Lowe’s Research Report
Lowes Inc.
LOW
Current Price: $64.90
Recommendation: Sell
Analyst Name: Shaoyong Wang
Email: wang.565@osu.edu
Fund Manager: Royce West, CFA
Course: Finance 824
Date: August 17th, 2005
Key points:
•
•
•
•
•
•
•
Historical low interest rate fuels the astonishing
growth of real estate market.
Strong earning growth by home improvement stores
such as Lowe’s is largely the result of housing boom.
Lowe’s current stock price is based on the bullish
growth estimation, which is not sustainable.
Rising interest rate and potential “housing bubble”
burst will negatively affect Lowe’s share price.
Intrinsic value calculation shows that Lowe’s stock is
overpriced.
Relative evaluation also demonstrates that Lowe’s
stock outperforms its peers and subjects to a
correction.
Time series trend analysis suggests that Lowe’s stock
may not be able to jump significantly without a major
shock.
Key Statistics:
Trailing P/E
Forward P/E
PEG ratio
EPS
Forward EPS
Profit Margin
Dividend
Dividend Yield
22.56
16.78
0.94
2.69
3.65
5.97%
0.18
0.28%
Lowe’s Research Report
Table of Contents
Introduction............................................................................................................................................................. 3
Company Overview ............................................................................................................................................ 3
History................................................................................................................................................................. 3
Products............................................................................................................................................................... 4
Service................................................................................................................................................................. 4
Marketing............................................................................................................................................................ 4
Distribution ......................................................................................................................................................... 4
Information System............................................................................................................................................. 4
Macro Economic ..................................................................................................................................................... 5
Housing Market .................................................................................................................................................. 5
CCI & Disposable Income .................................................................................................................................. 5
Sector Analysis ....................................................................................................................................................... 6
Entry Barrier ....................................................................................................................................................... 6
Buyer & Supplier Power..................................................................................................................................... 6
Competition......................................................................................................................................................... 6
Performance Drivers ........................................................................................................................................... 7
Sector Valuation.................................................................................................................................................. 7
Company Analysis .................................................................................................................................................. 8
RISKS ................................................................................................................................................................. 8
Financial Statement Analysis.............................................................................................................................. 9
Income Projections.............................................................................................................................................. 9
COMPANY VALUATION .................................................................................................................................... 9
Two-Stage DDM Analysis................................................................................................................................ 10
Two-Stage FCF Analysis.................................................................................................................................. 10
Relative Valuation ............................................................................................................................................ 11
Time Series Analysis ........................................................................................................................................ 12
Conclusions........................................................................................................................................................... 14
References............................................................................................................................................................. 15
Appendix............................................................................................................................................................... 16
Appendix A: Lowe’s Financial Statement........................................................................................................ 16
Appendix B: Lowe’s Growth & Margin Check................................................................................................ 19
Appendix C: Financial Projections ................................................................................................................... 20
Appendix D: DuPont Analytics ........................................................................................................................ 21
Lowe’s Research Report
80% of company sales. 2
Introduction
Company Overview
History
Lowe’s was incorporated in 1946 and is based in Mooresville,
North Carolina. It operates more than 1,125 home
improvement stores, predominantly across the Midwest, South
Atlantic, and South Central regions of the United States. With
fiscal year 2004 sales of $36.5 billion, it is a FORTUNE 50
company and serves approximately 11 million customers a
week in 49 states. 1
Lowe’s was started by Carl Buchan as a typical, small town
hardware store selling everything from overalls and snuff to
wash tubs and work boots in North Carolina.
Lowe's is a specialty retailer serving the home decor, home
electronics, and building contractor markets. The company
serves retail customers, including Do-It-Yourself (DIY)
homeowners, Do-It-For-Me (DIFM) and others buying for
personal and family use. It offers a line of products and
services for home decorating, maintenance, repair, remodeling
and maintenance of commercial buildings.
Lowe’s stores feature a home fashions and interior design
center; a lawn and garden center; an appliance center; an
outdoor power equipment center; an outdoor grill and patio
furniture specialty shop; a hardware store; an air conditioning,
heating, plumbing and electrical supply center; a lumber yard,
and building material center. The stores are divided into big,
medium, and small size categories. Big stores, which have
more than 100,000 square feet of selling space, account for
Later, Lowe’s concentrated on selling only hardware,
appliances and hard-to-find building materials. By eliminating
wholesalers and dealing directly with manufacturers, Lowe’s
established a lasting reputation for low prices.
In 1980s, U.S. housing market started soaring and Lowe’s
reached its first billion-dollar sale year in 1982. Housing boom
creates two types of new customers: DIY homeowners seeking
to improve their property value and DIFM homeowners
willing to hire third parties to accomplish their home
improvement projects. Anticipating their needs while still
accommodating contractors, Lowe’s began to enlarge its
stores and expanded products offering.
