The smaller member of the duopoly that dominates the home supply retailing field, Lowe's (LOW), has been on an amazing surge recently. Here is the 1-year chart of LOW, shown on a percentage basis compared to the Big Dog, Home Depot (HD):
As you can see, just since the beginning of November, LOW has come close to making up its lost ground against HD. On Friday, it surged 5% almost in an instant when word broke that D.E. Shaw has taken an activist position in the stock. Bloomberg broke the story, and in the video interview with a reporter, the major point made is that Team Shaw must have a plan for LOW to increase margins. CNBC has confirmed the activism story.
This article documents the potential attractiveness of LOW to an activist investor, and why I added a little more LOW after the news broke, having luckily entered in the $94-95 range at the beginning of the week.
Because I have been "out there" with support for economy-sensitive stocks in general since June 2016, and homebuilders and HD since November 2016, the next section provides a brief overview of how I came to that view and how I look at the housing stocks now.
Bullish on housing, cautious on some builders; looking for value
When the US economy showed real signs of bottoming and turning up from its cyclical industrial slowdown in Q2 2016, and did so without help from a new QE program out of the Fed, I began to believe that finally, the Great Recession was in the rear-view mirror and that a return to economic normalcy had begun. So, I began asking myself, what sector or sectors was farthest behind the curve? The answer was not smartphones or related components; it was housing and related stocks. This is where the depression was, a true depression, and the recovery has just begun. My belief was that the legions of younger Americans residing in the homes of their parents were, by the magic of capitalism (following the government-led rescue of the banking and building sector), going to drive a long and strong recovery in the housing sector. HD has been banging that drum for some time, pointing out that even though homebuilding and renovations have improved a lot, off their depressed bottom, they are still below historical averages as a share of GDP. My own take is that these parameters are likely to move above their long-term averages, so that a multiyear investment play looks likely to me.
In that setting, stronger names that have been underperforming tend to get second chances. Either management joins the uptrend more fully of its own efforts, or an activist comes in, and/or the company becomes takeover bait. With LOW too large to be taken over, and as will be shown next, with its metrics inexplicably far below those of HD, that leaves an activist investor to push LOW toward greater efficiency. This can often be a great thing for the long run. About 15 years ago, an activist pushed McDonald's (MCD) to clean up its act (and its bathrooms), and the stock has barely looked back in its ascent. Perhaps the same will occur for LOW.
Here's the quantitative story.
LOW lags HD, thus can provide (lots of) alpha
LOW and HD are similar in total store count with a concentration in North America (largely the US) and store size. Both have intensified a focus on e-commerce. Each is headquartered in the southeast; Lowe's is older. Each is much larger than the #3 US home improvement chain, privately held Menard Inc. Both LOW and HD have followed similar stock market strategies, with a heavy focus on a fairly large amount of corporate debt associated with an aggressive tactic of raising EPS by shrinking the float (share buybacks).
However, HD has higher sales. LOW generated $36 B in revenues over the past two quarters, while HD reached $53 B. This is despite a large acquisition that LOW made in 2016 in Canada, of RONA, a Quebec-based chain.
E-Marketer Retail has data showing store productivity for each chain. It's no contest, and the gap has widened. First, LOW's sales per square foot, then HD, over selected recent years:
- Trailing 12 months: $307
- 2016: $301
- 2014: $273
- 2012: $253.
Not bad, but compare with HD:
- Trailing 12 months: $390
- 2016: $375
- 2014: $338
- 2012: $311.
In 2012, the ratio of HD:LOW for this metric was 1.23X. For the TTM, it was 1.27X. The trend was in force in 2015, the first year before the large but not transformative RONA deal. Then, the ratio was 1.25X.
Note: more data is found on those linked webpages than is shown here; trends and data shown generally also favor HD.
Basically, HD is more productive. LOW's most recent earnings call slide presentation shows (slide 10) this telling comment:
... Enhance operating discipline and focus on making productivity a core strength.
A recent LOW presentation, Strategy Slide 2017, is replete with slides saying the same thing in somewhat different ways. The latest conference call was also a bit of a slugfest where analysts beat on LOW for not keeping up with HD; HD has been sailing unruffled through this period, with one "beat" after another. This sequence, near the end of the call, told the tale:
Good morning. Thanks a lot for taking my question. Can you give us some quantification of how far along you are into the competitive pricing actions you've been taking? Are you close to being done?
... Obviously, we're going to continue to react to the competitive intensity of the marketplace. I feel good about the actions we took coming out of the first quarter when we recognized an opportunity to improve our value perception.
No one cares that an executive feels good. That's a bad sign, not a good one, because when one lacks data, one resorts to emotions.
