We initiated our coverage from Lowe’s (NYSE:WEAK) in “Lowe’s: Facing Pressure to Normalize” in August with concerns that the company’s pandemic performance boom is fading and it faces pressure to readjust to a standardized growth model and trajectory. The stock fell 20% over the next four months, from $229.76 to $183.62. Over the past two months or so, it has recovered just as much and is now back up to $222.21. Is it FOMO or a reflection of fundamentals? We are looking for some updates.
We previously highlighted Lowe’s has the advantage of using its multi-channel platform to gauge consumer preferences, regardless of which channel they use. The company actively turns this knowledge into a useful marketing strategy. It targeted gardeners and pet owners in the 1H by offer workshops and partnership with Petco, in addition to its many existing private label partnerships, such as Kobalt, Bosch, DeWalt, Rubbermaid and Scott’s. Encouraged by the initial results, the 2H company continued its efforts to attract buyers by targeting a specific consumer base, one at a time. He renewed partnerships with the NFL to help homeowners’ DIY projects, then promoted among Millennials how to make basic home improvements. Overlaying this targeted marketing, it implements loyalty programs such as the MVP Business Rewards Program with CRM to win back more business users, such as electricians and HVAC professionals. The proactive attitude to “win business” with a more sophisticated strategy is the result of the new changes she has brought.
These changes came against a backdrop of slowing year-over-year revenue growth. Although it is still almost twice as high as before the pandemic, its revenues are no longer growing but declining on a TTM basis. The company improved efficiency by reducing both cost of revenue and operating expenses in the third quarter to prevent the downward trend in revenue from impacting earnings. It still generated higher net profit and EBITDA in the third quarter.
But as we noted previously, Lowe’s net working capital has weakened while inventory has increased. The gap between its accounts receivable and payables has not seen any notable improvement since, while its inventories, although reduced, still stood at 85% of its turnover last quarter, i.e. the highest levels historical. Although the strategies implemented so far this year are on track, their effects are not yet powerful enough to reverse the trend.
Although its net income improved 22% year-over-year in the third quarter, its operating cash flow was lower, mainly due to operating debt repayments of approximately $2.1 billion in the during the quarter. He explained it’s 10Q that this primarily comes from the deferred federal tax refund in the fourth quarter of 2022, authorized due to the impact of Hurricane Ian. But on a TTM basis, its operating cash flow is down secularly, even before revenue starts to decline. So far, it’s still higher than before the pandemic, but not by much.
The same cannot be said for the free cash flow conversion rate. Both in terms of EBITDA and revenue, its converted free cash flow declined to a lower level than in 2019. From this perspective, the normalization pressure has been greater than expected. Despite record profits, only 40% was converted into free cash flow. Disregarding volatility during the pandemic, this level was last seen in 2010. If these levels continue to decline, it will limit its future expansion plans in terms of additional hires or acquisitions, not to mention its ability to continue to reward shareholders.
Lowe’s rising earnings per share contrast sharply with its continued decline in negative total shareholders’ equity. Its total liabilities decreased by 3%, but its total assets also decreased by 9.5%, leading to a further decline in total equity since we highlighted it in the last article.
Lowe’s has reduced negative cash flow in its financial businesses since 2020 and has yet to slow the pace significantly. Persistent debt remains at one of the highest levels in the last twenty years. It typically has no more than $2 billion in liquidity at the end of the period, which represents about a quarter of its quarterly funding needs. This therefore leaves little room for a decline in its cash flow from operating activities. Negative equity is unlikely to be reversed in the near future. The burden of discounting its future cash flows will continue.
For the coming year, Lowe’s has focused on the results of his investigation from enterprise customers, whose response showed that around 70% of them are still behind schedule in their project queues, but are being held back due to macro-environment concerns. And most homes in the United States that are 40 years or older give rise to more reasons to DIY. However, professional DIY or startup home improvement projects tend to be fragmented in nature. Lowe’s heavy debt burden, declining cash flow trend, and continued leverage won’t help it seize future opportunities. Being more efficient and better targeting customers is the right way to generate more organic growth for Lowe’s. However, until management decides to seriously tackle its debt problem, the pressure to return to normalization after the pandemic boom is still present. It is worth paying attention to this as much as profits and financial results, because 2.75x debt/EBITDA this ratio simply won’t be enough to become a growing company.
Financial overview and valuation
We have updated the fair value measurement with our models. Its free cash flow for the full year 2023 is expected to be reduced by around 20%, in line with our previous expectation of a double-digit decline in the base case, and we gave it this year and the next year to return to normal before. However, over the past five months, Lowe’s predicament hasn’t improved much, and we haven’t heard about management’s intentions to tackle some of the tough issues head-on. We downgraded all three scenarios to further discount its cash flows on top of a continued weakening trend over the next year, to the point of another high single-digit decline or low double-digit decline in free cash flow. The current price has become higher than our upper estimate.
The risk to our thesis could arise if Lowe’s revenue growth increases significantly over the next 12 months. Given that the weakening of free cash flow conversion occurred while the secular trend in its operating cash flow was still above the pre-pandemic level and its profits were lifted to a record level in the third quarter, we think it will take strong double-digit revenue growth to make a difference. Asked about 2024, management gave a cautious outlook citing the “discretionary spending of DIY customers, that’s still something we manage” as they have been impacted by their disposable income and the housing market. If housing markets were to rise significantly next year, it is safe to say that inflation would not decline and the Fed would return to action. So we think the upside risks are not high at this point, as the market appears to have fully priced strong growth or even more for next year into its current price. Any disappointment will lower its price.
Over the past five months or so, Lowe’s has continued its strategy of targeting specific consumer bases to drive more organic sales while also strengthening various partnerships with name brands. Along with improving efficiency, the company is on track for growth. However, no decisive steps have been taken to reduce its debt burden as its cash flow weakens. Future constraints will not ease and we believe further standardization is still underway. We consider the current price premium to be too high and recommend a sell at this time.