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This page was added to your Industry TrendsAs per IHS global insight report, home improvement market was ~ $264 billion in 2010 and experienced modes growth vs. 2009. The market is expected to advance 4.6% in 2011 to ~ $276.4 billion on modest improvement expected in the housing market. In longer term total market is expected to growth at CAGR of 5% to $344 billion by 2015.
There are number of positive trends which bode well for the overall growth of the home improvement market. Home ownership will increase in the longer term, despite experiencing declines due to mortgage crisis. Once the extra inventory is out of way and housing slowly comes back it will generate more jobs and lead to higher home ownership.
More and more people are entering the baby boomer age group who are expected to spend more time at home and spend more of their disposable income on home improvement projects. Another trend which is favorable to this industry long term is the increase in the number of homes more than 25 years old, which is expected to be as high as 75% of the total installed base. Increase in the mix of older houses will support the long-term trend of higher spending related to refurbishing of homes and home improvement.
Home Depot and Lowe’s control an increasing share of this market and will continue to eat away market share of smaller competitors on the strength of their excellent retail presence, and strong focus on distribution and supply chain management to offer its products at lower cost to consumers. Long term both companies will be on stable path of growing revenue, earnings and cash flow and deliver increased shareholder value.
Analysis of Lowe’s Business
An expanding network of more than 1700 retail stores covering majority of US GDP provide it an unparalleled economies of scale leading to low cost position in the market. Low has huge purchasing power, highly automated distribution network seamlessly connected with vendors, distribution centers and stores providing it a wide moat which is highly expensive to replicate providing it strong competitive advantage generating positive economic returns for its shareholders.
Current housing market environment has posed stiff challenge for Lowe’s to generate excellent returns it has generated in the past for its shareholders. Sales have been down, margins are under pressure, and unemployment in construction services hovering around record figures has posed a stiff challenge to Lowe’s growth in short term.
Despite all these challenges Lowe’s grew its EPS by 17% in FY11, though from a much lower EPS point reached at the height of crisis in FY10. If I look at EPS of LOW, I will say that they are still above the levels achieved in normal times before the housing bubble and are expected to reach $1.62 per share in FY12 which will be ~14% growth above the 17% growth achieved in FY11. LOW will be able to achieve these EPS target based on combination of tight cost controls, reduced share counts and some improvement in the housing market.
Despite all these challenges Lowe’s generated excellent free cash flow and further strengthened its balance sheet in the time of crisis. Lowe’s free cash flow increased from merely $337 MM in FY08 to ~ $2.5 Billion in FY11. I will have to admit though that most of this increase in the FCF has come from steep decline in capital expenditure due to smaller investments in opening new stores. Which I think is the sign of a good management who is taking appropriate measures to curtail capital investments in anticipation of slower growth short term. This is also adding to strength of their balance sheet in this time of extreme uncertainty. That Lowe’s was able to increase its dividends by ~ 46% in FY11 is testament to their shareholder orientation and confidence in the financial strength of their company.
Overall Lowe’s has a strong balance sheet with ~ $1.1 Billion in cash and cash equivalents and ~ 36% Debt to Equity ratio (much smaller vs. Home Depot) and excellent interest coverage ratio of 11 to 1 (11 dollars in cash from operations vs. $1 of interest expense) vs. 8 to 1 for Home Depot.
In addition Lowe’s return on invested capital is improving with each passing year. Before the crisis Lowe’s generated an excellent ROIC of ~ 15% to 16%. As with everyone Lowe’s ROIC was severely impacted by the mortgage crisis. But this is on mend now. Lowe’s has improved its ROIC to ~ 8.23% in FY11 vs. 7.39% in FY10 and is expected to further improve in FY12. I expect ROIC to be in mid teens in next two to three years as housing market improves.
ValuationsCurrent issues with the housing market appear to be well priced in the Lowe’s stock price and reflect a continuation of weakening housing prices and starts, the primary driver of home improvement projects. Any marginal improvements from here will drive the stock forward towards its intrinsic value which I estimate to be between ~ $23 and $27 dollars
I believe that addition of company’s tangible book value and its earnings power should provide a good estimate of the intrinsic value of any business. Lowe’s current tangible book value is ~ $13 and it earned ~ $1.42 in FY11. Even if we apply a very conservative multiple of 10 to calculate the earnings driven value of Lowe’s, that will provide us with ~ $27 in intrinsic value ($13 + $14.2), providing us with ~35% margin of safety for a low risk business with limited downside. On top of Lowe’s low valuation, Lowe’s offer ~ 2.7% dividend yield which is expected to be even higher in the future. Lowe’s has on average increased its dividends by ~ 27% in last 5 years (dividend per share declined by ~ 20% at the peak of crisis).