Several years ago, Lowe’s was still a marginal player in the
industry dominated by the industry giant Home Depot. Thanks
to its extensive customer research, Lowe’s concluded that 80%
of home improvement decisions were initiated not by men, but
by women. So Lowe’s began making its stores cleaner and
brighter and adding more designer-name goods by the likes of
Laura Ashley and Michael Graves. Its stores include home
Appliances
Lumber
3%
Seasonal Living
0%
Millwork
3%
2%
Flooring
0%
Paint
4%
3%
11%
Nursery
4%
9% Tools
Fashion Plumbing
5%
7%Lighting
Building Materials
Hardware
Outdoor Power Equipment
Cabinets & Countertops
6%
7% Rough Plumbing
6%
Rough Electrical
6%
6%
Walls/Windows
6%
6%
6%
Home Organization
Figure 1: Lowe's Sale by Product Category
Furniture
Other
décor that appeals more to women than contractors. The focus
1
http://www.lowes.com
2
http://finance.yahoo.com
Lowe’s Research Report
of Lowe’s on female shoppers has allowed the company to
successfully coexist with Home Depot.
Products
Advanced information system enables Lowe’s to launch
special order sales (SOS), allowing customers to select unique
and expressive products beyond the 40,000 items carried in
stores with improved product selection process, order entry
and lead time.
A typical Lowe’s home improvement store stocks more than
40,000 items, with additional hundreds of thousands of items
available through its special order system. Each store carries a
wide selection of recognized, national brand name
merchandise such as Whirlpool®, KitchenAid®, Pella®,
Werner®, Kohler®, DeWalt®, Troy-Bilt®, Jenn-Air®,
ClosetMaid® and many more. Figure 1 illustrates sales by
product category for 2004.
In addition, Lowe’s continues to improve commercial business
customer initiatives. Commercial business customers can
phone or fax their order, which will be ready for pickup the
same day or the next day. The order can also be delivered to
job sites, seven days a week in most areas.
Lowe’s also carries many brands that are exclusive to Lowe’s,
such as Troy-Bilt®, American Tradition®, STAINMASTER®
Premier Living™, Kobalt™, Portfolio®, Harbor Breeze®, and
Top-Choice™ Lumber.
Besides market campaign through television, radio,
newspaper, magazine, direct mail, event sponsorships,
Internet, community relations and in-store programs, Lowe’s
continues to launch many new marketing programs. For
example, Lowe’s has over 1,000 how-to guides and buying
guides online to help customers make more informed buying
decisions.
The company sources its merchandise from approximately
8,000 vendors worldwide, with no single vendor accounting
for more than four percent of total purchases. Lowe’s utilizes
its Global Sourcing Division to purchase directly from foreign
manufacturers, avoiding third party importers. It is also
concentrating on the electronic exchange of items and order
information with vendors. 3
In addition, Lowe’s is focusing on certain product lines where
it expects market share improvement such as appliances,
flooring, and fashion plumbing. Nursery and tools are
important traffic drivers, attracting customers to Lowe’s
stores. Lowe’s is also emphasizing more project work
consistent with an aging demographic
Service
Majority of home improvement products are commodities
with little differentiation. Therefore, Lowe’s distinguishes
itself from others through bright lighting, wide aisles,
attractive displays in its store, and superior customer services.
Lowe’s makes home improvement attainable and affordable
through specialty sales initiatives such as installation sales,
special order sales and purchase advantage like Everyday Low
Prices.
Lowe’s offers installation services in over 40 categories such
as flooring, millwork and kitchen cabinets/countertops.
Installation sale has proven to be a successful service initiative
with an expected growth rate of approximately twice the rate
of total company sales growth.
3
Lowe’s 10-K
Marketing
Distribution
Lowe’s operates ten highly automated regional distribution
centers (RDC). Each Lowe’s store is served by one of these
RDC’s. The company also operates ten flatbed distribution
centers in order to distribute the merchandise that requires
special handling. Approximately 50% of the merchandise
purchased by the company is shipped through its distribution
facilities, while the remaining portion is shipped directly to
stores from vendors. As part of the Rapid Responsive
Replenishment (R3) initiative, Lowe’s is increasing the
shipments of products through RDC network and increasing
the frequency of RDC deliveries. It maintains the building of
new distribution centers as its business grows.
Information System
Lowe’s is continuously assessing and upgrading its
information system to support growth, augment new sales
initiatives, control costs and enable better decision-making. It
has the point-of-sale system, the electronic bar code scanning
system, various design systems, and dual UNIX servers in
each store, providing real-time perpetual inventory
information and supporting all in-store selling functions.
