The Long and Short
Lowe’s curve should flatten to Home Depot
Meredith Contente | February 24, 2023
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Lowe’s Companies (LOW: Baa1/BBB) is quickly approaching its adjusted leverage target of 2.75x, as it ended the third quarter last year with leverage of 2.5x. While the new leverage target hinders its ability to move to the ‘A’ ratings category, management remains committed to its current high ‘BBB’ ratings. The new leverage target allows LOW to fully invest in its new operational strategy while increasing shareholder rewards. The new strategy is aimed at increasing its professional business revenue base and omnichannel offerings, which is expected to translate into improved operating margins. Furthermore, debt increases are expected to moderate this year.
When comparing the curves of LOW and Home Depot (HD – A2/A/A), the long end of LOW’s curve has widened to a greater degree, versus intermediate paper. In fact, LOW 30-year paper now trades roughly 70 bp wide to HD. This differential was only 50bps during the height of the pandemic. This differential could flatten once the new leverage target is hit and margins continue to benefit from operational improvements. LOW is likely to tap the market post first quarter earnings, which could provide for an attractive entry point.
Exhibit 1. LOW Curve vs. HD Curve (Today vs. 2.5 years ago)
Ratings Intact as Operational Improvement Plan Bears Fruit
LOW’s new leverage target of 2.75x has no impact on the current ratings, as the leverage threshold for LOW’s current ratings is roughly 3.0x. With LOW ending its most recent quarter with adjusted leverage of 2.5x, LOW is expected to reach its leverage target sometime this year. Both agencies currently maintain a stable outlook on their ratings and have highlighted that its operational improvement plan remains highly achievable.
Omnichannel investments have already begun to bear fruit with continued strong increases in online sales. In the last quarter, LOW posted digital sales growth of 12%, which was over four times their US growth rate. Furthermore, a new store inventory management system has improved fulfillment capabilities, thereby increasing the percentage of sales using the buy online pick-up in store option (BOPUS). BOPUS is a good margin driver as it saves LOW’s on shipping costs while reducing headcount needs. Furthermore, its market delivery model for bulky items such as appliances and cabinets now covers half of its store base. This model has holding facilities that alleviate the need for stockroom inventory and improves inventory turns. Lastly, the company has narrowed its private label focus in order to improve the penetration rates of its strongest exclusive brands. Private label is now focused in strategically targeted categories, which is expected to improve visibility while highlighting their value proposition.
Additionally, management is targeting long-term Pro growth and has witnessed roughly 600 bp in Pro penetration since 2019. LOW delivered its tenth consecutive quarter of double-digit Pro growth last quarter. Additionally, LOW launched a Pro Reward program in 2022 which has further driven customer loyalty as Pro Reward customers transact three times more than those not enrolled in the program.
Adjusted operating margin moving in right direction
LOW has guided to an adjusted operating margin of 13% for fiscal 2022, which if achieved, will represent 40bps of growth from the year-ago period. Management is also targeting a long-term adjusted operating margin of 14.5%, which they expect to achieve between 2025-2027. Given the current economic environment, management has provided three scenarios for margin outcomes in fiscal 2023 (Exhibit 2). Under all three scenarios, LOW is still expected to post adjusted operating margin growth in fiscal 2023, with the minimum growth rate being 30bps and the maximum growth rate being 90 bp. Management noted that under the “Robust Market” scenario, they expect to hit their 14.5% margin target by 2025 and by 2027 under the “Moderate Market” scenario. Furthermore, once the 14.5% margin has been hit, they have guided to a 15% adjusted operating margin within 24 months.
Exhibit 2. LOW Fiscal 2023 Scenario Planning
Debt increases set to moderate
With the new leverage target quickly approaching, debt increases will moderate significantly. That said, the potential for large multi-tranche debt issuances, which have a tendency to re-price secondaries, has decreased. In both 2021 and 2022, net debt increased by nearly $7 billion each year. In 2022, LOW tapped the market twice bringing $9 billion of total volume, while in 2021 we saw $4 billion in new volume. Moving forward, management has guided to $7 billion of additional net debt over a 3-year period ( around $2.3 billion per year). LOW may look to tap the market after it posts earnings on 3/1/23. LOW has tapped the debt market after first quarters earnings for the past four years. Any new issuance is likely to come with a concession to secondaries which could provide for an attractive entry point.