Lowe’s Stock: Better Results May Be In The Price (NYSE:LOW)

Shares have Lowe’s (NYSE:LOW) have been a reasonable performer over the past year, gaining 19%, as the housing market has withstood pressures from higher rates better than many investors may have feared. Since recommending shares as a buy in October, Lowe’s has rallied by over 31%, ahead of the market’s 26% gain. Shares have actually eclipsed my $215 price target from several months ago, raising the question of whether it is time to take profits. This has come even as the company’s 2024 outlook is disappointing to me, though I view it as conservative. Still, I would be inclined to take profits here, as I believe the market is also pricing in a higher EPS result than guidance.

In the company’s fourth quarter reported on February 27^th, Lowe’s earned $1.77, beating consensus by $0.10 even as revenue fell by 17% to $18.6 billion; about 4.5% of this decline came from the sale of its Canadian business. For the full year, it earned $13.23. Same-store sales fell by 6.2% with unfavorable January weather and a decline in big-ticket items driving the weakness. Traffic was the primary source of weakness with average ticket flat. Winter storm weather was a significant challenge; in fact, in January, building materials retailers saw sales decline 4.3% sequentially, which was the sharpest drop since February 2019. Lowe’s viewed weather as a 200bp headwind in January. Sales did subsequently bounce back in February for the industry, consistent with the notion weather distorted results.

The company has seen a pullback in DIY (do it yourself) spending with strength in November and December followed by that “sharp drop” in January. By comparison, “pro” spending was flat sequentially. “Big-ticket” items continue to be a headwind, given inflation, with projects tending to be smaller than in years past. This has been a headwind for kitchen and appliance sales. Given this softening in demand, LOW has continued to focus on cost controls, and gross margins expanded 7bp year over year to 32.4%, as supply chains eased. Still given the deleveraging from lower sales, operating margins fell by 48bp to 9.1%. Lowe’s has managed its merchandise given lower sales, and inventories are nearly 10% lower than last year at $16.9 billion.

As discussed in my prior buy recommendation, Lowe’s is a solidly cash generative business, and its aggressive return of cash to shareholders has been a significant piece of my bull thesis. In 2023, Lowe’s generated $6.2 billion of free cash flow, but there was a $2.2 billion headwind from working capital, for $8.4 billion of true, run-rate free cash flow. As a result, in Q4, it bought back $400 million in stock, taking the full year total to $6.3 billion. Its dividend also costs about $2.5 billion. As a result of buybacks, its share count fell by 5% year over year. That $8.8 billion capital return is consistent with its run-rate free cash flow, but given working capital headwinds, the company’s debt balance grew to $36 billion in debt from $33.4 billion last year. Still, debt to EBITDA leverage is a reasonable 2.8x, and it carries $1.2 billion of cash and equivalents.

Alongside earnings, Lowe’s is guiding to revenue of $84-85 billion in 2024, as same store sales fall 2-3%. With a 12.6-12.7% operating margin, it expects EPS to be $12-12.30. Given the company plans to spend about $2 billion on cap-ex, this should translate to about $7.5-7.8 billion of run-rate free cash flow; assuming some working capital benefit after last year’s drag, reported free cash flow should be about $9 billion in this scenario. Lowe’s plans to repay a $450 million bond with cash this year. After its dividend, that leaves about $6 billion for buybacks, which would reduce the share count by 4.5-5%.

Now, frankly, this outlook is disappointing. Back in October, I argued the company had up to $13.50 in earnings power, which would translate to $10 billion in free cash flow. Given this weaker guidance, it may seem surprising the stock has performed quite so well and is trading more than 19x earnings and down to a 5.5% run-rate free cash flow yield. Ultimately, I am trimming my $13.50 outlook, but believe Lowe’s can beat its guidance and expect about $12.50-$13 in EPS.

This is primarily driven by macro assumptions as Lowe’s has taken a decidedly cautious outlook. Its base case assumes no change in macro conditions vs H2 2023 and as such it expects flat 2024 gross margins. In Q1, it expects comps to be down 5-6%. While these will improve over the course of the year, it assumes no sequential improvement in demand, just the benefit of easier comparables. Additionally, it see pro sales outpacing DIY in 2024. With a recession looking less likely, I continue to expect some growth in home-related spending, which should benefit Lowe’s.