Frame relay network is used to enable high-speed
communications between stores and its customer support
centers.
Lowe’s Research Report
Figure 3, the total value of private non-residential and public
construction spending has changed little since 2000. 4
Mil ($)
Macro Economic
Since Lowe’s derived all its sales within the United States, its
performance is largely dependent upon the general economic
health of the country. In particular, the number of new housing
start, the level of repairs, remodeling and additions to existing
homes, commercial building activities are all important macro
economics factors. Moreover, as much of Lowe’s inventory is
purchased by its customers for their discretionary projects,
consumer confidence and disposable income are also good
indicators.
600,000
550,000
500,000
450,000
400,000
350,000
300,000
2000
2002
Residential
Housing Market
Benefiting from a historically low interest rate, housing
market has enjoyed tremendous growth for the past several
years and shown no signs of slowing down. Figure 2
demonstrates the existing home sales and new housing start
increase at an annual rate of 7.4% and 5.6% respectively.
These rates are in their historical highs.
2001
2003
2004
Year
Non-Residential
Figure 3: Residential vs. Non-Residential Construction Value
CCI & Disposable Income
Consumer’s willingness to spend on home improvement
projects can be partially mirrored by Consumer Confidence
Index (CCI), an important indicator of overall consumer
spending. Consumer spending accounts for about two-thirds of
GDP and empirical data prove that CCI is consistent with the
actual spending made by consumers.
Besides CCI, disposable income in real term decides how
much a household is willing to set aside for spending. If a
household has more income to spend, it is highly likely that
they will use that money for some discretionary items such as
a home improvement project. Figure 4 shows an average of
4.7% increase of disposable personal income and rising
consumer confidence due to an overall good economy.
Figure 2: Existing Home Sales & Housing Start (2000 – 2005)
Unlike the robust expansion seen on the residential housing,
commercial building activities remain flat. As demonstrated in
4
http://www.census.gov
Lowe’s Research Report
Entry Barrier
Large incumbents have a heavy market penetration in certain
areas. For example, 30% of all Home Depot stores are located
in three areas: Florida, South California and New Jersey. This
creates a big entry barrier in those regions to prevent others
from entering the market.
Fixed cost, such as the cost for setting up distribution centers
and opening a retail store, is high. In the case of Lowe’s, cash
acquisitions of fixed assets were $2.9 billion for 2004 and $2.3
billion in both 2003 and 2002.
Buyer & Supplier Power
Figure 4: CCI & Disposable Personal Income
Sector Analysis
The home improvement market in the United States is large
and fragmented. The industry includes giants like Home Depot
and Lowe’s, with an annual sale of $75B and $38B
respectively. Other stores such as Building Materials ($2.4B),
Builders FirstSource ($2.2B) and Fastenal Co. ($1.4B) are
operating at a much smaller scale.
There are three types of customers:
•
•
•
Do-It-Yourself (DIY) Customers: These customers
are typically homeowners who purchase products and
complete their own project and installation.
Do-It-For-Me (DIFM) Customers: These customers
are typically homeowners who purchase materials
themselves and hire third parties to complete the
project and installation.
Professional Customers: These customers are
professional remodelers, general contractors,
repairmen and tradesmen.
The whole industry logged a historical healthy growth record,
due in part to certain socioeconomic trends. In particular,
wealthy “baby boomers” desire second-home ownership and
the younger generation purchases their first home at a younger
age. The increase of disposable income and home
improvement expenditures by minorities and immigrant
population is also an important factor for the continuous
growth of the home improvement industry.
In general, buyer’s power is moderate. For small items, as the
switching cost among different home improvement stores or
hardware stores is low, customers can enjoy a great bargaining
power. For large ticket items, customers are likely to stick to
one store, so they will have a limited bargaining power.
On the side of suppliers, their power is small in this industry.
Many products sold by home improvement retailers are
commodities, such as lumber and plywood. Without much
product differentiation, suppliers rely on large chain stores to
distribute their products. However, as retail stores compete
intensively on prices, they have to maintain a good
relationship with vendors to reduce their cost.
Competition
The home improvement retailing business is highly
competitive, based in part on price, store location, customer
service and depth of merchandise. A company needs to
compete with not only a number of traditional hardware,
plumbing, electrical and home supply retailers, but also
discount stores, mail order firms and warehouse clubs.
The intense competition in the industry is reflected in the
profitability ratio. The industry five-year average of gross and
net margin is only 29% and 5%, correspondingly. Little
product differentiation can be seen among competitors.
Competitors thus have to compete in areas such as customer
service, price, brand loyalty and use of technology. Rapidly
entering new distribution channels and developing creative
advertising campaigns are also frequently employed by the
firms to gain competitive advantages.
