To RONA's Shareholders: Take The Money And Run

| About: Lowe's Companies, (LOW)

Summary

To RONA's shareholders: Take the money and run.

Lowe's is a wealth creator.

RONA is a wealth destroyer.

The premium over the intrinsic value is 33%.

Home Depot is the greatest wealth creator of the industry.

Lowe's Companies, Inc. (NYSE: LOW) and RONA Inc. (OTC:RONAF) (TSX: RON, RON.PR.A) announced Wednesday, February 3, that they have entered into a definitive agreement under which Lowe's will acquire all of the issued and outstanding common shares of RONA for C$24 per share in cash (and all of the issued and outstanding preferred shares of RONA for C$20 per share in cash). The total transaction value is C$3.2 billion (US$2.3 billion). The offer represents a premium of 104 percent to RONA's closing common share price on February 2, 2016 (C$11.77) and a 38 percent premium to RONA's 52-week high of C$17.36. In 2012, Lowe's had made an unsolicited bid to acquire RONA for $1.8 billion, which was opposed by the company and politicians in Quebec.

In the following analysis, we will show how Lowe's is creating value and how RONA is destroying value, using our proprietary data and our own valuation methodology based on the integration of the economics of strategy and the principles of modern corporate finance. We will also incorporate Home Depot (NYSE: HD) in our analysis because it is a major player in the home improvement chain.

The Companies

Founded in 1946 and based in Mooresville, N.C., Lowe's is a home improvement company serving approximately 16 million customers a week in the United States, Canada and Mexico through its stores and online. With fiscal year 2014 sales of US$56.2 billion, Lowe's has more than 1,845 home improvement and hardware stores and 265,000 employees.

RONA Inc. is a major Canadian retailer and distributor of hardware, building materials and home renovation products. RONA operates a network of close to 500 corporate and independent affiliate dealer stores in a number of complementary formats. With its nine distribution centers, RONA serves its network of stores and several independent dealers operating under other banners, including Ace, for which RONA owns the licensing rights and is the exclusive distributor in Canada. With more than 17,000 employees in corporate stores and more than 5,000 employees in the stores of its independent affiliate dealers, RONA generates annual consolidated sales of C$4.1 billion.

Founded in 1978, Home Depot, Inc. is the world's largest home improvement specialty retailer with fiscal 2014 retail sales of $83.2 billion. Home Depot has more than 2,200 retail stores in the United States (including Puerto Rico and the U.S. Virgin Islands and the territory of Guam), Canada and Mexico.

Creating Value

Creating value takes more than acceptance of value maximization as the organizational objective. Most companies affirm to maximize value but that is not true. The choice of value maximization as the corporate objective must be complemented by a corporate vision, strategy and tactics that unite participants in the organization in its struggle for dominance in its competitive arena. How does an investor determine if a company is creating value or not?

As shown in the following table, the creation or destruction of value is measured by calculating the market value added (MVA). Market value added will increase if value expands by more than the amount of capital committed to the business and vice versa. Mathematically, market value added is the market's assessment of the net present value of all investments the company has made, those already in place plus those expected to materialize in the future. It shows how successful management had been at allocating, managing, and redeploying scarce resources of all kinds. For RONA, the MVA is negative as shown below: Minus C$514,978,000. RONA has not added to the value of its invested capital. RONA is a value destroyer.

By comparison, Home Depot, a close competitor of Lowe's and RONA, has created an MVA of $145,850,204,000. The Home Depot is a value creator. Lowe's has created an MVA of $57,128,396,000. Lowe's is also a value creator.

MARKET VALUE ADDED (2015)

$ in million (C$ for RONA)

Home Depot

Lowe's

RONA

Market Value of Total Capital

178,779.241

(100%)

82,463.364

(100%)

1,983.806

(100%)

Invested Capital

32,929.037

(18.4%)

25,334.968

(30.7%)

2,498.784

(126%)

Market Value Added

145,850.204

(81.6%)

57,128.396

(69.3%)

- 514.978

(-26%)

Click to enlarge

Therefore, MVA measures the wealth the company has created for its owners since the start of the company. It does so by comparing the total cash that investors have put or left in the business with the present value of the cash that they can expect to take out of it. Also, as I have demonstrated elsewhere, MVA is the same thing as the corporate aggregate NPV (net present value). It is literally a summing up, in the market's mind, of the net present value of all investments, those the company already has made plus the present value of those deemed likely to materialize down the road.

