By: Margin of safety equity research
Lowe’s Companies Inc. Analysis. Near-Term Headwinds but Above-Average Long-Term Potential
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Incorporated in 1952, Lowe’s Companies Inc (LOW) is the world’s second largest retailer in home improvement. Currently, it has a network of over 1,750 retail outlets across the U.S., Mexico, and Canada.
Its products include appliances, lumber, paint, millwork, building materials, lawn & landscape products, flooring, plumbing, seasonal living, tools, hardware, lighting, nursery, outdoor power equipment, cabinets & countertops, home organization, rough electrical and home fashion. Lowe’s stocks popular national brands and exclusive private brands across different categories. Its service lines are structured around installed sales (flooring, millwork and cabinets & countertops), protection and repair services and credit financing through GE Money Bank, Lowe’s Project Card and Lowe’s Visa Card. Services under the installed sales package are offered through a number of independent contractors. Appliances form the majority (11%) of sales, followed by lumber and paint (7%), millwork, building materials, lawn & landscape products, flooring and rough plumbing with 6% each.
Lowe’s achieved sales of $48.82 million in FY 2010, registering y-o-y increase of 1.3% in comparable stores sales. The projected decrease in comparable stores sales for FY 2011 is ~1%. Total sales for the year are expected to increase by 2-3% and diluted EPS is likely to fall in the range of $1.37-1.40.
REVIEW OF THE COMPANY, BUSINESS ECONOMICS
Lowe’s Companies Inc, a Fortune 50 company, is a dominant player in the home improvement retail segment. On the back of its efficient supply chain management, cost-reduction strategies, branding, economies of scale, and integration of the latest technologies into its supply chain and distribution network; Lowe’s has secured a durable competitive advantage. Lowe’s faces stiff competition from its main competitor, Home Depot (HD). The market currently imposes several entry barriers for new entrants, including high capital requirements, resources required for penetration, a downturn in the housing market, and dominance of the leading players. This fragmentation leaves room for domestic expansion by both Lowes and Home Depot, who are better placed than their smaller peers in terms of economies of scale, wider reach and financial strength. A crucial part of Lowe’s economic moat is its network of 14 regional distribution centers, which incorporate state-of-the-art technology to maximize automation. The firm has constructed an efficient supply chain to efficiently manage its multibillion dollar inventory of merchandise to its stores throughout North America. In addition, Lowes runs 15 flatbed distribution centers for merchandise that requires special handling. However, key competitors, such as Home Depot are fast catching up on most of these fronts that have traditionally been the areas of strength for Lowe’s. Therefore, apart from successfully implementing its growth strategies, Lowe’s has to continue innovating to attain higher customer engagement and cost-economies. For the two main rivals with largely similar offerings, pricing and customer services will become the key differentiators going forward.
Presently, Lowe’s is reeling under pressure on several fronts as reflected by its relatively weak FY 2011 results. The Company has cited external factors, such as high fuel prices, a weak economic recovery, sagging consumer confidence, bad weather conditions, and withdrawal of Government stimulus, as contributing to its current weak performance. Continued weakness in the housing market, contraction of lending by financial institutions, geopolitical instability, and high unemployment rates have put a damper on US consumer confidence and are suppressing investments in the home improvement sector. To address these headwinds, Lowe’s is implementing a turnaround strategy that is expected to streamline its organizational and operational structures to bring in more functional and managerial efficiency. The restructuring included the layoff of almost 1,700 middle-levels managers across stores and hiring of 8,000-10,000 part-time salespersons. The ~1.5% increase in selling hours is meant to cater to the additional ~1.4% potential transactions that arise during the weekends due to higher foot traffic. Lowe’s is belatedly waking up to the reality that tough market conditions are here to stay and is bracing itself for hard times ahead. Accessibility to physical stores has been a weak area for Lowe’s. The Company operates only 1,750 stores as compared to ~2,250 stores by Home Depot. To consolidate its physical presence, Lowe’s is targeting newer and more convenient locations for opening stores, while scaling back operations in low performing geographies. The Company is expected to open 26 new stores and close 27 for the full year 2011.
