Description

Lowe's is the world's second largest home improvement retailer with over 1,464 stores as of early November 2007.  The largest home improvement retailer is Home Depot with more than 2,200 stores in the US, Canada, and Mexico.

With exposure to both housing markets and consumer spending (like all retailers), Lowe's and Home Depot have both been severly punished by investors for reporting negative comps and with an expectation that housing activity could continue to decline - leading to some strong headwinds for Lowe's in the next 12 to 24 months.

By every quantative/valuation metric, Lowe's is significantly cheaper (by far) than it has been at any time in the last 10 years.  Specifically, the company currently trades at a forward PE of approx 12.2x FY 09 (ending Jan 09) estimates.  This is very attractive for a company that can still grow (its stores and square footage) on an organic basis in the next 4 to 5 years - one one this produces prodigious amounts of cash flow that can (and is) being used to repurchase stock, pay a dividend, and invest in opening new stores.

The Business and Economic Model

Lowe's is actually a 61 year old company - having opened its first small store in 1946 in North Carolina.  The company wend public in 1961 (well before Home Depot was founded) and focused on professional builders for the majority of the business.  In 1982, Lowes started to begin serving do-it-yourself customers.  However, it was not until 1994, when Lowe's honed in on its current incarnation of opening only large stores (with more than 85,000 sq feet) that the company really created its current business.  Today, the average store is around 113,000 sq feet (new stores are around 117K sq feet each).

As of 2006, the company's biggest sales categories and the respective sales percentages were:

Appliances              9%
Lumber                   8%
Flooring                  7%
Millwork                 7%
Paint                       7%
Building Materials    6%
Fashion Plumbing     6%
Lighting                    5%
Tools                       5%
Lawn & Landscape   5%
Hardware                  5%
Seasonal Living         5%
Cabinets/Countertops 4%
etc.

The economic model has also been fairly stable over time.  The company has gross margins of approximately 34%, and pre-tax profits of around 10% (both of these over the last 5 years).  By way of contrast, the company used to have gross margins (in the late 90s - presumably before the housing boom) of around 27% and pre-tax margins of around 7%.  Presumably, however, some of the increase is margins can be attributed to operating leverage and efficiencies - both in better purchasing (GM impact) as well as SG&A related (PTM impact).  Since the housing market woes will clearly have an impact on sales going forward, we can expect to see some deleveraging in the near term (perhaps 18 to 24 months - thought others are predicting a shorter downturn and quick recovery - I remain somewhat skeptical).

Sales growth - sales have grown at 17% per year over the last 5 years.  They actually grew at 25% per year in the 5 years ending 2000 (when there wasn't as pronounced a housing boom).

Part of our thesis is that while housing markets clearly have an impact on purchasing and remodelling decisions, the impact is likely to be near term in nature and is more than reflected in the current valuation of the company.  In the meanwhile, there remains a reasonable amount of growth potential and market share gains opportunity still to come, and the company through off ample amounts of free cash flow in the mean while.

Lowe's itself states that the domestic US market for its concept is around 2,000 stores - which makes sense given that HD already has this many stores and most of the exist stores are located within 10 miles of a HD.  Lowes emphasizes excellent customer service and this strategy has allowed the company to consistenly grab market share from HD as well as others.  HD and LOW are a significant share of the overall US home improvement market of $725 billion of which $560 billion is products and $165 billion is services. 

In comparison, LOW's 2007 sales were $46.9 billion and HD sales were $90.8 billion - giving them a combined 25% share (based on the products portion alone) and a much small portion of the services portion.  These are the only two companies that have the scale in this business and there is room for both of them to win at the expense of the other 75% of the pie.  Since there is net household formation over time in the US, the overall pie should increase somewhat faster then GDP.

Since LOW is smaller than HD, it has been focusing only on the US, whereas HD already has a meaningful - though still small - international presence in Canada and Mexico (under 200 stores).  In contast, LOW entered Canada for the 1st time in 2007 and is planning to enter Mexico.

Real Estate

Like HD, LOW owns the majority of the land and real estate under its stores.  As of the end of 2006, the company owned 86% of its stores (including stores on which it leased the land on a long-term basis).  The company also owned and operated 11 regional distribution centers and 12 flatbed truck distribution centers as of the end of 2006.  It is difficult to value these stores based on the company's filings, but it is likely that the $20 billion on the company's balance sheet undervalues this real estate.  These properties, could, at some point, be spun out or sold in a sale lease back transaction, thereby freeing up capital for higer returns in the core business or elsewhere.

Valuation

The current estimates for both FY 2008 and FY 2009 are at $1.85 per share.  Given the housing markets current trend, there is probably still some downside to these numbers.  However, the company has been buying back shares despite investing significantly in opening new stores.  Therefore, even if comps continue to be negative for a couple of years, sq footage growth is help offset some of these loses, so total sales should still expant in the next 3 years, though perhaps by a more modest 5% to 6% while the housing head winds remain.  However, at somepoint, sales will pick up again to high single digits or greater. Based on modest assumptions, EPS should be between $2.50 to $3.00 per share in 2010.  Assuming a 15x multiple, this leads to a price targe between $37.50 to $45.00 per share sometime in 2010.

Comparison to Home Depot

LOW and HD are basically a doupoly in the business and sell virtually the same products.  Historically, LOW has been better at execution and customer service, which is why they have continued to gain market share against HD.  It would be reasonable to expect that HD, under new management, may begin to execute better and that this would slow LOW's competitive advantage against HD - this remains to be seen.  Given the duopoly nature of the business and that HD is also quite undervalued, both companies probebaly have good prospects for LT investors.

However, just for comparison, here is how HD and LOWs compare (all figures as of end of 2006)

                          LOW              HD

Stores:                  1,385            2,147
Average Size (sq ft)   113,000           105,000
Stores in US             1,385            2,100
Avg Rev per Store        $33.8M           $37.6M

Total Revenue           46,900 M         79,000 (excluding HD Supply - which was sold)
Operating CF             4,502 M          7,661 M
Cap Ex                  -3,916             -3,542
FCF                        586 M         4,119 M

Gross Margin              34.5%            32.8%
Net Margin                 6.6%             6.3%

2008 EPS Est.             $1.85            $2.43

Stock Price (Dec 14)     $22.72           $26.63  

Forward PE                12.28x           10.95x

Market Cap               33,400 M         44,940 M  

Net Debt                  5,100 M         11,900 M

Robert Niblock, the former President of Lowe's - became Chairman and CEO in 2005.  Unlike the compensation fiasco with Nardelli at HD (since replaced with Frank Blake), Niblock and Lowes have a more modest (and reasonable) compensation pacakge for the CEO - esp in light of the company's size and performance.  Specifically, Niblock was paid $2 million in salary and incentive compensation in 2007 and also awarted $4.5 million in options.

Catalyst