To be more precise, the MVA from October 2011 to October 2015 for Home Depot has increased regularly from $36.4 billion to the $145.9 billion shown in the above table. An increase of 300%. Same story for Lowe's which saw, for the same years, its MVA increase from $9.1 billion to the $57.1 billion shown in the above table. An increase of 527%. During the same time, the MVA of RONA has decreased, each year, by an average amount of the same magnitude as the one reported in the above table, which is minus C$515 million.

When a firm's MVA increases, it is triply significant. That shows that the owners' wealth has expanded, that the firm's NPV has increased from some improvement in its operational excellence and enlargement of its strategic opportunities, and that the firm's total shareholder return has increased, too. And what does all that boil down to? Increasing EVA (economic value added). Increasing EVA is the key to creating wealth, maximizing NPV, and generating total shareholder return, all at the same time!

EVA is calculated as net operating profit after taxes (NOPAT) less the total dollar cost of its capital. Economic value added is also measured by the return on capital less the cost of capital spread, multiplied by capital. Positive EVA firms provide a higher return and more profit than shareholders could earn elsewhere, and thus deserve to sell for a value exceeding their invested capital. Firms with zero EVA match investors' expectations and should sell just for book value, and negative EVA firms warrant book value discounts (unless they are turnaround or takeover candidates like RONA or start-ups).

The following table shows the same story as MVA under the EVA (economic value added) perspective. Without surprise, we see the EVA per share of Home Depot on a solid ascend from $0.93 in 2011 to $3.99 in 2015. Lowe's is on a value increasing path with an EVA per share more and more in step with a value creator. During the same time, RONA was working on its takeover candidacy with negatives EVA.

Home Depot, Lowe's and Rona EVA/ Share (Trailing 12 months)

In C$ for RONA

2011

2012

2013

2014

2015

Home Depot Inc.

$0.93

$1.35

$2.20

$2.68

$3.99

Close competitors

Lowe's Companies Inc.

-$0.15

-$0.06

$0.21

$0.60

$1.47

RONA Inc.

$0.07

-$0.40

-$.32

$.02$

-$0.11

Click to enlarge

The MVA Behavior

The behavior of MVA should give assurance that the alpha we expect to obtain in investing in a particular stock will persist over time. It is why we need to do this calculation, to check if the corporation does what it pretends to do.

Companies that are leaders in value creation, like Home Depot, bring a different mindset and take a different approach to strategy development. They strive not just to be different from their competitors (which is necessary yet insufficient), but also to be both different from and more profitable than their competitors, like Home Depot does. They realize that others will seek to copy their success; therefore, they strive to develop capabilities and strategic assets that are hard to match. Creating such distinctive strategies is a difficult challenge, and only a few companies in any given industry, like Home Depot and Lowe's, are likely to be successful at implementing and sustaining them.

From where does the market value added comes from and how do you know that the company will continue to add or destroy market value in the future? Simply by looking at the performance spreads over time. A subject we will now address.

Sustainable Competitive Advantage

Companies that have generated returns on their capital higher than their cost of capital (positive performance spread) for many years of operation usually have a competitive advantage, especially if their returns on capital have increased over time. It goes without saying that the reverse reasoning applies to find takeover candidates (negative performance spreads over time).

This line of reasoning is fundamental. In other words, having an unexpected or a temporary return on capital, greater than the cost of capital, is not enough to be able to declare that a business has a competitive advantage. Simply put, you cannot expect to obtain abnormal return (alpha) as an investor if the business you invest in does not have a sustainable competitive advantage. In the same way, it is not enough to find a company with an unexpected or a temporary return on capital lower than its cost of capital to state that it is a takeover candidate. The performance spread of the company needs to be negative over a long period of time and for the recent periods.

Again, we say that a business has a competitive advantage when the difference (the performance spread) between the return on capital and the cost of capital (a difference correctly measured, that is obtained after transforming GAAP numbers into a rigorous computation of economic profit, after deducting the full cost of capital, and eliminating the accounting distortions) is positive. The higher the positive performance spread, the bigger the competitive advantage.

