LOW Presents an Interesting Opportunity - If You Believe Management

While its sexier competitor Home Depot gets all the attention, LOW is an interesting play at current levels. Lowe's currently trades at a similar multiple to Home Depot despite having a stronger outlook on earnings. The key to the story is whether LOW will be able to achieve its guidance (set forth by management) for the year.

 

LOW Valuation Looks Attractive on the Surface

Both LOW and HD trade at a 21x 2015 EPS multiple. However, the outlook for LOW appears brighter, as LOW's management has guided to higher earnings growth for 2015. Additionally, beyond 2015, LOW has also set longer-term targets of 21% EPS growth over the next three years. 

 

The Catch - Investors Don't Believe LOW Will Hit Their Guidance

The problem is that investors and Wall St analysts are skeptical that LOW will be able to achieve its full-year earnings guidance of $3.29. The biggest challenge comes on the company's comp guidance of 4.0% - 4.5%. In 1Q, the company posted a 5.2% comp on the easiest comparison for the year (a 0.9% comp in 1Q14). Going forward, the comparisons accelerate and become much more difficult. Will LOW be able to maintain a 4.0% - 4.5% comp through those quarters? Investors are skeptical, since doing so would imply an acceleration in the underlying sales trends throughout the year. 

Additionally, LOW has historically under-performed HD for some time, and 1Q15 saw a continuation of this trend. There is a general sense among investors that in order for LOW to hit their targets, they will need help from the macro environment, whereas HD is less reliant on the macroeconomic environment and can get there mostly through their own company-specific initiatives.

If management is unable to achieve its 4.0% - 4.5% comp guidance, their operating margin guidance of 80-100 basis points of expansion is also at risk. Management noted that above a 1% comp, they expect to achieve 25 - 30 basis points of margin expansion per one point of comp. If they achieve a 3% comp for example, they would expect 50-60 basis points of margin expansion. Assuming a 3% comp and 50-60 basis points of margin expansion for the remainder of 2015 would generate $3.16 in 2015 EPS, or 16% of EPS growth, which would be below its guidance for the year and below the trajectory of its long-term targets. While that's not a bad earnings growth number, it would be a negative sign to investors if the company was not on track to meet its short-term and longer-term financial targets. Additionally, investors may feel even more comfortable owning Home Depot, which is gaining share and may be perceived as a safer bet with the same underlying drivers.

As a result, the LOW story really rests on its same store sales performance for the year. If you believe LOW will be able to maintain a comp of 4.0% - 4.5%, despite the difficult comparisons and their under-performance relative to HD, the stock may be able to outperform. If not, look for the stock to continue to under-perform its competitors.

 

My LOW financial earnings model is available on my site.