We purchased 15 shares of Lowe’s Companies at $65.40 on February 15.
Business Summary: North Carolina based Lowes, a member of the S&P 500, operates over 1,100 building materials and home improvement stores in 44 states. Its primary competition is Home Depot (HD). There are two other privately held companies that have significant market share: Menards (a Wisconsin based retailer) and True Value (a Chicago based retail co-op). The older, yet smaller, Lowes has been nipping at the heels of Home Depot with aggressively store expansion outside of its base in rural settings to the suburban territory than has been HD’s strength. Value Line (VL) estimates LOW will have 45% more stores in 4 years time. The high teen growth of the past five years has been fueled by historic low interest rates causing record numbers of home ownership nationwide.
Strengths: The Retail Home Improvement industry also benefits from re-finances as over 70% of the money is generally returned to the home in the form of reduced monthly mortgage payments and/or home improvement projects. Inventory management is the key to any successful retail store. Lowes latest inventory initiative is its Rapid Response Replenishment (R3) system. VL estimates that success in R3 could lead to a one-half increase in its operating margin.
Weakness: A key weakness to LOW strategy is 70% of its stores are within 10 miles of a HD store. (Source: Morningstar)
Key Metrics: LOW has a VL Financial Strength of A+ (second highest rank) and Earnings Predictability of 100. LOW has a S&P Quality Rank of A+ (highest ranking) and an IQ of 99% (out of 100). Morningstar gives LOW a Below Average “Business Risk”, a wide “Economic Moat”, a B (good) “Stewardship” grade. All metrics indicate Lowes is financially sound with good prospects into the future.
Industry Outlook:VL and S&P both believe that HD and LOW, which control only 30% of the market, can still benefit from market consolidation. The “Do-It-Yourself” home improvement market is giving way to the professionally installed home products and both LOW and HD have been acquiring these ancillary businesses to grow sales.
Latest News from Lowes: LOW 4thQ and FY2004 earnings results will be announced on Wed. Feb. 23 at 9:00 AM.
Quality: Section 1 of the SSG shows consistent growth in sales (R2 is 1.00) and earnings (R2 is 1.00) include the PTP line and Lowes has near “perfect “railroad track” lines NAIC investors seek. However, the last three years has seen a decline in LOW’s EPS growth. A quick look at PERT-A, Col. D for the Q ending Apr 04 you will see the EPS decline is isolated to this one quarter. Section 2A of the SSG and PTP Q over Q change (Col. N of PERT-A) confirms the inventory management program (R3) as well as management’s ability to control costs.
Section 2 of SSG: Pre-tax profit and ROE are trending up.
The Key Metrics above confirm quality in Lowes.
Growth: Section 1 of SSG: LOW has had consistent and strong growth in the past. My initial placement of future sales (1-2 of the SSG) was set at 16%, which is below VL’s forward looking rate (16.5%), the historical rate (20.3%) in Sec. 1-1 and TTM of Sales (18.2%) in Col. T of PERT-A.
My initial placement of the future EPS growth (Sec. 1-4) was set for 17%. I used Preferred Procedure (PP) to crosscheck my estimates. Using VL estimates of rising margins, higher taxes, and fewer shares outstanding I got future EPS of $6.36 and EPS growth of 18.6% via PP. For comparisons four or five years out, OPS (S&P Consensus Estimate) has future EPS at 18%; VL at 19.5%; and First Call (www.earnings.com) at 17%. I selected my future EPS of $5.69 growing at 16%. (Normally I would not be so conservative with my future EPS growth. Look at cautionary tales down below for my reasoning.)
Value: Section 3 of the SSG: PE ratios have been consistently trending down, which I believe reflects the maturation of the industry as well as the irrational highs of the late 90’s and early 21st century. Outliers were selected for Year 2001. Payout Ratio (3-G) is stable holding around 5% of EPS.
Section 4 of the SSG: I used as an average high PE of 24 and confirmed it with the future high PE of VL ($130/ $5.25) of 24.7. This is a PEG ratio (1-4/ 4A) of 1.5 is the upper limit of my comfort level for future value.
Aver. High P/E of 24 x EPS of $5.90 gives a high price of $141.60. Average Low P/E of 14 x TTM EPS of $2.75 gives a future low of $38.50.
Zoning was set to 25-50-25 the U/D ratio is 4.3:1. The top of the “buy” price is $64.3. Current Price is $58.10. Relative Value is 98.1. Projected relative value is 84.7. Appreciation (Sec. 4E) is 143.7%
Total Return: Section 5 of the SSG: The Total Return is 19.7% and PAR is 14.3%
Cautionary Tales: My first run through LOW on the SSG gave me an uncomfortably high returns and a high future price that was bothersome. Growing up on Classic (BTW, I did this SSG in TK5), I have trained myself to be concerned if the PEG ratio (Sec. 1-4 / Sec. 4A) is greater than 150% or the total return is greater than 18% (a doubling of money in 4 years time). I am also concerned when I see appreciation (Sec. 4E) creeping above 150% or the U/D ratio nears 7:1. As such I trimmed my judgments to avoid these figures.
I wanted to show others how I reduced my judgments and yet still had LOW as a stock to purchase for the obvious reason that I believe Lowes to be an excellent company at a reasonable price and tolerable risk. Here is where I was uncomfortable: a mildly uncomfortably high total return (19.7%), a tad optimistic total appreciation (Sec. 4E) of 143%, a future high price of $141.60, which is more than VL projects ($130); on EPS growth of 16%. All of these “yellow” flags caused me to adjust slightly downward my final judgments to protect against being too optimistic.
Final Judgments: My final judgments are: future sales of 16%; future EPS of 15%; high P/E of 22.5; low P/E remains unchanged; high price of $127.1; low price of $38.50 (using 4Ba); Current Price of $58.10; an U/D ratio of 3.5:1; appreciation (Sec. 4E) of 119%; RV of 98.1; Projected RV of 85.4; Compounded Total Return of 17.2%; and PAR of 12.5%
Recommendation: Lowes is a buy up to $60.60. I recommend that someone else do a SSG on Home Depot and we see which company is the best purchase for the DC Model Investment Club.
Posted by Kevin Gillogly