Lowes survived the last global recession by enhancing its operational efficiencies and taking strategic initiatives for growth. The efficiencies resulting from these actions over the last couple of years have become its key differentiator against its competition. The Company revamped its supply chain to achieve greater trailer utilization, reduced distances travelled, and higher number of mode conversions, bringing in cost reduction of ~$490 million over the last six years. A superior IT-based inventory management system is an area where Lowe’s is a step ahead of Home Depot. In 2010, Lowe’s reduced its reliance on third-party vendors, bringing in IT systems for onsite repairs in-house, this is expected to save $14 million per annum on a recurring basis. The company expects further savings through the introduction of after-sales services for major appliances in the outdoor power equipment or OPE category. These repair services bring cost-reductions in the form of a lower rate of OPE returns, while boosting repeat clientele. This combined with Lowe’s economies of scale, allows it to price its offerings competitively and absorb the impact of its promotional schemes, such as the 5% daily discount on purchases made through consumer credit cards. The Company is also increasing the number of its service stores and regional distribution centers to achieve cost-efficiencies related to transportation and faster shipping to enhance customer satisfaction.
As its finishes FY 2011, the Company plans to revise its market segmentation and pricing strategies based upon the local factors using Base Price Optimization, patch area expansion and market assorting through the implementation of Integrated Planning and Execution. This program is designed to customize its offerings based on the specifics of each store location: demographics, customer preferences, and store employee knowledge will all factor in to its IPE strategy. Differential pricing will be another factor that can help Lowe’s increase local market share over the longer term. To make inroads into newer customer segments in the flooring and other offerings, the Company plans to cover various pricing points in the near-to-medium term. This includes economical offerings to cover lower income groups and cater to changing customer preferences in favor of low-priced items in these challenging economic times. Understanding the market’s requirement for personalized services, Lowe’s is actively improving upon its client interface through its Project Specialist Exterior (PSE) and District Commercial Account Specialist (DCAS) programs. Both PSE and DCAS have shown some measurable results in installed sales (10% y-o-y increase in FY 2010) and Commercial Business Customer sales (higher increase than company average), respectively. The Company is also benefitting from its newly introduced customer care centers that handle after-sales services and customer complaints. After a pilot in 100 stores, it expects the model to continue generating repeat sales in the long-term.
The growing significance of online and mobile technology for the retail sector has also caught Lowe’s attention. In FY 2010, the Company redesigned its website to focus on a more personalized customer web experience with an interactive online platform and a larger selection of products and services. The number of items available online are expected to reach 260,000 by the end of FY 2011. This restructuring has led to an increase in online conversion rates by 78% and overall traffic by 19% y-o-y. In the trailing twelve months to July 2011, online unit sales registered an increase of 1.3%. Lowe’s has taken the initiative of launching its website in Spanish to cater to the rapidly growing Hispanic population in the U.S. Considering that online sales currently account for only 1% of the sales, it has introduced a mobile version of its website to tap into a wider audience on the go. The mobile version got over 1 million hits in the first month. This is a timely step in the right direction as online conversion rates are expected to grow proportionally to the growth in mobile ecommerce in the coming years. The Company is in the process of rolling out 42,000 handheld devices (Apple’s iPhone technology) for more than 60% of its physical store locations. The devices are expected to bring in operational efficiency for employees through features, such as real-time inventory check, access to instructional videos, and access to the Company’s website. Though Lowe’s move is a reactionary one, where rivals like Home Depot have already begun similar deployments from Q3 FY 2010, it is likely to consolidate its position with its existing customer base and help the Company keep pace with HD. Additionally; Lowe’s is utilizing social media for its broad-based branding and marketing. The Company has met significant success so far with Lowe’s becoming among the most recognized brands online.
Along with HD, Lowe’s is likely to maintain and enhance its position as a leading market entity in future. Many of its initiatives have already started to show results, though it is still grappling with less-than-expected overall performance as evident from its Q3 FY 2011 results. Revenues increased by 2.3% y-o-y, while the comparable sales registered a minor increase of 0.7%. Comparable sales for the first three quarters combined are still negative. Gross margin for the quarter decreased by nearly 1% y-o-y, while declining by ~0.4% for the first nine months of 2011. Among the key external factors affecting results include sagging consumer demand for big-ticket items, inflation, unemployment, and high fuel prices. Lowe’s performance is also negatively impacted by underperforming stores. Reorganization efforts, like the Every Day Low Price (EDLP) strategy and store opening/closing or relocation are also exerting short-term downward pressure on margins. Lowe’s is migrating to a new policy of procurement under which the emphasis will be to acquire inventory at the lowest possible rates and pass on the benefits partially to the customers in the form of EDLP. On the other hand, the proprietary credit value proposition launched in Q2 FY 2011, which allows 5% discount daily to Lowe’s credit card holders, increased the comparable sales by 90 basis points, while suppressing the gross margin by 35 basis points. These measures offer cost-advantage to customers and are designed to capture greater market share in the long run, though they appear to be putting a damper on short-term profitability.
