The Lowdown on Lowe's

09/16/2010 11:42 am EST


Paul Larson

Editor, Morningstar StockInvestor

Paul Larson, editor of Morningstar StockInvestor, and analyst Peter Wahlstrom say that the world’s number-two home-improvement retailer is a first-rate stock.

Lowe’s (NYSE: LOW) is the second-largest home-improvement retailer in the world ($47 billion in annual revenue) and has established itself as a solid operator over the past decade.

The company’s stores offer products and services for home decorating, maintenance, repair, and remodeling. Lowe’s targets retail do-it-yourself and do-it-for-me customers, as well as commercial business clients.

Its scale enables consolidated purchasing power, which leads to a low-cost position, while a highly automated distribution network seamlessly places vendors, distribution centers, and stores on one platform, driving operational efficiency.

These competitive advantages generate positive economic returns and support a wide economic moat. Lowe’s largest rival, Home Depot (NYSE: HD), is aggressively restructuring its distribution network to improve efficiency. However, we believe the large, fragmented home-improvement market provides an opportunity for both companies to expand profitably well into the future.

A critical component of Lowe’s strength is a network of 14 highly automated regional distribution centers, [which serve] 1,700 stores across North America. Its logistics system allows the company to make large-scale purchase orders at a discount, giving it a low-cost edge. Lowe’s then retains some of the cost savings and passes the remainder on to its customers in the form of low everyday prices.

After a decade of aggressive growth, [Lowe’s and Home Depot] have dialed back domestic expansion plans and are poised to take on smaller rivals (such as traditional hardware, plumbing, electrical, and home supply retailers, as well as other home-improvement stores and lumber yards) as the market recovers.

Lowe’s moat trend (the sustainability of its competitive position—Editor) is stable, in our view. We believe there is ample opportunity for both Lowe’s and Home Depot, even when using our (relatively) smaller $400-billion estimate, to expand and prosper in the fragmented US home-improvement market.

This year should be the start of a multiyear recovery for Lowe’s, and we project the firm to generate modestly positive comparable sales (2.5% year over year) for the first time since 2005. Longer term, we estimate annual retail sales growth of 5%–6%, driven by comparable sales growth (about 4%) and a 2% annual increase in average square footage.

Our ten-year financial model also includes a 9.8% operating margin at the end of our forecast period, compared with 6.6% in 2009. Through 2019, we project average return on invested capital of 12.5%.

Our fair value estimate [for Lowe’s] is $36 per share, which implies [a multiple of 26x] forward earnings [and] an enterprise value/EBITDA multiple of 11.4x. (Enterprise value is a company’s market value plus debt minus cash, while EBITDA, a measure of operating cash flow, stands for earnings before interest, taxes, depreciation, and amortization. The stock closed above $21 Wednesday—Editor.)

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