SmartMoney
Daily Screen
December 1, 1998
Can Lowe's Buy Its Way to the Top?
By Paul R. La Monica
THE BUZZWORD in retail these days is obviously the Internet. Books-A-Million (BAMM), a third-tier book retailer, announced last week that it had revamped its Web site and its stock soared. Everyone's speculating about how many people will do their holiday shopping over the Web. But for the time being, do-it-yourselfers aren't buying most of their hammers, garden tools or new kitchen sinks over the Web. Odds are they're either going to Home Depot (HD) or Lowe's (LOW), the second-largest home-improvement retailer.
It's true that Home Depot is far and away the leader. Everyone knows those gargantuan orange warehouses are one of the biggest retail success stories of recent times. But Lowe's is no slouch either. With over $10 billion in sales last year, Lowe's has shown that there is definitely room for two big home-improvement chains. And last week it announced a major acquisition that has many predicting better times ahead for the company.
One of many deals announced last Merger Monday was Lowe's agreement to acquire Eagle Hardware & Garden (EAGL), a major home improvement retail chain in nine Western states, for $1 billion. This comes on top of Lowe's announcement earlier this year that it intends to open 100 stores out West in the next three to four years.
When Lowe's made that announcement in May, some analysts were concerned about how Lowe's would fare since it would be entering new markets against not only Home Depot but Eagle as well, a company that had already made a reputation as a strong regional player. Now that Lowe's is teaming up with Eagle there is less concern of any major price wars occurring that could hurt profits industrywide. "If these three companies were to bump heads out West, it would have been costly for all of them," says Craig Gordon, an analyst with NationsBanc Montgomery Securities. "The world is put at ease now that it is back to Lowe's against Home Depot. That is something everyone is comfortable with."
What's more, the deal is expected to immediately add to Lowe's 1999 earnings. As a result, analysts have ratcheted their earnings estimates upward for next year by 1.2%, helping to place Lowe's on this week's Earnings Revision Screen.
John Harris, an analyst with Schroder & Co., upgraded Lowe's to "Outperform" (Schroder's second-highest rating) after the Eagle acquisition was announced. Harris says Eagle should be able to benefit from greater buying power because Lowe's, based on estimated 1998 sales figures, is approximately 12 times larger than Eagle. In addition, Lowe's inventory management systems are better than Eagle's. So Lowe's will be able to strengthen the Eagle franchise while also taking advantage of Eagle's existing expertise in operating in the West, an attractive market that Lowe's is finally going to tap.
Eagle only has 32 stores but it is a market leader in Seattle, Denver and Salt Lake City, and it has been expanding in Southern California and Arizona as well. Sally Wallick, an analyst with Legg Mason Wood Walker, says the Eagle deal will help Lowe's continue its shift from a retailer that had operated predominantly in smaller markets to one that has stores in major metropolitan areas. That's because Lowe's will now benefit from Eagle's plans to enter high-growth markets such as Phoenix and Las Vegas.
And entering new markets with the help of a company that already does business there is especially crucial according to Harris. He sees the overall environment for home improvement retailers weakening in the next year as growth in existing home sales has slowed down over the last few months. But Harris says with this acquisition, Lowe's has the opportunity to increase its earnings and boost its return on investment at a higher rate than it would have previously. Harris raised his earnings estimates by two cents for 1999 and by three cents for 2000. As a result, Harris thinks the improving fundamentals outweigh the weakening economic trends.
Of course, value investors might be a little skittish when looking at this stock. Lowe's has had a great year. It's up 77% since January and at 42 1/4 is now just 6% off its 52-week high, having roared back in recent weeks after falling as low as 26 1/2 in October. But Gordon recently raised his target price for Lowe's to 60. That represents an upside of 42% from current levels. Gordon's target does value Lowe's at a hefty premium of 36 times his estimated 1999 earnings. However, Home Depot trades at 39 times next year's estimates. Currently, Lowe's trades at about 27 times 1999 estimates.
Sure, Home Depot deserves a premium to Lowe's. But when you look at the two companies' growth rates, it's hard to justify a 12 point gap in P/Es. Home Depot's earnings are expected to increase by 27% this year and 23% next year while analysts are predicting 28% earnings growth for Lowe's this year and a 20% increase in 1999. Home Depot has an expected long-term growth rate of 23% compared to an estimated growth rate of 21% for Lowe's. And if anything, expect that difference to narrow once all the analysts factor in earnings accretion from Eagle. Harris has already raised his growth rate target a percentage point to 22%.
So let other investors keep propping up and pulling down the latest Internet retailer du jour. Instead, you can play it safe with this do-it-yourself retailer that is poised for a healthy level of tried and true earnings growth. Earnings: Remember them? Believe it or not, they still matter.
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