Lowe's: Seizing Downturns For Future Fortunes

Introduction

Lowe's Companies (NYSE:LOW) is one of the most fascinating companies on the market. It also has very passionate investors, which I get from countless conversations on Seeking Alpha and beyond.

This is no surprise. The company, which operates more than 1,700 home improvement stores in the U.S., has helped countless investors reach their financial goals.

Not only has this company hiked its dividend for more than 50 consecutive years, making it a dividend king, but its stellar stock price performance has contributed to a massive total return.

Since 1986, investors in LOW have compounded their money at 17.7% per year, beating the S&P 500 by exactly 700 basis points per year. This has turned a $10,000 investment into $4.7 million!

Even better, this performance has been very consistent.

Over the past ten years, LOW has returned 19.6%. On a five-year basis, that number barely drops to 18.3%. During any of these time intervals, LOW has outperformed the S&P 500.

Unfortunately, the stock has now entered a period of weakness. While things could be a lot worse for investors, LOW shares have been unchanged since mid-2021, trading roughly 20% below their all-time high.

The worst part is that economic challenges make a sudden rebound unlikely.

Nonetheless, LOW remains in a good spot. It has a healthy balance sheet, a lot of room to keep hiking its dividend and buy back shares, and growth measures to improve its business.

While its stock price may be pressured for a while, buying this stock on weakness remains the way to go for dividend growth investors.

In this article, I'll walk you through the details and my thoughts on the matter.

So, let's get to it!

Lowe's Is Positioning Itself For Higher Growth

Earlier this month, the company presented at the annual Goldman Sachs Global Retailing Conference, where it told us a lot about the market challenges it faces and ways to grow its business.

The company noted that housing turnover has decreased due to rising interest rates, while high home equities provide long-term positivity.

Key demand drivers for Lowe's are home price appreciation and personal disposable income.

The problem is that people are unable to unlock this value. After all, people are not selling their homes to avoid the risks of having to take on an expensive mortgage for a new home.

While it sees long-term benefits from elevated home prices, the DIY customer, accounting for 75% of the company's revenue, is holding back on big-ticket purchases.

As a result, comparable store sales declined by 1.6% in the second quarter.

In order to deal with slugging consumer demand, the company aims to enhance its Pro penetration from 19% to 25%, targeting the small to medium-sized Pro market.

Online penetration has grown from 4.5% to 10.5% in the past five years.

Looking at a presentation slide from last year's Investor Conference, we see that roughly half of the home improvement market consists of Pro customers.

However, they account for just a quarter of Lowe's customers. Addressing that market and focusing on a deeper online penetration, the company will be able to gain market share in what is estimated to be a $1.0 trillion market.

So far, the company has done tremendously well in addressing the DIY segment of the home improvement market.

Past strategies involved improving in-store environments, expanding product inventories, launching loyalty programs, implementing CRM, and forming strategic partnerships.

The recent partnership with Klein Tools and extending brand portfolios for professionals like electricians and HVAC specialists also demonstrates a continuous effort to grow the Pro business and address the pressure on DIY sales.

Adding to that, while the exact timing of a return to a normalized demand environment remains uncertain, Lowe's remains focused on managing the near term.

Investments, a strong balance sheet, and an emphasis on the Total Home Strategy are expected to navigate the company through these challenges.

Essentially, the Total Home Strategy is a strategy that consists of the aforementioned factors that should allow LOW to gain market share and become a dominant player in all areas of the home improvement market.

One big accomplishment is the company's expansion in appliances. While this segment is one of the victims of the current deadlock in the housing market, the company is in a great spot to benefit from a rebound at some point in the future.

We're incredibly excited about our market share position in appliances. We exited last year with appliances being roughly 14% of our total sales revenues. So it is a big part of our business. Part of the reason why we have taken market share is a combination of things. Number one, we've dedicated the most space. We have the widest selection of brands. And we have now the ability of market delivery to deliver next day in every market where we have market delivery currently in place. And we'll have the entire company, for all intents and purposes, built out on market delivery by the end of the fiscal calendar. - LOW

What I find so interesting about this segment is that the company's growth measures have done a great job expanding market share. More space per item, good service, a wider selection of brands, and great service, including fast delivery.

These measures sound so generic and boring, as everyone with brick-and-mortar exposure seems to apply this.

However, applying these measures successfully is tricky. It's also what makes companies like LOW successful.

The company is also trying to move in the direction of the Tractor Supply Company (TSCO), which is a smaller Lowe-like retailer focused on rural customers. That company is currently doing much better, as rural spending has been stronger since the pandemic.

By optimizing space productivity, the company aims to create a one-stop-shop experience for rural customers, consolidating items related to home improvement, farming, and ranching.

So far, according to the company, initial results were positive, showing increased transactions, average ticket size, and wallet share in these areas.