However, as the firms expand to larger markets and utilize
new sales channels such as the Internet, additional forms of
competition are expected. For example, traditional brick and
mortar stores, when pushing ahead with their e-commerce
Lowe’s Research Report
initiative, may need to adapt some of their operation structures
for the unique nature of e-commerce.
2005, which stands for a more than 20% annual price
appreciation.
Performance Drivers
The home improvement industry is driven mainly by
residential and commercial real estate construction. This can
be verified by the data from Figures 2, 3 and 5. As illustrated
in Figure 5, the revenue of the whole industry grows at rate of
12%, which is close to the sum of existing home sale growth
rate (7.4%), new house starts growth rate (5.6%) and
commercial construction growth rate (0.0%).
Figure 6: Home Improvement Sector Stock Price
Figure 7 and Figure 8 further check the relative value of home
improvement retail against the value of consumer
discretionary sector and S&P 500, using price/forward
earnings, price/EBITDA, price/sales and price/cash flow data.
Figure 5: Home Improvement Sector Performance
A problem with the above analysis is that the sale growth in
the market outside the United States has been ignored. For
example, Home Depot has stores in Canada, Mexico, and
recently announced its plan to open stores in China. However,
as the major home improvement sales were made within the
United State, this approximation should remain roughly
accurate.
Sector Valuation
The overall price of all stock in this sector reflects the hot
market of real estate. As shown in Figure 6, the stock price
almost doubled from upper $20 to lower $50 from 2002 to
Figure7: Home Improvement Relative to Consumer Discretion
Lowe’s Research Report
To capture these growth opportunities, Lowe’s has put into
place several initiatives primarily related to infrastructure,
specialty sales and merchandising and marketing.
•
•
•
Figure 8: Home Improvement Relative to S&P 500
As it can be seen, price/EBITA, price/sales and price/cash
flow are all well above the consumer discretionary sector.
Relative to S&P 500, price/forward earnings, price/EBITA
and price/cash flow outperform. Also, it can be observed that
these numbers are close to their five-year mean, which may
signal that the investor’s expectation of the future housing
market is not as high as it was two years ago.
Compared with the consumer discretionary sector, the
price/forward earning of home improvement stores looks
inexpensive. Meanwhile, price/sales seems attractive when
compared with S&P 500. These can be explained by relatively
low P/E ratio of their stocks and their relatively large sale
numbers.
Company Analysis
Within the industry, Lowe’s is #2 with a market capitalization
of $51B, trailing Home Depot, which has a market
capitalization of $89B.
Significant growth opportunities exist for Lowe’s. In fiscal
2004, only 54% of Lowe’s stores were in the top 100
metropolitan markets, where these markets comprise over
65% of the home improvement market. There are also
expansion opportunities in many smaller markets, where
Lowe’s can utilize its 94,000-square-foot store prototype other
than 116,000-square-foot store prototype to reduce fixed asset
cost while still maintaining profitability.
Infrastructure. Lowe’s has invested heavily in capital
projects, including new and existing stores,
information technology and distribution network.
Specialty Sales. To capitalize the increasing demand
of the wealthy “baby boomers”, Lowe’s developed an
installed sales model to meet DIFM customer needs.
Lowe’s is also continuing to focus its efforts on the
commercial business customer. Its logistics system
ensures adequate inventory level and the every day
low price (EDLP) strategy.
Merchandising and marketing. Lowe’s is focused on
offering a rational mix of opening price points to
premium products to balance the objectives of
increased customer count and average ticket. Its
branding strategy is designed to build the Lowe’s
brand quickly, efficiently and effectively by offering
the best-known and most-respected national brand.
In summary, Lowe’s shows great potential to grow. It ended
fiscal 2004 with 1,087 stores in 48 states, with plans to open
another 150 stores in fiscal 2005. By the end of fiscal 2005,
Lowe’s expects to increase total square footage by 13-14%.
Approximately 80% of Lowe’s stores will be the large store
prototype and 57% will be in the top 100 metropolitan markets
across the country.
RISKS
Lowe’s is not free of risks. The expansion strategy of Lowe’s
may be impacted by factors such as environmental regulations,
availability and development of the land. In addition,
competitors like Home Depot may already have had the
ownership of key real estate in established locations. Lowe’s
may not be able to secure locations that are as convenient to
its current customer base.
Substantial investment of Lowe’s in new technology and
operation processes to gain market shares and keep its EDLP
program is another source of risk. The investment benefit may
not be able to be realized in a short time frame.
The long-term debt of Lowe’s is subject to the risk of interest
rate change. However, this risk does not seem so threatening
as other risks. Currently the interest rate is low and it will
probably not go up rapidly. At the mean time, Lowe’s is
paying off its debt and has the ability to access variable rate
instruments available through Lowe’s line of credit to offset
this risk.
