Lowe's: Acquisition Confirms Stretched Valuation

| About: Lowe's Companies, (LOW)

Summary

Lowe's agreed to buy Canadian home improvement store for a large premium.

The deal allows the company to gain better scale in the Canadian market were Lowe's was struggling to gain traction and obtain real estate space.

The cash deal signals a shift away from stock buybacks that help push the stock higher over the last five years.

In a not well-received move, Lowe's (NYSE:LOW) agreed to buy Canadian home improvement operator RONA for a huge premium. Lowe's traded down over 6% Tuesday toward 52-week lows based on the news.

The move comes after years of a surging stock price produced by a slow growing company using cash flow to repurchase shares and boost earnings. The reason for the negative reception by Wall Street isn't clear although several potential hiccups exist for concern.

The deal involves Lowe's paying roughly $2.3 billion in cash to acquire RONA for C$24 per share. Th offer price is an incredible 104% premium from the closing price on February 2. Lowe's does offer that the deal is accretive in the first year following closing of the transaction. What isn't clear is the level of synergies needed to achieve a positive contribution to earnings.

RONA provides a leading position in the Canadian home improvement market. Lowe's only has a small presence of 42 stores in the country. With nearly 500 stores, RONA allows Lowe's to leapfrog Home Depot (NYSE:HD) that lists 182 Canadian stores.

Part of the fear in the market is that the deal is close to the top in the Canadian home improvement market that has seen years of strong growth. Also, the negative results from Target (NYSE:TGT) in the country probably leave a bad taste for American investors. Note that the projected 4% growth rates appear irrational considering the ongoing impact of the commodity slump on the economy that relies heavily on oil and potash.

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Source: Lowe's/RONA merger slides

What the deal does is take away from the stock buybacks of the past several years. Though some investors don't like companies spending billions on buybacks, Lowe's successfully used the process to grow earnings and boost the stock. Now the additional $2.3 billion in cash spent on RONA will slow buybacks considering the company only ended last quarter with $1.2 billion in cash on the balance sheet.

LOW Chart

LOW data by YCharts

The suggestion with this purchase is that the company no longer sees the stock as cheap. According to the stock buyback yield, the company has spent a small percentage of the market cap on buybacks as the stock soared.

My recommendation on the stock in November was that the stretched valuation was causing a reduced impact from the share buybacks. My comments in a U.S. News & World Report article last week are confirmed by this move of Lowe's moving away from buying stock to purchasing another company that offers a more attractive valuation.

The key takeaway is that Lowe's was a stock priced for perfection. The deal adds risks to the stock where investors were used to large gains. Investors will probably view the deal in the light of the failed Target attempt to expand into Canada. This move is more logical considering Lowe's is buying a Canadian company instead of building their own stores.

The deal is probably a wise move for long-term growth in the North American market, but my view of the stock remains neutral. The small size of RONA doesn't add a huge risk to the Lowe's story, but the move confirms the previous view that the stock was overvalued.

At roughly 17x forward earnings, my recommendation is to continue avoiding the stock.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any 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.

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