Based on discounting future owners earnings (as defined by Warren Buffett as equal to Net Income + Depreciation and Amortization + Noncash charges – average capex) at ~ 10% provides us with approximate intrinsic value of $26.2, providing us with ~ 30% of margin of safety. Including 2.7% dividend yield provides us with margin of safety of ~ 33% for a very low risk business. Lowe’s has grown its owners earnings by 29.2% in FY11 (growth is higher given the low base of owner earnings established at peak of crisis in FY10). For my model I have assumed current owner earnings growing by ~ 7% in next 3 years and by 10% in year 4 and 5. Beyond year 5 I have assumed owner earnings to be growing at a terminal rate of 3% (estimating earnings beyond year 5 is always tricky so I have to be conservative)
Historically Lowe’s stock has traded at an average P/E of 18 (average 2002 – 2011). Applying 10 year average P/E to FY11 earnings of $1.42 provide ~ value of $25.7 providing us with 28% margin of safety. If conservative P/E of 16 is applied that provides us with an intrinsic value of ~ $23. On historical P/BV basis, Lowe’s has traded at average P/BV ratio of 2.8, even if we apply conservative P/BV ratio of 2 will provide us with an approximate value of $26.6 providing us with 32% upside opportunity excluding 2.7% dividend yield.
Clearly based on multiple models I have highlighted above Lowe’s is undervalued and provide us with great opportunity to buy this low risk well managed business for cheap.
RisksClearly the major risk to all the estimates is how quickly we come out of this housing quagmire. (Warren Buffett is very optimistic and predicts that we should see good improvement in housing market in next 1 – 2 years when current excess inventory will be absorbed). Stock price might suffer further if economy deteriorates further
CompetitionThough competitive, home improvement market can be easily categorized as a duopoly with Lowe’s and HD leading the market shares. Both competitors have maintained a very rationale pricing environment ensuring that profitability will be intact once the housing market improves.
DisclaimerI currently have a position in shares of LOW and will add to my position if shares fall further.
About the author:
Dheeraj Grover
I am an individual investor with deep interest in the field of value investing. My ideas and thinking is inspired by highly respected value investors like Ben Graham, Warren Buffett, Walter Schloss, Bill Ruane and Tweedy Browne
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Anyway, I have some points to cover about your analysis.
1. I would ask you about the home improvement market. Who are the competitors Lowe's recognizes, aside from Home Depot? What are the market shares they have controlled over the long-run and what does it say about industry stability?
2. You've mentioned Lowe's "1700 retail store" network twice, and you did not even use it to buttress your research. You could've tried looking into the average square footage per retail store, and then try to gauge their efficiency in maximizing the benefits of a scale economy as far as cost absorption and revenue generation are concerned. Plus, the movement of retail stores in both Home Depot and Lowe's could've said something about the corporations' outlook on the housing market.
The housing market is integral to the health of the industry. No homeowners, no potential business, right? You were looking into the number of houses that are "at least 25 years old" but I don't even see actual figures in your report, and I'm not even sure if I should even make the assumption that all these houses are both owned and occupied.
3. What has been Lowe's EPS during the era prior to the housing bubble? Assuming share count was constant, how did it move? Operations was responsible for how much % of EPS?
4. Are you sure the improvements in FCF came from the steep decline in capex alone? I'm thinking you could've given us more insight by providing Net OCF and Net OCF prior to changes in working capital.
5. How much does Lowe's give in dividends? It paid a greater amount of dividends, yes, but can LOW's still afford to increase 'em? In fact, what is funding their dividends? I've seen companies that paid dividends with borrowed money...
6. IMO, interest coverage ratios are not as important as coverage ratios taking into consideration ALL required payments, i.e. debt principal payments, interest, and rent expenses for leases. Your analysis would be better off taking these into account (on a historical basis) and projecting it forward with their current obligations.
7. What is the denominator for your computation of ROIC? Since leverage is pretty small, where does Lowe's shine, profitability or efficiency? The likelihood of ROIC increasing beyond 15% depends the efficacy of its cost controls or its ability to generate more sales without investing more into its business.
8. Your 5Y CAGR of owner earnings, given your 7% Y1 to Y3 g and 10% Y4 and Y5 g, is roughly 8.2% a year. Does this underperform its historical growth? And justify your terminal 3% growth, please. IIRC long-run inflation was a bit lower than 3%.
BTW, I don't think you should add dividend yield to a DCF-sourced MOS. Owner Earnings is just an alternative method of computing free cash flows to the firm. To adjust it for equity, you should consider the amount Lowe's must shell out to repay its outstanding debt. Even then, the resulting amount is just going to leave you with a lump sum Lowe's can use for "value-adding" techniques like share repos or dividends, investments in securities or associates, or retain it as cash. Considering those, adding dividends to owner earnings is, well, redundant.
9. As far as your valuation is concerned, you're just projecting price multiples forward. The only other model you're using is DCF, and honestly I don't even know if your 10% discount rate accurately reflects the risk investors are taking with Lowe's. Aswath Damodaran has pegged a US equity risk premium of about 5%. Last I checked, a 5Y T-Bond runs a coupon rate of 1% (look up Bloomberg). Your 10% discount rate is roughly equivalent to almost 2x the equity premium, so it makes me wonder if you're overestimating it or not.
You might want to consider reverse DCF. It's basically an estimation of what sort of growth the market is expecting from the company based on its current price, and can be done in less than 5 seconds on MS Excel thanks to Goal Seek.
10. Your definition of "risk" as far as the report is concerned falls only on the stability of the business Lowe's is in, rather than the risk from company-specific fundamentals. Aside from Buffett's optimistic statement on the housing market, there is nothing else. Don't limit yourself to good ol' Warby. Neither should you limit yourself to the IHS global report.
Overall, your work needs... work. Answering some of the questions I wrote above may help make your future projects more substantial in terms of content.