Lowe’s Research Report
On the rivalry side, after years of under-investing in its stores
and spotty customer service, Home Depot has a renewed focus
on these crucial areas. For example, Home Depot launched
Designplace Initiative to offer an enhanced shopping
experience to its design and décor customers by providing
personalized services from special-trained associates and
enhanced merchandise selection in an attractive setting. All
these efforts are a potential threat to Lowe’s for its market
share.
Financial Statement Analysis
Income statement, balance sheet and cash flow analysis of
Lowe’s are presented in Appendix A.
From 2001 to 2005, the revenue of Lowe’s grew at an average
rate of 18%, while the cost of revenue increased at almost the
same rate. Increase in sales is mainly attributed to Lowe’s
ongoing store expansion 5and comparable store sales increase6.
The increase in gross margin and SG&A expense as a
percentage of sales in fiscal 2004 is due primarily to the
implementation of Emerging Issues Task Force Issue No. 0216 (EITF 02-16), which resulted in the reclassification of
vendor reimbursements for cooperative advertising and thirdparty in-store service costs from SG&A expense to a reduction
of cost of sales when the associated inventory is sold,
favorable to gross margin and unfavorable to SG&A.
Excluding EITF, the gross margin and SG&A as a percent of
sale remain flat.
Store opening cost is averaged about $0.9 million per store.
Depreciation as a percentage of sales remains nearly
unchanged and interest expense has decreased slightly due to a
lower debt level.
In fiscal 2004, Lowe’s added safety stock in stores as a
precaution of the implementation of distribution network
initiative. As a result, inventory level has increased
significantly. This will be corrected in the latter half of 2005
when Lowe’s distribution network initiative is in place.
Lowe’s spent $1B on stock repurchases. Inventory increased
30% from $4,584M to $5,982M. This higher inventory level
and share repurchase program, result in a decrease in working
capital.
Heavy investment in capital projects, such as new and existing
stores, information technology and distribution network, leads
to a 25% jump in capital expenditure in fiscal 2004. This is
5
6
140 stores added in 2004, total 1,087 at the end of 2004
Comparable store sales increase 6.6% in 2004
considered as a long-term investment and its effect may not be
able to foresee anytime soon.
Income Projections
Income projection for Lowe’s is shown in Appendix C. Note
that some crucial assumptions were made. These assumptions
can be checked against historical data and consensus estimate
shown in Appendix B. For example, the sale growth rate
(18%) is in line with other analyst estimation, so is the oneyear EPS estimation ($3.65). Profit margin is forecasted to be
about 7%, which is a pretty aggressive number for retail
stores.
To further support this buoyant forecast, DuPont ROE analysis
(Appendix D) was provided. A quick inspection shows that
Lowe’s has achieved better ROE year after year, largely as a
result of its continuous improvement over profit margin.
COMPANY VALUATION
Many methods exist to value a stock, each with its own
advantages and disadvantages [1]. Two valuation models,
namely two-stage DDM and two-stage FCF models [3], are
used to gain an insight view on intrinsic value of Lowe’s
stock. As a supplement to this intrinsic value analysis, relative
value analysis is also performed. Finally, a time series analysis
on Lowe’s stock price is given to predict one-year target price.
For the valuation process, some important parameters
including systematic risk and a discount rate are needed. The
systematic risk is measured by the historical = 0.922. To
mitigate the problem that the historical beta may not be a good
predication of the future beta, a sensitivity analysis is
followed. The discount rate is thus calculated using CAPM
with risk-free rate = 5.16% (Lehman Brothers long U.S. Tbond rate) and historical average equity market risk premium
= 6.96%. This results in a discount rate of 11.58%.
( k s = R f + β ( R M − R f ) = 5.16% + 0.922 × 6.96% )
Another key parameter used in the models is growth rate. As
discussed earlier, the growth rate in home improvement sector
is highly correlated with the existing home sale and new house
start number. An estimation of a growth rate at 18% (12%
growth in existing home sale and new house start, plus 6%
growth in same store sale) for the next five years reflect an
optimistic view on the effect of booming housing market.
Long-term growth rate is set to be 10%, consistent with S&P
500 growth rate.
Lowe’s Research Report
Two-Stage DDM Analysis
The two-stage DDM formula for estimating intrinsic value can
be describe as:
5
P0 =
t =1
Dividend
d 0 (1 + g1−5 ) t
(1 + k s )
t
+
The following formula establishes the relationship between the
long-term growth rate and P5 .
P5
(1 + k s )
It can be seen from the above calculations that the results
produced by two-stage DDM are influenced heavily by the
predicted future price P5 . The effect of the change of the 5year growth rate is much less important than the change of the
anticipated future price. Therefore, it is essential to establish a
validation process to validate the assumption made against P5 .
