Home improvement stores, such as Lowe’s (NYSE: LOW), have been one of the biggest success stories in American retail, with steadily growing revenues for the past few years.
Lowe’s, in particular, has benefited from the growing popularity of do-it-yourself and the collapse of rivals such as Sears Holdings (NASDAQ: SHLD). Over the past few years, the hardware big box has reported some impressive gains in revenue. For example, Lowe’s entered 2014 with revenues of $53.42 billion in January, and that figure grew to $56.22 billion in January 2015 and $59.07 billion in January 2016.
The numbers show us that Lowe’s revenues have been growing at a rate of around $3 billion a year, but does this chain make money? That depends upon which financial number you take a look at.
Lowe’s did report a net income of $2.546 billion on January 31, 2016, but it also reported a profit margin of .08% and a free cash flow of -$115 million on the same day. Lowe’s also generated $4.784 billion in cash from operations, while it had around $712 million in cash and short-term investments.
So How Much Does Lowe’s Owe Anyway?
As you can see, Lowe’s makes money, but it does not hold onto that cash. Like a lot of retailers, it has high overhead, including large amounts of big-ticket merchandise, such as appliances and lawn mowers on floor plans. Under such arrangements, Lowe’s receives items from manufacturers without taking upfront payment; it is then obligated to sell them in a specific period of time.
Such arrangements can make it difficult to figure out what Lowe’s liabilities are and how much money it can generate. Currently, Lowe’s has $23.16 billion in liabilities and $31.27 billion in assets on paper. The problem with those numbers is that they may not reflect the real value of the merchandise in Lowe’s stores.
For example, for a $700 stove that is not selling, Lowe’s may eventually sell that appliance, but it might have to do so at a steep discount (say for $300) and lose money on the deal.
These kinds of obligations are why the death spiral can overtake some retailers very quickly. They operate at a low profit margin and expect a certain level of sales to cover the cost of operations. If the sales do not come in, the company starts losing money, as is the current case at Walmart Stores Inc. (NYSE: WMT).
The worst case scenario is the death spiral, in which the cost a retailer is paying for merchandise exceeds the sales. In those cases, such as in the present situation at Sears, it is often more profitable for the retailer to close the doors and sell off the real estate than to remain in operation.
Can Lowe’s Success Continue?
Lowe’s is obviously very far from the death spiral, but it does seem to be on shakier ground than its share price would indicate. A big problem is that much of the company’s success seems to be based upon steadily increasing revenues.
The danger here is that revenue growth can suddenly and sometimes inexplicably stall or even reverse at the most successful retailers. This happened at Walmart over the past year and at Target (NYSE: TGT) during the last quarter of 2015. Could the same thing happen at Lowe’s?
Lowe’s is, after all, very different from Target and Walmart. It is a specialty retailer, but it sells to some of the same customers in the same markets. To answer this question, we’ll have to identify the factors driving Lowe’s success and examine them.
Factors Driving Lowe’s Success
The main drivers of Lowe’s current success are a number of economic trends that may not be permanent. These trends include:
- Lower gasoline prices, which give working and middle class customers more disposable income. Some of that will be spent on new appliances and home improvement projects that benefit Lowes.
- Income stagnation, particularly among the middle class, which encourages do-it-yourself projects and encourages people to spend more time at home. Households with less income are more likely to perform tasks, such as fixing plumbing themselves.
- Very low interest rates, which can encourage home buying and home improvement projects that are often financed with home equity loans.
- Rising real estate and housing prices in some parts of the country. That encourages real estate speculation and home improvement projects as people try to increase the value of their homes. A side effect is the growing number of people buying property to rent out, which may require work.
- The decline of Lowe’s historic competitors, particularly department stores like Sears, discounters like Walmart, and mom and pop hardware stores.
It is not clear how long these trends can continue or if they are permanent. Gasoline prices are determined by lower oil prices, a condition that is not necessarily permanent. Interest rates are determined by Federal Reserve policy, which is determined by a wide variety of outside factors.
Is the Real Estate Bubble the Real Threat to Lowe’s?
Real estate prices might be even more unreliable. Some parts of the U.S., particularly Denver and San Francisco, do appear to be in the midst of a real estate bubble. The problem is that the middle class does not seem to be participating in this bubble. It also appears to be a regional phenomenon.
Where I live in Colorado, Denver is experiencing housing shortages and record high property values. Yet a little over 100 miles away in Canon City, property is moving so slowly that prices on some properties fell by several thousand dollars in a matter of months. Real estate is moving so slowly in Canon City that when I was there looking at a for-sale sign on a house, the owner actually ran out and tried to get me to come in and take a look.
This uneven real estate market could be a threat to Lowe’s because much of its success is based on the presumption that Americans will constantly want to improve their homes to increase value. If real estate prices stop going up or start falling dramatically, there could be little or no incentive for home improvement.
Another danger Lowe’s could face is that working or even middle class homeowners, its primary customers, could get priced out of the housing market in some regions. This seems to have occurred in San Francisco and it could occur in other areas such as Denver. The opposite of San Francisco and Denver is cities like Philadelphia and Detroit, where a large percentage of the housing stock is effectively worthless.
Therefore, Lowe’s is not a good buy and hold stock because the bottom could fall out of its business at any time. All it would take is a sudden crash of the housing market or a prolonged period of falling real estate prices to reverse Lowe’s revenue growth. Stay away from this stock; there are much better retail plays out there, such as Walgreen (NASDAQ: WBA), that have the potential for prolonged revenue growth.