By Brian Sozzi
By its very definition, an activist investor is a person or group that seeks to implement far-reaching change at publicly held companies. Whether it's Carl Icahn, William Ackman, or Gordon Gecko (who raked an ineffective Teldar Paper over the coals) they all have that killer instinct, the ability to smell blood in the water from a mile away. So the activist swoops in to save the existing shareholder base from added years of subpar returns, and of course to boost the value of their initial investment, by putting forth proposals that are designed to extract maximum value. At the bare minimum Gecko wanted new management making the decisions at Teldar Paper, ones with skin in the game. Ackman tried his hardest to get Target (TGT) to undertake a leaseback transaction but came up snake eyes, though has saved face by bringing significant first step changes to JC Penney (board seats won, closing of uneconomical lines of business, and perhaps not so vocally pushing Ullman aside to land Apple retail store whiz Ron Johnson).
Activist investors will tend not to enter the fray for the sake of trying to boost a share price of a dog, the opportunity from timing to untapped value need to be just right to start the ball rolling. In the shark ridden waters of activist investing there is always a player poised to strike, especially now with macro softness loosening up valuations on publicly held companies. I think there is one giant minnow swimming around the world of retail all but daring the sharks to make a move. That minnow is blue in color, and is named Lowe's (LOW).
The operating environment for Lowe's and larger rival Home Depot (HD) have been far from ideal dating back to 2007. Come to think about it, conditions on the ground (which includes remodeling 3 bedroom homes into McMansions) were unrepresentative of true wealth creation as the housing market was propped up by a multitude of tulip mania-esque factors. Rather than go down memory lane macro wise, I want to focus on why Lowe's fits the profile of a company that demands the attention of an activist investor.
First are top level management compensation and the performance of the company. CEO Robert Niblock's recent pronouncement that new store growth would be curtailed further is a sign that he is feeling the heat by shareholders, in my view. That out of the way, Niblock has hauled in $47.8 million in total compensation (sufficiently above that of Frank Blake, CEO of Home Depot, during the comparable period) since officially reaching the top post (I began in 2007; the CEO title was effective on December 15, 2006). During that four year period, two other higher ups at Lowe's, CFO and EVP Bob Hull and Greg Bridgeford EVP of Business have amassed $12.6 million and $11.7 million, respectively, in total compensation. It's worth pointing out that all three men were granted significant hikes in total compensation in 2008 relative to 2007, while the fundamental performance of the company was faltering amid a lack of foresight internally (which is strange considering how close Lowe's is to housing market trends) as the housing market bubble popped. However, throughout the economic chaos, Niblock can be quoted from 2007 earnings calls stating the following:
2Q07
* "The core of our business remains relatively strong."
* On the 1Q07 earnings call, he mentioned that guidance was for "improving sales trends through 2007."
* "We're not directly at risk with regard to sub-prime lending."
* "Improving results are an encouraging sign."
3Q07
* "It's clear that the pressures on our industry are greater than previously anticipated."
4Q07
* "Our original plan for 2007 proved too optimistic."
* "As 2008 unfolds we anticipate at least some of the headwinds will lessen."
The performance of the business was worsening, yet Lowe's executives continued to inject unrealistic expectations into the mix, while being paid lavishly. Sure sounds like a Teldar Paper case if I ever saw one. Let's see what shareholders have been witnesses to over the last four years and in the early stages of 2011:
* EBITDA margin of 10.54% in 2010, down from 12.57% in 2007. If planning was more effective, capex shouldn't have hit an all-time high of $4.0 billion in 2007 and only shrunk to $3.2 billion in 2008; therefore margins would be stronger in a still depressed housing market. Lowe's capex in 2010...$1.3 billion.
* ROA of 8.55% in 2010, down from 13.49% in 2007 as a result of late in the economic cycle store openings.
* ROE of 10.72%, down from 17.59% in 2007.
* On May 25, 2007 the company expanded its share repurchase plan by $3.0 billion.
* A re-leveraging of the balance sheet to $6.5 billion in 2010 from $4.5 billion in 2009 to support an ambitious share repurchase plan. Buying back the stock doesn't seem to be a proper use of shareholder funds given how the business is performing fundamentally.
* Same-store sales at Lowe's have trailed Home Depot's in the last eight quarters.
* Since the broader market bottomed in March 2009, shares of Lowe's have risen 42% against a 68% increase for Home Depot.
It's not enough for a public company to be underperforming its peer group or internal potential for an activist investor to arrive on the scene. The activist requires a combination of management with a track record of ineffectiveness that may be leading to unrest on the part of top institutional shareholders, unrealized value underneath the negative story, and a weak board composition. The moneyshot for Lowe's is in the hard assets it owns and the potential to really ruffle some feathers given the shareholder ownership and board structures:
* 89% of the stores are owned, including stores on leased land.
* 14 of 15 regional DCs are owned, along with 14 flatbed DCs.
* The top three shareholders are what I would describe as passive.
* Management owns very little of the float.
* Outside of Lead Independent Director David Bernauer and Director Raul Alvarez, the board is absent strong retail experience.
What an activist could do at Lowe's:
* Leaseback transaction along the lines of what Ackman proposed to Target.
* Replace Niblock after gaining a spot, or spots, on the board. In turn, install a new CEO that will: (1) halt all domestic store openings to run an analysis of which stores should be exited and which markets are ripe for the new Lowe's smaller prototype model; and (2) reallocate capital to a higher dividend to attract new longer term shareholders, instead of aggressively repurchasing shares of a company basically that is a turnaround around story at this point in time.
To its credit, Lowe's has developed a best in class, highly efficient distribution model and a website that is vastly improved in functionality. These things are not enough, and now is the time to bring change to the organization prior to the eventual recovery in the housing market. The only question is when the shark will bite the blue minnow, not if.
