Description

Idea: Short Lowe’s Inc. (“LOW”) common stock at ~$215 / share

Investment Thesis: LOW has been materially overearning due to inflation (ticket +29% vs. pre-covid) and pull-forward of housing related spend. The setup for 2023-2024 EPS revisions is asymmetric as the impacts of slower housing turnover percolate and goods prices deflate. This is an attractive way to play goods deflation in a business with high operating leverage, with EPS revisions as high as 30-50% in cases where ticket fully normalizes.

• LOW is overearning relative to historical levels
  • 2022 EPS of ~$13.75 compares to 2019 EPS of $5.74 or a 3-year CAGR of ~34%. This compares to ~13% EPS growth in the 3-year period prior to covid
  • 2022 sales guidance ex. Canada implies a 10.5% topline CAGR since 2019, compared to ~3.0% topline growth in the 3-year period prior to covid
• Ticket size and inflation have been material drivers of profitability with price +29% above pre-covid levels and well ahead of LSD growth pre-covid.
  • EBITDA margins have expanded ~400bps (compared to 100bps for HD) which is primarily a function of pricing actions and SG&A leverage (60-65% fixed costs) on a less productive store base.
  • As consumer balance sheets weaken and goods deflate, we expect LOW to lose pricing power. Normalizing topline to pre-covid trendline levels can result in 25-50% EPS revisions given the high fixed cost structure
• Less severe moves (MSD comp declines) can put the LOW buyback at risk of being cut by ~50%
  • The debt-funded buyback program has driven 1/3 of EPS growth post-covid
  • At ~4-5% SSS declines management would likely reach its leverage target (2.75x) and be required to fund the buyback out of cash flow

Background:

• Home Depot and Lowe's are the two largest home improvement retailers in the US, with ~17% / ~11% market share respectively. As these businesses have matured, topline growth has been a function of driving higher comps versus opening new stores.
• The businesses exhibit stable gross margin profiles (~32-34%) even in tougher macro environments given limited inventory obsolescence and limited price-transparency in the channel.
• Both platforms benefit from high fixed cost structures (~60-65% of SG&A) with the largest expenses being payroll and rent. Driving higher comp sales through this fixed cost base is highly accretive to EBITDA / margins.
• In their mature state, ~65% of EBITDA is converted to FCF and a key part of these stocks is the dividend (moreso for HD) and buybacks (moreso for LOW).
• LOW is generally regarded as the lower quality operator of the two and has been attempting to close the productivity gap to HD.

Valuation / Scenarios:

• LOW currently trades ~15.5x FY24 EPS or ~1.5x below its historical pre-covid multiple of ~17x and below HD at ~19x
• Bear Case: Management hits the midpoint of their guidance and stock trades at historical multiple despite lower growth relative to pre-covid as street looks-through to FY25
• Base Case: Topline and gross margin retrace half of covid-outperformance and stock trades at a 1x discount to historical multiple
• Bull Case: Topline and gross margin revert to pre-covid trendline (~3% CAGR from 2019) and stock trades at 2x discount to historical multiple

Risks:

• Inflation is stickier as wages and employment remain strong
• Reduced housing turnover and lower home prices are mitigated by large home equity cushions
• Margin benefits prove to be more resilient and less transient than we believe

Catalysts:

• Softer housing fundamentals will flow through the homecenters in Q4/Q1
  • The cyclical components that drive inflections in home improvement typically materialize 2-4 quarters after the NAHB index inflects.
  • Given the backlog in home remodeling and supply chain constraints, this cycle has taken longer to materialize
  • The NAHB remodeling index decelerated materially in Q4, with the future indicators index declining 13pts to 58
• The LOW share buyback program, a key driver of earnings growth, is at risk in weaker growth scenarios
  • LOW has been running a ~$13bn debt funded buyback program (up from ~$5bn pre-covid) with a target leverage ratio of 2.75x
  • Negative comps of 4% would require the buyback to be funded out of FCF, which would cut it to ~$5-6bn (FCF post-dividend)
  • The buyback has driven 1/3^rd of post-covid EPS growth and is a significant driver of EPS growth in street models

Misperceptions:

• Sales growth can remain robust in a downturn as consumers are “locked-in” to their homes
  • Lower housing turnover is typically negative for home improvement wallet share
  • Higher prevailing mortgage rates are typically associated with late-cycle economic conditions
  • Volume weakness in stores is a sign of underlying weakness that has otherwise been masked by inflation in ticket size
• LOW is catching up to HD’s productivity and margin profile
  • While we agree the margin profile has improved, we disagree as to the causes and the sustainability of the margin in the face of deflation and topline deterioration
  • We do not perceive any structural changes to LOW’s business model as the margin uplift is what one would expect by modeling the topline pull-forward and pricing-driven gross margin expansion
  • In fact, LOW has underperformed the margin profile a model would have predicted given SG&A cost inflation and investments in their supply chain

Catalyst

• Softer housing fundamentals will flow through the homecenters in Q4/Q1
  • The cyclical components that drive inflections in home improvement typically materialize 2-4 quarters after the NAHB index inflects.
  • Given the backlog in home remodeling and supply chain constraints, this cycle has taken longer to materialize
  • The NAHB remodeling index decelerated materially in Q4, with the future indicators index declining 13pts to 58
• The LOW share buyback program, a key driver of earnings growth, is at risk in weaker growth scenarios
  • LOW has been running a ~$13bn debt funded buyback program (up from ~$5bn pre-covid) with a target leverage ratio of 2.75x
  • Negative comps of 4% would require the buyback to be funded out of FCF, which would cut it to ~$5-6bn (FCF post-dividend)
  • The buyback has driven 1/3^rd of post-covid EPS growth and is a significant driver of EPS growth in street models