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Lowe's Shares Approaching A Positive Inflection Point

 November 19, 2012 09:45 AM

(By Mani) Shares of Lowe's Companies, Inc. (NYSE: LOW) are approaching a positive inflection point on prospects of a recovery in the US housing market and, hence, a sustained improvement in demand trends at the leading home improvement retail chains.

Mooresville, North Carolina-based Lowe's is the second largest home improvement specialty retailer in the United States. The company operates more than 1,650 retail stores in the United States and Canada.

Lowe's represents one of the most dominant and best-capitalized large-cap chains in the hardlines retail sector. It recently announced plans to slow new unit growth dramatically and focus more intently on cost controls. The chain is committed to using excess cash to aggressively repurchase shares.

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"We believe that the discounted valuation at which shares currently trade meaningfully undermines the financial strength and longer term profit potential of LOW," Oppenheimer analyst Brian Nagel wrote in a note to clients.

Housing activity is expected to continue to improve next year. The National Association of Realtors forecasts 2013 new home sales of 575K, up from a 2011 trough of 306K and also forecasts a 9 percent increase in existing home sales to 5.05 million from 4.64 million in the prior year.

Meanwhile, mortgage rates remain at record low levels should further support a housing recovery in coming quarters.

Moreover, Hurricane Sandy should serve as a near-term driver of improved demand for home improvement retail spending in coming quarters. Home Depot noted a $70 million sales lift during the last week of its third quarter as a result of Sandy, and management also cited a potential sales benefit similar to that of Hurricane Irene at $360 million.

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"Typical benefits from hurricane-related spending last about a year. We estimate hurricane-related spending could add as much as 1% pt. to LOW comps through late 2013," Nagel noted.

Over the past several quarters, Lowe's has undertaken an aggressive strategy to review product lineups in its stores and ultimately enhance its merchandise offerings.

"We are optimistic that the investments needed to drive these efforts are now coming to an end and that over time these initiatives will help to drive better results at LOW," the analyst said.

The company is well under way with its merchandising transformation. Line reviews will be largely completed by the end of the year with merchandise resets expected to be wrapped up in mid-2013 Comp and margin benefits from management initiatives should start to accrue more meaningfully in mid-2013.

In the July conference call, the company noted positive early results in the paint category with comps and margin growth exceeding expectations. As part of the paint line review process and resets, Lowe's has been able to create new products, tailor products to market, emphasize private brands when appropriate, reduce stock keeping units and costs while increasing inventory of higher volume items, but reducing net inventory.

"We are optimistic that the initial success in this area is a harbinger of positive results in other areas as resets are completed," Nagel wrote.

Meanwhile, gross margins are now on pace to turn positive as comparisons ease versus prior year quarters.

"We expect LOW margins to turn positive as it laps disruption from prior-year merchandising initiatives (Exhibit 8). The fourth quarter could be the first quarter of margin improvement since Q111," he said.

As part of its move to Everyday Low Prices (EDLP), the company has attempted to pull back in promotions. Fewer discounts in areas such as appliances, cabinets, countertops and millwork detracted more than 100 basis points (bps) from the first quarter comps. In the second quarter, the negative comp impact was more minimal as management returned to more aggressive big-ticket promotions in July.

"We expect a return to more disciplined promotional activity during the second half of the year and a more comparable promotional cadence to follow in 2013. Comp pressures from the transition to EDLP are likely to subside," Nagel said.

As recent re-merchandising and other re-positioning efforts at Lowe's take hold, and importantly the investments needed to drive these efforts begin to abate, earnings growth for LOW should accelerate and importantly track better than that of its primary competitor Home Depot (NYSE:HD)

In addition, Lowe's is under-owned at a time when a larger number of investors are increasingly seeking well-positioned plays on a recovery in the US housing market. To date it seems that most investors have gravitated toward Home Depot given the chain's recent fundamental prowess.

"We believe that the market will begin to look more favorably on LOW due to its lower valuation and more significant operating margin expansion from here," Nagel noted.

Since late 2010, shares of Lowe's have significantly underperformed shares of Home Depot while still outperforming the market. During this period, shares of Lowe's are up 28 percent versus gains of 82 percent and 10 percent for Home Depot and the S&P 500, respectively. Lowe's continues to underperform Home Depot year to date with shares up 26 percent compared to a 52 percent gain in Home Depot.

Shares of Lowe's currently trades at a P/E multiple of 16.3x that is about 2x lower than the P/E multiple of its primary competitor Home Depot's 19.1x, and compares to a five year average multiple gap of about 0.75x.

"We believe this variance could moderate as over time the LOW initiatives serve to improve the operating performance of the chain," Nagel added.



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