5
2001
2002
2003
2004
2005
$0.07
$0.08
$0.09
$0.11
$0.15
g long =
P5 k s − d 0 (1 + g1−5 ) 5
P5 + d 0 (1 + g1−5 ) 5
P5 = $80
Table 1: Historical Dividend Payment
Table 1 gives the dividend number that will be used for the
calculation. For sensitivity analysis, P0 is computed with
k s = 11.58% ± 2% and g1−5 = 18% ± 2% . The range of
discount rate is determined by examining the competitor
Home Depot’s (1.31) 7, which leads to a 14.28% discount
rate. Future price P5 varies from $80 to $100, with a $10
interval. This reflects 23% ~ 54% stock price appreciation
over 5 years, well above historical S&P 500 appreciation rate.
Assuming that P5 = $80,
k s = 0.0958
k s = 0.1158
k s = 0.1358
g1−5 =16%
$51.53
$47.10
$43.12
g1−5 =18%
$51.57
$47.14
$43.17
g1−5 =20%
$51.63
$47.19
$43.21
P5 = $90
P5 = $100
g1−5 =16%
11.14%
11.19%
11.23%
g1−5 =18%
11.10%
11.16%
11.20%
g1−5 =20%
11.06%
11.12%
11.17%
The above computation suggests that the implied long-term
growth rate varies little when the expected future price ranges
from $80 to $100. It stays around the level of 11%, close to
the hypothesized 10% long-term growth rate.
It can then be concluded that with k s = 0.1158 and implied
long term growth rate around 11%, the stock price will range
from $47.10 to $58.76, more than 10% lower than the current
stock price ($65). Thus, the intrinsic value calculated by twostage version of the DDM does not support Lowe’s current
stock price.
Two-Stage FCF Analysis
Assuming that P5 = $90,
k s = 0.0958
k s = 0.1158
k s = 0.1358
g1−5 =16%
$57.85
$52.88
$48.41
g1−5 =18%
$57.90
$52.93
$48.46
g1−5 =20%
$57.96
$52.97
$48.50
Similar to the two-stage DDM analysis, two-stage FCF
analysis uses free cash flow in place of dividend used in the
two-stage DDM, as illustrated in the following formula:
FCF0 (1 + g1−5 ) t
5
P0 =
t =1
(1 + k s )
t
+
P5
(1 + k s ) 5
Assuming that P5 = $100,
k s = 0.0958
k s = 0.1158
k s = 0.1358
g1−5 =16%
$64.18
$58.66
$53.70
g1−5 =18%
$64.23
$58.71
$53.75
g1−5 =20%
$64.28
$58.76
$53.79
7
http://ir.homedepot.com/fundamentals.cfm
With FCF0 = $169M / 772M = $0.22 , P5 = $80, the range of
estimated intrinsic values using the FCF model is $43.49 to
$51.94, which is 20% lower than the current stock price.
k s = 0.0958
k s = 0.1158
k s = 0.1358
g1−5 =16%
$51.94
$47.49
$43.49
g1−5 =18%
$52.00
$47.55
$43.55
g1−5 =20%
$52.08
$47.62
$43.62
Lowe’s Research Report
Again, the stock valuation obtained from the two-stage FCF
model does not support Lowe’s current stock price.
performance of the Home Depot stock during the past several
years.8
Relative Valuation
Dearness of Lowe’s stock can be verified using the relative
valuation method. Figure 9 gives the stock valuation of
Lowe’s relative to the whole consumer discretionary sector. It
can be observed that Lowe’s stock price is well above the
sector in three out of four categories --- price/EBITA,
price/sales and price/cash flow. Only its price/forward earning
is of a fair value, which might be due to the reason that the
high growth rate expectation offsets the high stock price.
Figure 10: Lowe’s Stock Relative to Home Improvement Retail Stores
Figure 9: Lowe’s Stock Relative to Consumer Discretionary
Checking Lowe’s stock value against other home
improvement stores further proves that the stock of Lowe’s is
relatively overvalued. As shown in Figure 10, all of the four
measurements indicate that Lowe’s stock is priced well above
the rest stock within the sector.
In particular, a relative valuation is made between Lowe’s and
Home Depot. As shown in Figure 11, Lowe’s stock is
relatively more expensive than Home Depot’s stock. However,
this comparison may not be a good one because of the glaring
performance of the Lowe’s stock and the lackluster
8
Over the past several years, Lowe’s stock almost tripled,
while Home Depot’s stock has declined nearly 20%.
