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I have covered Lowe’s (NYSE:LOW ) several times in the past year or so. And my overall impression in the past was of the valuation risks. It's undoubtedly a great business. However, its valuation in the past year was too high and left little or no margin of safety. The stock price has indeed fallen by about 14% since my last coverage in October 2021 and by about 28% from its 52-week-high. And some readers asked if my thesis has changed or not, given such a large price movement.

This article assesses its valuation in two independent approaches: By its PE multiples and also its yield spread relative to the risk-free rates. And you will see that, unfortunately, I'm still maintaining my hold thesis for the mixed signals that I'm seeing. The valuation has indeed become attractive and features about a 15% of margin of safety in terms of FW PE. However, the rising interest rates have pressured its yield spread to the thinnest level in a decade. And at the same time, rising interest rates and high inflation are likely to persist and pressure consumer discretionary spending.

Lowe’s finished the first quarter of 2022 (ended April 29, 2022) with mixed results. The first quarter's total sales were $23.7 billion, about a 3% decrease from the $24.4 billion of sales it raked in during the first quarter of last year. At the same time, comparable store sales also were down by 4.0 percent. To make the bad news less bad, comparable sales in the U.S. fell by 3.8% industry-wide, and a lot of it is due to seasonality. So LOW’s performance is not that horrible against this broader backdrop. Furthermore, its Pro customers segment witnessed a strong growth rate of 20%. As CEO Marvin R. Ellison commented (and the emphases were added by me):

“Our sales this quarter were in line with our expectations, excluding our outdoor seasonal categories that were impacted by unseasonably cold temperatures in April. Because 75% of our customer base is DIY, our Q1 sales were disproportionately impacted by the cooler spring temperatures. Now that spring has finally arrived, we are pleased with the improved sales trends we are seeing in May.”

The business also affirmed its outlook for 2022. It affirmed its EPS (fully diluted) to be in the range between $13.10 and $13.60. As a result, its current PE multiple is about 15.6x on a TTM basis and only about 14.2x on an FW basis if we take the FW EPS to be $13.4, the mid-point of the guidance range. As you can see from the first chart below, such a PE multiple is below its historical average and indicates some level of undervaluation.

When we expand our view to an even broader time horizon, the valuation becomes even more attractive, as you can see from the second chart below. This chart depicts the stock's yearly average PE during the last decade. The average is 16.7x, and again the current valuation is about 7% below the average on a TTM basis and about 15% below on an FW basis, a quite substantial discount for such a stable stock. In terms of standard deviation, the undervaluation is even more dramatic. The current TTM PE is actually close to the -1x standard deviation level, and the FW PE is below it.

However, the picture becomes more complicated when we gauge its valuation against risk-free rates, as elaborated on next.

Author based on YCharts data

Author based on YCharts data

Details of the calculation and application of the yield spread have been provided in our earlier article. The yield spread is an indicator we first check before we make investment decisions. We’ve fortunately had very good success with this indicator because of:

The yield spread (“YS”) has been stable in a bounded range between -1.5 percent and 0.5 percent in the long run, as you can see. And now, its YS is near the lowest level in a decade. Such a narrow YS has been an effective leading signal in the past for lower return and high risks, as you can see from the second chart below. The chart shows the total return on investment (“ROI”) regressed on yield spread. You can see a clear positive correlation with a Pearson correlation coefficient of 0.60. And the current YS is near -1.1%, indicating relatively high valuation risks ahead in the near term.

Looking forward, the interest risks could persist in the long term and pressure LOW’s profit and valuation at the same time, as discussed next.

Author based on Seeking Alpha data

Author based on Seeking Alpha data

Despite the large stock price correction, I'm still maintaining my hold thesis on LOW for two main considerations: The thinnest yield spread in a decade and the major macroeconomic uncertainties. It's true that its PE is at an attractive level now. However, its yield spread against the 10-year treasury rate is currently about negative 1.1 percent, the narrowest level in a decade.

Looking forward, the interest risks could persist or even exacerbate given Fed’s current dot-plot and its mission to combat the surging inflation. Besides the interest rate uncertainties, there are a few risks on the horizon for LOW. As CEO Marvin R. Ellison commented (and the emphases were added by me):

This quarter we delivered over 65 basis points of operating margin improvement, driven by our Total Home strategy and the execution of our Perpetual Productivity Improvement or PPI initiatives. Despite some increased uncertainty in the macro environment, we remain confident in the outlook for the home improvement market and our ability to deliver operating margin expansion in 2022.

In my view, the macroeconomic uncertainties Ellison was referring to include several major factors. First, it includes the current volatility and also the perceived risks for liquidity in the U.S. and world financial markets to tighten up. And the housing market sensitively depends on such liquidity. It also includes the current high inflation and the ripple effects on labor costs. With the current macroeconomic parameters and ongoing geopolitical conflicts, it's unfortunate that these certainties are going to persist for the next few years.

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This article was written by

** Disclosure: I am associated with Sensor Unlimited.

** Master of Science, 2004, Stanford University, Stanford, CA 

Department of Management Science and Engineering, with concentration in quantitative investment 

** PhD,  2006, Stanford University, Stanford, CA 

Department of Mechanical Engineering, with concentration in  advanced and renewable energy solutions

** 15 years of investment management experiences 

Since 2006, have been actively analyzing stocks and the overall market, managing various portfolios and accounts and providing investment counseling to many relatives and friends.

** Diverse background and holistic approach 

Combined with Sensor Unlimited, we provide more than 3 decades of hands-on experience in high-tech R&D and consulting, housing market, credit market, and actual portfolio management. We monitor several asset classes for tactical opportunities. Examples include less-covered stocks ideas (such as our past holdings like CRUS and FL), the credit and REIT market, short-term and long-term bond trade opportunities, and gold-silver trade opportunities. 

I also take a holistic view and watch out on aspects (both dangers and opportunities) often neglected – such as tax considerations (always a large chunk of return), fitness with the rest of holdings (no holding is good or bad until it is examined under the context of what we already hold), and allocation across asset classes.

Above all, like many SA readers and writers, I am a curious investor – I look forward to constantly learn, re-learn, and de-learn with this wonderful community.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.