Long Term Growth Rates/Averages
Chart: Earnings and Book Value per Share (2002-2011)
Long term revenue growth of Lowe’s has been strong, but the overall revenues in later years have witnessed a decline, mainly on account of weaker macroeconomic conditions. The 5-year growth rates fell to 0.9%, while the 3-yr rates fell to 0.6%. The Company struggled to keep up with the recent economic downturn, particularly due to the severe impact on the industry in which it operates. However, Lowe’s rebounded during the last fiscal, registering a growth of 3.38%. These trends were reflected in the Net Profit Margins as indicated by Chart 1. After the peak rates of 6.62% in 2006, margins troughed to 3.78% in 2009, finally rebounding to 4.1% in 2010 with the first signs of economic recovery. The increase is also attributed to the introduction of Project Specialist Exterior (PSE) program, District Commercial Account Specialist (DCAS) program and the mobile website, introduced during FY 2010. The EPS growth over the longer term has been lower than the revenue growth, recovering impressively over the last 3 years, driven by the increase in sales volume and share repurchases. Book Value Per Share has mirrored the revenues trend. Lowe’s has been an outperformer in terms of returns on investments, giving higher than average industry returns. Free cash flows have been quite unstable over the period. To account for this, our valuation model uses a five-year average to calculate the forward FCF for the first year.
Balance Sheet and Financial Health
Lowe’s Companies Inc. is a moderately levered company with a debt equity ratio of 0.35 against the industry average of 0.31. Its current interest coverage ratio of 11.3, places it in a highly comfortable position, especially when compared to the industry average of 1.7. The Management is planning to increase its Adjusted Debt to EBIDTAR target from 1.80x to 2.25x to acquire additional debt capacity of $3 billion to be utilized by the end of 2012. As a result, the short-term credit ratings will be downgraded to A2/P2 and the long-term ratings to A-/A3. However, the move will reduce the WACC by almost 50 basis points. The Company also maintains a positive liquidity position with current ratio of 1.14 in line with the industry trends. It has a quick ratio of 0.16 as compared to the industry average of 0.44. Operating cash flows increased by 1.5% y-o-y to $3.89 billion during the first nine months of FY 2011, while free cash flows registered a decrease of 6.8%. Net cash inflow was $0.02 billion as compared to $0.45 billion during the same period. Cash from operating activities ($3.89 billion) and net change in investments ($0.47 billion) more than offset buybacks ($2.43 billion), capital expenditures ($1.26 billion), dividends paid ($0.47 billion), and debt repayments ($0.03 billion) in the past three quarters. During 9M FY 2010, operating cash flows ($3.83 billion) more than offset buybacks ($1.62 billion), capital expenditure ($1.01 billion), repayment of long-term debt ($0.54 billion), and dividends ($0.42 billion).
The liquidity position for Lowe’s is augmented by a $1.75 billion Senior Credit Facility (renewed in October 2011), with a $0.5 billion letters of credit sublimit, and uncommitted revolver credit lines of C$50 million. Cash & cash equivalents and short-term investments were $0.97 billion and $0.91 billion at October 28, 2011 and July 29, 2011, respectively. Net debt position was $5.65 billion and $5.71 billion, respectively. The increased emphasis by Lowe’s on improved logistics, which has saved it approximately $490 million over a period of 6 years, is one of its key strengths as this translates into competitive pricing by the Company. Other initiatives, such as the PSE and DCAS programs for enhancing sales, mobile website, mobile applications and Integrated Planning and Execution program put the company a step ahead of the competition.
At the current PE multiple of 15.7x, Lowe’s is trading lower than the industry average of 16.2x. This represents a dip from 19.8x and 18.6x in FY 2009 and FY 2010, respectively. The forward multiple of 13.0x places Lowe’s lower than the recession levels and we do not see any significant departure in the near term. The Price to Book ratio of 1.7 is higher from the value investing perspective and also when compared to the industry average of 1.2. Historically, the this ratio for Lowe’s has stayed in the similar range. The EV/EBITDA multiple of 7.1 is lower than the industry median, making the stock attractive vis-à-vis its peers.
At $23, Lowe’s is trading at 24-25% less than its weighted intrinsic value of $30.03. The current stock price also falls lower than its EPV of $33.98, further indicating that the IV models are consistent. At a Margin of Safety of 35%, the target acquisition price for Lowe’s is $19.50. A modest, yet safe, dividend yield of 2.5% will bolster returns over time. Operationally, Home Depot has been performing better than Lowes over the last several years and is also worth a look; but it appears to be trading at only a modest discount to intrinsic value.
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Disclosure: Long LOW, purchased at $22.97.