Lowe’s Research Report
In this analysis, Lowe’s monthly closing price data of Lowe’s
stock from July 2001 (Lowe’s has 2 for 1 stock split in June)
to August 2005 were downloaded and analyzed.
A plot of autocorrelations (ACF) using the raw data shown in
Figure 12 reveals that stock prices of adjacent periods are
correlated with each other. This is because factors influencing
the stock price are likely to be similar in adjacent periods. As
it can be seen, ACF starts at around .75 and decays gradually
to smaller values with the increase of the lag.
p ric e
0.4
-0.2
0.0
0.2
ACF
0.6
0.8
1.0
S e rie s
0
5
10
15
Lag
Figure 11: Lowe’s Relative to Home Depot
A time series model can be generally described as:
y t = E[ y t | Ω t −1 ] + ν t
where y t = ln( Pt ) − ln( Pt −1 ) and
y t can be further
decomposed with a predictable part and unpredictable part.
4.2
4.0
3.8
A stock price trend analysis facilitated by time series theory is
presented below to help understand how much momentum is
built within and whether this momentum can take the stock
price to a new high.
3.6
Fundamental analysis reveals that the current Lowe’s stock is
overpriced. However, one shortcoming of the above analysis
is not taking consideration of the market momentum factor,
which might push current stock price even higher despite that
price might not be achievable in the long run.
After a logarithmic transformation of the raw data, the time
series plot (Figure 13) shows an increasing trend, which
suggests differencing the series at lag 1 to remove the trend.
The time series plot, ACF and partial autocorreation (PACF)
plots of the differenced series are presented in Figures 14
through 16.
ln.price
Time Series Analysis
Figure 12: ACF of Lowe’s Stock Price
0
10
20
30
40
50
t im e
Figure 13: Plot of the Log Transformed Stock Prices
Many models, such as ARMA, ARCH, GARCH, Nonlinear
and neutral network model [2], are available to forecast the
predictable part of y t . For the simplicity purpose, ARMA
(Autoregressive Moving Average) model is used.
Lowe’s Research Report
0.3
candidates to be fit to the transformed data. Ultimately the
ARIMA (1,1,1) model produced a relatively better result. The
definition of an ARIMA (1,1,1) model is given as follows:
0.1
0.0
in which:
φ
θ
-0.1
ln.price.diff
0.2
(1 − φB )(1 − B ) X t = Z t + θZ t −1 ,
is the autoregressive (AR) coefficient,
-0.2
is the moving average (MA) coefficient,
B is the backward shift operator, i.e., BX t =
0
10
20
30
40
50
X t −1
Z t is a white noise series with mean of 0 and variance of σ 2 .
T im e
Figure 14: Time Series Plot of the Differenced Series
0.4
10
15
Lag
Figure 15: ACF of the Differenced Series
0.2
0.3
-0.1
S e r i e s l n .p r i c e .d i f f
0.1
5
0.0
0
residuals(price.111)
0.2
-0.2
0.0
0.2
ACF
0.6
0.8
1.0
S e r i e s l n .p r i c e .d i f f
Two parameter estimates are highly significant. The AR
coefficient is .72 with a standard error of .23, and the MA
coefficient is -.84 with a standard error of .17. The time series
plot, the ACF and the PACF of the model residuals are
presented in Figures 17 to 19. The large ACF at small lags
shown in figure 12 have disappeared and the residuals appear
to be consistent with a realization from a white noise process.
It is thus concluded that the stock price data follow an ARIMA
(1,1,1) model with coefficients given by the estimates.
10
20
30
40
50
0.0
T im e
Figure 17: Time Series Plot of Residuals of ARIMA (1,1,1) Model
-0.3
-0.2
-0.1
Partial ACF
0.1
0
5
10
15
Lag
Figure 16: PACF of Differenced Series
The three graphical displays seem to indicate that the trend has
been successfully removed. In the following steps, several
low-order ARIMA models were identified as potential
Lowe’s Research Report
0.8
0.6
0.4
-0.2
0.0
0.2
ACF
0
5
10
15
Lag
Figure 18: ACF of Residuals of ARIMA (1,1,1) model
S e r i e s r e s i d u a l s ( p r i c e .1 1 1 )
Chg.9
Sep-05
$64.18
Oct-05
$63.47
-1.26%
-2.35%
Nov-05
$62.95
Dec-05
Jan-06
Feb-06
Mar-06
Apr-06
May-06
Jun-06
Jul-06
Aug-06
$62.59
$62.33
$62.14
$62.00
$61.91
$61.84
$61.79
$61.75
$61.72
Avg.
$62.39
-3.15%
-3.71%
-4.11%
-4.40%
-4.62%
-4.75%
-4.86%
-4.94%
-5.00%
-5.05%
-4.02%
0.0
0.1
0.2
The forecast number is consistent with Lowe’s stock 50-Day
Moving Average ($63.06). The time series analysis suggests
that without a major shock, Lowe’s stock is unlikely to keep
up its momentum to reach a significant higher price.