A business with a performance spread of zero or negative has no competitive advantage. The more negative the performance spreads are, the longer they have been negative, and we expect them to continue to be negative, the better we have a takeover candidate.

In the table that follows, we present the performance spreads over time of Lowe's, RONA, and one of their dominant competitor Home Depot to help put our results in perspective.

Home Depot, Lowe's and RONA Performance Spreads (Trailing 12 months)

2011

2012

2013

2014

2015

Home Depot Inc.

4.6%

5.8%

9.2%

10.4%

15.3%

Close competitors

Lowe's Companies Inc.

-0.5%

0.0%

0.7%

2.2%

5.5%

RONA Inc.

0.7%

-1.8%

-1.2%

0.2%

-0.6%

Click to enlarge

It is impressive to see how Home Depot has been able to maintain a positive performance spread, a competitive advantage, a moat, over time, whereas, RONA, the company that Lowe's will take over, has not been able to produce significant positive numbers during the same time. The data for Lowe's reveals its strategy: To increase the rising path of its performance spread.

A company with a positive performance spread, that is a return on its capital greater than its cost of capital, a necessary condition for market value creation, will see it decreases to zero and become negative if it is not able to embark on a new strategic value increasing trajectory when its performance spread tends toward zero. As has been the case for RONA.

That is not the case for Home Depot. The positive performance spread means that Home Depot has a solid position in the home improvement retailer business. Lowe's strategy is to assail the competitive advantage of Home Depot. On the contrary, RONA is in trouble. It has no competitive advantage.

Intrinsic Values

Equipped with the above information on performance spreads, we have estimated the intrinsic value of Home Depot, Lowe's and RONA. The comparison of the intrinsic value with the recent market price before the offer of Lowe's to buy RONA shows that Home Depot and Lowe's are exchanged at a fair price. RONA was under valued at $11.77. The premium over the intrinsic value is 33% much less than the 104% over the closing market price on February 2nd.

Further, as shown in the last three columns of the table, the actual market value of a share is a combined value of two ingredients: The value of assets in place and the value of growth opportunities.

What do we mean by this and what confidence do we have in our estimations presented so far?

Intrinsic or Fundamental Risk

To answer these questions, we need to recall that the value of any company (i.e., the market value of total capital) is composed of two parts: The value of assets in place, [Va], or the value of the current operations (i.e. the discounted value of the current net operating profits), plus the value of the future growth opportunities [Vg]. In the simplified approach that we use here, this second part is just the result of subtracting the first part (i.e. the value of assets in place) from the market value of total capital [VT].

As you can see in the table below, [Va] plus [Vg] is equal to [VT] or 100% as it should be. The connection with the fundamental risk is simple: The greater the market value of the total capital of the corporation is composed of the value of the current operations [Va], the less significant is the value of the most uncertain part of the total value, i.e. the future growth opportunities [Vg]. For Home Depot and Lowe's, the market value of their total capital is practically equal to the value coming from their current operations, the most confident part of their value. The balance should come from [Vg] in a "normal" situation. Normal, here, means a situation where the performance spread is positive. Or, at least, a condition where the intrinsic value and the market value are in equilibrium as it is in their cases.

However, in the case of RONA, we are not in a normal situation, but one where the future growth opportunities have a negative expected value of minus 26%. It implies that the only value of its current operations is higher than its market value. Hence, the percentage of 126% for the value of the current operations [Va]. In summary, the market doesn't give a penny for the growth opportunities of RONA and undervalues the value of its current operations.

Intrinsic Value, Value of Assets in Place,

Value of Growth Opportunities

(Trailing 12 months)

In dollars

Intrinsic Value

Recent Price

Total [VT]

Va

Vg

Home Depot

114.13$

123.79$

100%

49.4%

50.6%

Lowe's (before the offer to RONA)

69.99$

71.87$

100%

50.2%

49.8%

RONA (before the offer of Lowe's)

18.08$

11.77$

100%

126.4%

- 26.4%

Click to enlarge

Actionable advice:

RONA's shareholders should take the money offered by Lowe's and run. This stock has no future. However, the future of RONA augurs well with Lowe's. Home Depot and Lowe's should have their place in a diversified portfolio: Their positive performance spreads foreshadow healthy returns in the future. Investors should pay attention to the evolution of their performance spreads.

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.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.