This Retailer’s a Cash Spigot

01/17/2011 12:41 pm EST

Focus: STOCKS

Paul Larson

Editor, Morningstar StockInvestor

Lowe’s new value-minded strategy should drive dramatic growth in returns over the next few years, write Peter Wahlstrom and Paul Larson of Morningstar StockInvestor.

Lowe’s (NYSE: LOW) recent analyst day reinforced our favorable view of the shares and increased our confidence in management strategy. We continue to believe that Lowe’s will be a primary beneficiary of the ongoing recovery in the US home improvement retail marketplace as housing turnover, unemployment, and consumer spending trends stabilize and improve over the next few years. As these current headwinds reverse, the operating leverage inherent in Lowe’s business model should allow the firm to deliver 15%-plus annual earnings growth over the medium term, resulting in significant share price appreciation for patient investors.

Lowe's shares are trading well below our $36 fair value estimate. [Shares closed at $25 Friday—Editor.]

Less Growth, Much More Value
The message of slowing store growth and margin expansion highlights management’s commitment to wringing additional productivity out of its existing assets to drive returns on invested capital higher. Management believes that it can drive returns from around an 8.5% level this year, to more than 17% in just five years. The magnitude of the proposed increase is somewhat staggering, and investors are certain to apply a heavy discount given the uncertainty surrounding the timing and actual achievement of this goal.

More share buybacks and dividend increases are in store over the next five years. Lowe’s plans to repurchase roughly $3.6 billion of its shares each year through 2015 ($18 billion in total). This move is to be supported by a combination of strong free cash flow generation (around $3.2 billion on average annually), and just under $5 billion in incremental net borrowings. Even if the US economy recovers more slowly than expected, (a 2% same-store sales growth level, for example) management believes that it can still repurchase $12 billion of stock by the end of 2015 (some 50% higher than our prior estimate.)

Dividends Galore
These are some very large numbers. If the company were to repurchase $18 billion in stock today, it would represent just over 55% of the current market capitalization. Management also officially “upped” its dividend payout ratio to between 25% and 35%, which implies that the firm expects to increase its dividend at a 20% rate for the foreseeable future. This suggests that the firm can hike its dividend to around $1 per share by 2015. [The annual dividend is currently at $0.44 per share, for a 1.8% annual yield—Editor.]

Though the near-term outlook for the US home improvement market remains muddled, we believe the worst of the downturn is now behind the industry, and Lowe’s.

[Lowe’s shares are up 17% in the four months since Larson and Wahlstrom last recommended them. For another housing recovery play, check out the latest from George Putnam.]

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