Conclusions
-0.2
-0.1
Partial ACF
Forecast
Time
r e s i d u a l s ( p r i c e .1 1 1 )
1.0
S e rie s
5
10
15
Lowe’s stock has demonstrated strong performance for the
past several years. This can be credited by the following
factors:
Lag
•
Figure 19: PACF of Residuals of ARIMA (1,1,1) model
Based on the ARIMA (1,1,1) model, the stock prices of the
next 12 months were predicted as follows:
•
•
Historically low interest rate: Without this, the
housing market would unlikely grow so fast purely
on the basis of the favorite demographic change of
the population and income growth. By concentrating
on home improvement sectors, offering brand name
products and maintaining its EDLP tactic, Lowe’s
has successfully ridden this housing boom cycle.
Aggressive growth strategy: By store openings and
product line expansion, Lowe’s has achieved an
average 18% annual growth rate for the last several
years. Lowe’s also spent heavily on its infrastructure,
which will be relied upon by its future growth.
Innovation marketing: By tailoring stores to women’s
preferences, Lowe’s has successfully competed with
Home Depot and gained market share steadily.
Lowe’s financial statement proved its success on taking
advantage of these great opportunities. With trailing P/E
22.34, forward P/E 16.63 and PEG 0.94, Lowe’s stock looks
attractive at first sight. However, according to the intrinsic
9
Chg stands for the price change relative to current stock price, which is
about $65.
Lowe’s Research Report
value calculation, Lowe’s share is definitely overvalued.
Below are the principle evidence:
•
•
•
•
From many perspectives, real estate market is
overheated. Many signs show that the real demand is
lagging supply, and there are a lot of speculations in
this market. The rising interest rate will act as a
catalyst for the correction of the housing market.
Lowe’s share price is based on the 18% future growth
rate. As Lowe’s become larger and larger, and the
housing market cool down, this rate will become
unsustainable.
Intrinsic value calculation does not support its current
stock price. Price at $65 is believed to be too high.
Relative evaluation especially the one made against
Home Depot supports the above assertions.
In summary, although Lowe’s has solid performance and the
real estate market is bullish, the stock price of Lowe’s seems a
little bit too high and cannot be justified by its fundamental
value. Therefore, the stock deserves a “sell” rating.
References
1.
2.
3.
Security Analysis on Wall Street, Jeffrey C.Hooke, John
Wiley & Sons, Inc., 1998.
Non-linear Time Series Models in Empirical Finance,
Philip Hans Franses and Dick van Dijk, Cambridge
University Press, 2000.
Merck & Company, A Comprehensive Equity Valuation
Analysis, Randall S.Billingsley, CFA, Association for
Investment Management and Research, 1996
Lowe’s Research Report
Appendix
Appendix A: Lowe’s Financial Statement
Lowe’s Research Report
Lowe’s Research Report
Lowe’s Research Report
Appendix B: Lowe’s Growth & Margin Check
Lowe’s Research Report
Appendix C: Financial Projections
Lowe's Income Projection
Revenue ($Mil)
Costs of Goods & Service
Gross Proft
Gross Margin
SG & A Expense
Store Opening Cost
Depreciation
Interest Expense
Pre-Tax Income
Taxes
Net Income
Profit Margin
Shares Outstanding (Thou)
EPS
2001
2002
2003
2004
2005
2006
2007
2008
18779
13483
5296
28.20%
3348
131
413
131
1272
469
802
4.27%
768950
1.04
21714
15104
6610
30.44%
3846
106
534
152
1972
743
1229
5.66%
794597
1.55
26112
17978
8134
31.15%
4724
110
658
151
2491
943
1548
5.93%
810000
1.91
30838
21232
9606
31.15%
5579
130
777
179
2942
1113
1829
5.93%
816000
2.24
36464
24165
12299
33.73%
7563
124
901
175
3537
1360
2177
5.97%
808000
2.69
43028
28398
14629
34.00%
8606
120
1076
158
4670
1721
2949
6.85%
808000
3.65
50772
33510
17263
34.00%
10154
120
1269
158
5561
2031
3530
6.95%
808000
4.37
59912
39542
20370
34.00%
11982
120
1498
158
6612
2396
4215
7.04%
808000
5.22
Note: Following assumptions were made to derive the forecast.
•
•
•
•
•
•
18% sales growth rate
SG&A expense is about 20% of sales
No significant upside in store opening cost
Interest expense remains flat
40% tax rate
Outstanding shares stay at 2005 level
Lowe’s Research Report
Appendix D: DuPont Analytics