This also has benefits with regard to shrink, which is a fancy word for people stealing things. This is an accelerating trend hurting every single retailer I have researched so far.

The good news is that the rural, remote, and suburban store locations are seen as beneficial, as they offer a unique cost structure that contributes to efficient shrink management.

Having said that, last year, the company showed an operating margin growth roadmap. This included an expected increase from 8.6% in 2018 to almost 15% in the 2025-2027 period, potentially boosting the return on invested capital to 45% along the way.

During the Goldman Sachs conference, Lowe's updated its five-year strategic plan. The company highlighted its use of data analytics and advanced cost analysis to optimize product costs, negotiate with suppliers effectively, and expand private brands, thereby enhancing margins.

With regard to pricing, Lowe's expects no significant impact due to inflation or deflation in the near term despite dealing with lumber deflation challenges.

As we look at the balance of this year, starting there, we don't think that you're going to see material impact to pricing relative to inflation or deflation. Because as a reminder, this year, in our home improvement channel, we dealt significantly with lumber deflation. And we think that we'll have maybe 75 basis points of lumber deflation negatively impacting comp sales in the third quarter. We think that's going to be virtually flat in the fourth quarter. And for '24, as I sit here today, we don't see any material impact to pricing relative to inflation or deflation, not within our specific home improvement segment. - LOW

Their inventory management focus is on productivity, turns, and ensuring essential categories are consistently in stock to meet customer demands.

The Low Dividend & Buybacks

If there's one thing that really stands out at LOW, it's the dividend.

Lowe's has hiked its dividend for 59 consecutive years, making it one of the few dividend kings in the United States.

The current dividend is $1.10 per share per quarter, which translates to a 2.1% dividend yield.

Over the past five years, the dividend has been hiked by 20.0% per year.

This was mainly caused by a massive success during the pandemic, which triggered a wave of DIY-related demand. This also pulled a lot of future demand forward, which is one of the reasons why the company is now seeing slower growth, but more on that in a bit.

The most recent dividend hike was 4.8% on May 26.

With regard to dividend safety, the dividend is protected by a 31% net income payout ratio and a very healthy balance sheet that allows the company to prioritize shareholders over debtholders.

The company is expected to end next year with $35.4 billion in net debt. While that may sound like a lot, it's 2.6x expected EBITDA. LOW enjoys a BBB+ credit rating, which is one step below the A range.

The company also generates loads of free cash flow. Although free cash flow is not expected to accelerate before the 2025 calendar year, the company is expected to maintain a 7% free cash flow yield. This puts the cash dividend payout ratio at 30%.

Because the company has so much excess cash and a healthy balance sheet, it's also one of the biggest buyback companies on the market.

Over the past ten years, LOW has reduced its share count by 45%. This significantly contributed to its stellar stock price performance, as it artificially increased the value of each share.

Over the past ten years, the company's net income has increased by 166%. Earnings per diluted share have risen by 384% during this period.

So, what about the valuation?

Valuation

Over the past ten years, LOW has consistently traded close to 12x EBITDA.

Using analyst estimates, the company is trading at 11.4x 2023E (calendar year) EBITDA.

That number drops to 10.7x EBITDA in the 2025 calendar year.

As we can see below, pandemic-related growth is over. The company is expected to see longer-term low-single-digit EBITDA growth, as there's just too much pressure on the DIY segment.

Even worse, I wouldn't rule out more weakness, as the Pro segment could suffer in case home prices fall.

So far, the general thesis includes a resilient housing market. In a scenario where unemployment rises, we could see forced selling, triggering a decline in home prices and Pro demand.

I'm not saying this to scare anyone. It's just the downside to my thesis and a scenario that I've been working on for a while.

However, instead of suggesting that people dump their LOW shares, I believe that LOW is a good investment during bigger corrections.

All things equal, I will likely turn bullish if LOW shares fall to $180. The current consensus price target is $248. A 12x valuation (as used in my model) suggests a fair price of $236.

I apply the same strategy to my other holding, Home Depot (HD). I aggressively added during last year's lows and plan to do it again if I get the chance. I may miss out on a future rally, but given my view on the economy, I'm not willing to chase potential rallies.

Takeaway

Lowe's is a compelling choice for investors seeking consistent dividend growth and potentially market-beating returns.

With a remarkable track record of hiking dividends for 59 consecutive years and an impressive annual total return compounding rate of 17.7%, LOW has shown resilience and strategic foresight.

Despite recent stock price fluctuations and potential economic challenges, the company remains well-positioned for growth.

By targeting the Pro market, optimizing online penetration, and expanding into segments like appliances and rural customer offerings, LOW continues to enhance its market share.

Moreover, prudent financial management, ongoing share buybacks, and a robust Total Home Strategy underscore its commitment to its many stakeholders.

For prudent investors, buying into LOW during market dips could offer a promising opportunity for long-term dividend growth and wealth generation.

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