First, I think it is just important to remember that America’s capital stock continues to age, and housing is no exception to this. The average house is about 40 years old. All else equal, older infrastructure requires more maintenance work. On top of this, tastes and styles change meaning older homes not only have more nondiscretionary maintenance but greater need for cosmetic changes. This is a reason I am structurally positive on the sector over the medium-term. Moreover, while some projects can be deferred, critical maintenance work (i.e. repairing a roof with a slight leak) does need to be done eventually. To the extent high inflation in 2022-2023 caused consumers to defer some activity, that demand should eventually be realized, whether this year or next.

It is also worth noting that consumer spending on home-related projects has retraced from its post-COVID boom. Spending is now about 9% below its peak, as a result, and is on a more sustainable footing. While spending is up a lot from pre-COVID, it is key to remember that this is nominal. Durable goods prices are up about 20% from pre-COVID. Factoring this in, real spending is only up about 6.75% over the past four years; or about 1.5% annually. That is a modest growth rate that does not suggest consumers are over-spending on their homes. If anything, there is room for additional growth here. Absent a recession, overall consumer spending should rise in 2024, which should facilitate a sequential acceleration in demand, aiding Lowe’s.

Now, knowing exactly when this will happen is unclear. However, I think it is important to remember that Lowe’s, given its retail focus, is more levered to renovation work on existing home; not construction of new homes. Here is where I have some optimism. As you can see below, while mortgages rates have fallen from their peak, they remain quite elevated, near 7%. With 10-year treasury yields near YTD highs, mortgage costs are likely to remain fairly high.

As argued in October, I see some positive tailwinds from this for Lowe’s. For homeowners with mortgages below 4%, the cost to move is extremely expensive as they will see a significant increase in mortgage costs as they take out a mortgage on their new home. All else equal, this makes it more attractive to do a $10-25,000 project to improve your existing house, rather than paying hundreds more every month in mortgage payments when moving. Low mortgage rates are like “golden handcuffs,” where the homeowner benefits from low payments but is stuck in their house. With rates staying persistently high and, in my view, the Fed unlikely to cut more than 3 times this year, more homeowners who may have hoped for a dip in rates to trade-up may start turning to DIY projects to improve their existing home.

At the same time, sometimes circumstances do necessitate a move, perhaps your job changes location or you have a new child and your family outgrew your home. Because so many have low-rate mortgages, the level of existing home inventory is very low. However, it is creeping up, 10% higher than a year ago. When people buy an existing home, they often make a few changes, which can create demand at Lowe’s.

Given the rate environment, I expect existing home sales to be lower than normal but also higher than 2023 given inventories are rising. This should begin to be a tailwind for Lowe’s results midyear. Between homeowners having capacity to do more work on their home and an increase in transactions, I believe Lowe’s is being overly conservative in assuming no sequential improvement in demand this year, which makes it more optimistic than guidance.

However, I no longer expect $13.50 in EPS, in part because Lowe’s reliance on growing pro sales faster than DIY sales concerns me. Lowe’s has always had a more retail focus, creating scope to increase penetration in the pro space. With Home Depot (HD) acquiring SRS, that company continues to cement its leadership in the pro space with Lowe’s more focused on DIY. With the leader in this niche actively getting bigger and stronger, share gains may prove difficult to come by, and I do not expect pro sales to be as robust, without sacrificing margin, as I did previously.

Given my view we will see some sequential improvement this year, I am looking for Lowe’s to earn about $12.50-$13 with about $8 billion in run-rate free cash flow. That does leave shares at 18.8x earnings and about a 5.8% free cash flow yield. Now, this is a discount to the 23x HD trades at vs consensus earnings (though given my view for a more favorable macro, I also do expect HD to beat consensus this year). Given HD’s stronger balance sheet, greater scale, strong pro business, and incremental earnings from SRS in 2025, HD should trade at a premium multiple to Lowe’s in my view.

While I believe Lowe’s has favorable fundamentals over the medium term and can deliver stronger 2024 results, this seems in the price. I view this as a business that can generate 3-5% free cash flow growth over the medium term (in line with nominal GDP), which on top of a 5.7% free cash flow provides an 8-10% long-term return potential. That argues for shares delivering market-like returns, and given the strong run in shares, I no longer see as much upside and am moving Lowe’s to a hold, particularly given homebuilders like Lennar (LEN) can be bought closer to 10-12x earnings. Lowe’s is a good business, but $240 represents fair value.

Shares are not so expensive as to merit a short or require an immediate sale. Similarly if shares pull back toward $220, I would be a buyer. But at these levels, LOW is a hold, and investors should deploy capital elsewhere.