I buy stocks.

Conclusion

Given the key drivers of Lowe's earnings growth the past three years are very likely to end over the course of the next two years, current holders of the stock are likely to be disappointed by returns. My base case is the stock drops about another -35% from here, and in a best case scenario medium-term returns are flat. Right now, analysts on Wall Street completely disagree with me, and Lowe's earnings are hanging in there. I don't expect this positive trend to last for more than six months, though. There are just too many headwinds to own this stock right now.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.