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When market all cheering for the Q3 result, mainly for the fact that the company is able to continue drive the total sales up. All of a sudden, sentiment went from negative to unrealistically optimism about its future path, which is clearly shown in its price compared to SPX and how wide the spread looks against 50d MA:
Q3 is better than most analysts view but let's be honest, the price is forward-looking and Q3 means little for that because of the current economy status, with the only certainty we know is the volatility. I believe the price for LOWE'S will fall by 20-40% in next 3-12 months, and below are 3 reasons why this will be the case.
#1. Sales Growth Normalization
Despite an up-beating Q3 earning result, I still hold my view that eventually the growth rate will have to revert towards the long term trend in Q4, and this has already showing reflected in the declining customer transaction by 7.5% in Q3. US consumption expenditure for Services is clearly still lagging vs goods compare to pre-Covid spread, And we should expect Services to grow much faster with more reopening and that will compress the growth on goods especially durable goods which had the biggest increase since covid. Therefore the 24% growth achieved in FY2020 vs 3yr CAGR of 2% pre-COVID is abnormal and unlikely to repeat given return to normal will diverge consumption demand away from home improvements.
To factorise this into valuation, projected Comp Sales growth for FY2021E decline to 3.8% and further decline by 2.8% for FY2022E. Reduce Company’s implied share price by ~ 20%.
#2. Lower Operating Margin
Supply chain remains a key challenge in 2022, and Lowe's dominant imports are from China which has the highest level of stringency on Covid control, this can turn into a threat for restocking inventory, and even if it manages to fill the shelf from suppliers elsewhere, or most likely from domestic suppliers as a last resort, that implies a much higher COGS. Even worse is the persistent high inflation which not only impacts on the raw material but also implies historical high energy bills and labour compensation. This industry doesn't have much price elasticity given the large players all sell homogeneous products and appliances, hence one of its key competitive power is the price. All above will result in a lower operating margin assuming the price remain similar level which contradicts the company's guidance .
To factorise this into valuation, Operating margin will be below expected by 50bps across FY2021 and FY2022. Reduce implied share price by 5 -10%
#3. Housing Market slowing down
One thing unique about this sub sector under Retail is its higher correlation to housing market. If I plot the 20 years historical data on the three in log term, they are not irrelevant, and especially post 2009, LOW and housing sales almost move in the same direction all the time, and in April 2020 they declined hand-in-hand. Note that I have lagged the data for LOW for one month, which fits better than without lagging. That suggest the Housing sales can be a meaningful leading indicator for LOW's price for the next 1-2 month. This is actually intuitive as the demand for home improvement is directly linked to demand on housing market, we can see that the aggregated Housing sales recovered quickly in Q2 2020 and reached new high in Jan 2021, since then it has declined quite significantly already, however LOW didn't move inline from this point. One can possibly explain this with the strong renovation demand with most people working from home during the period, again this echo my previous point, this source of growth is pretty much one-off and unlikely to be the driver for the next cycle, and eventually the price should revert towards what the housing sales indicates.
Therefore understanding how housing market will perform in next year is also key for predicting the market price for LOW.
It is the consensus view that Fed will start to hike rates in Q2 2022. With the October inflation climbing above 6% in US while unemployment rate declining to record low, there is higher probability that the tightening schedule will be accelerated. Reason being first there is no more excuse for easing and secondly the elevated inflation is much more persistent than we anticipated. In fact, it becomes almost clear that without tightening, it won't just go away because what caused for it is the unprecedented monetary easing itself. As such mortgage rate is also expected to go up accordingly. US aggregated housing sales could fall by 10% YoY as a result. To incorporate this into LOW's pricing, my assumption is Sales growth for FY2022 will fall by 2.7% and 5yr CAGR to FY2023 will land at 5% vs 2% 3yr CAGR pre-Covid. Therefore Implied share price declines by ~10%
Valuation Summary
So now let's see what the valuation says from various pricing models. Most of the comparables also indicate LOW’s share price tends to be overvalued.When I price it against its peers, the price has normalized those risk factors tend to impact the entire sectors, however LOW still looks expensive. Apart from P/E of the trailing 12 months, which is close to its current price while implied price from the P/E of next 12 months is 13% lower. This to some extent echoes our concern over the earning for next 3-12 months.
The DCF, with my own long-term view son both systematic and idiosyncratic risk factors shows the lowest implied price in the Base case. Implied share price is also 12% below current share price even in the Upside Case The implied share price in the Base and Downside Cases is a 30-40% discount to the current share price.
DCF assumptions & Sensitivity Analysis
According to my DCF model, the current market valuation is unlikely to be justified. If WACC is at 10.5% -11%, The current price is still overvalued at Terminal Growth Rate of 6%. While if Terminal Growth stays at 3.5% to 4.5%, we are still below the current price if WACC is as low as 9%.
In order to justify the current market price is fair or undervalued, we need a Terminal Growth at least 5% and WACC below 9%, both seem to be unrealistic even at our Upside scenario.
Key Risk factors
And then, there is always the other side of the story and below are the list of potential risk which can challenge my view above:
#1: better-than-expected Comp sales trend in next 12 months. i.e, FY22E sales growth similar to FY21E vs our base case of down 2.7% (implied price boost by 20%)
#2: Supply chain largely improves in short term helps to relieve the cost pressure, and enhance operating margin growth by 30 -50 bps(implied price boost by 5 -10%)
#3: later than expected rates hiking followed by continuation of strong housing demand. FY22-23E sales growth better than estimated by 1.5% (implied price boost by ~10%)
Recommended Hedges:
#1: We can mitigate these risks by purchasing Jun22 call options at $280–$295 (to limit losses to 15-20%). We could structure a zero cost collar by underwriting Jan23 put options at $160 –170 (30% to 35% OTM)
#2: Long ETF tracks S&P500 consumer Discretionary Sector.