The theme continued onward, though:
And are you seeing competitive respond as you take price actions?
Yeah. I think the marketplace remains competitive.
The very next questioner would not drop the topic:
Sorry. Okay. I was on the different line. A follow-up to Michael's question. It's around gross margin. And this quarter, in the slide deck, the gross margin headwind was described – one of them was described as competitive actions.
If in the first quarter, you called out pricing investments and second quarter you called the promotional activity, can we discuss what these descriptions? Are they just different ways to say the same thing?
After a response from HD, this gentleman continued the pounding (emphasis added):
Okay. And then regarding execution, we've talked over the past 12 months there's been some management change. There was – we talked about some inconsistency between merchants and some of the marketing, and then you've added some labor hours back to stores. If you think about how you performed in Q3 and going forward, are the bumps more or less ironed out? And can you talk about where you could be or where you should still be getting better?
With all this focus, it's no surprise that a basic resource, in this case, E-Trade's (ETFC) fundamental data array, shows HD with an operating margin of 14.53% and a net profit margin of 8.66%, whereas it shows LOW with an operating margin of 9.13% and a net profit margin of 5.16%.
Herein lies the opportunity.
What is the upside for LOW?
LOW has been trading around 1.2X sales per share, HD around 2.3X. At a certain point, similar companies doing similar things should tend, in many theoretical financial frameworks, to equalize. If one company has a better brand image, better store locations, superior managers and systems, then the competitors will not get equal, but the laggard has more room to improve than the leader; at least, that's one common way of looking at matters.
That brings us to a simple arithmetic question. LOW has consensus sales near $72 B for the 2019 FY, which ends in January 2019. What if it were to trade at 1.6X sales per share, about at a 30% discount to HD, where consensus is for $107 B and market cap is around $230 B?
LOW ended Q3 with 832 MM diluted shares outstanding, down sharply from 874 MM one year earlier. If we use 820 MM shares and a more conservative target valuation of 1.5X sales per share, we get a little over a 25% target price. With LOW having closed Friday at $100.86, I am thinking that it can trade up toward $125-130.
On a P/E basis, it is true that this would take it to 29X TTM EPS, but there are offsets. One is the benefit of a reduction in its Federal tax rate from 35% to 21%. If this benefit is not competed away at all, this alone can allow a 20% rise in EPS. Then, there is the fact that while LOW is less efficient than HD, it is indeed growing somewhat in line with its sector; and its Canadian and small Mexican operations are growing nicely. With my estimate for S&P 500 (SPY) earnings to be $140 per share this year post-tax reform, the SPY is near 20X forward EPS. If LOW can get its profit margins halfway toward those of HD, it can meaningfully beat forward consensus EPS.
We are getting into record territory for upward momentum of stock prices. Much is assumed. The same is true for LOW. There may be no upside to profit margins. Amazon (AMZN) may come into the sector in a bigger way than consensus assumes. General stock market risks and, in a period of rising rates, housing sector risks exist. I view LOW as having significant risks at this valuation for new money.
Concluding thoughts - it's easiest to "turn around" a winning story than a losing one
As a strong name, LOW is an interesting play for investors who believe that the bull market is strong, given an improving advance-decline line. I went long LOW just last week because when I looked at forward consensus EPS that had been set well before tax reform was passed, and then added my estimate of EPS gains due to the lower tax rate, I thought that LOW was trading around 15X forward EPS, or lower. Now that it is up 6-7%, with a reported catalyst, I think that the risk:reward favors LOW moving higher. Given the key fact that housing sector activity has been trending up from extremely depressed levels, and given the chance that LOW can follow in the path of MCD of early last decade and go from operational laggard to leader, I am sitting tight. I continue to like and own more value-oriented names in the homebuilder sector such as Toll Brothers (TOL) and MDC Holdings (MDC). HD, however, is looking a little pricey. Last May, I wrote an article titled Home Sweet Home Depot: $200+ Within 2 Years? Here we are, just 8 months later, and HD is knocking on the $200 door.
Who knows where these category-killer names, HD and LOW, will/should trade? Looking back at an old Value Line, HD had an average P/E of 46X for 1999-2000 combined. LOW had a 26X average P/E for those two years. LOW averaged a stock price around $12 in 1999-2000, so the stock has given great total returns since then despite the housing meltdown. Since I like duopolies, believe it is likely that indeed D.E. Shaw (the last employer of Jeff Bezos before he founded AMZN) is agitating for real change at LOW. In a highly valued stock market, the housing sector (ITB) is hot. Experience suggests not looking at this bull run in LOW and the sector skeptically... not yet. So, I remain long LOW and think that it could be an attractive stock on both the short term and, as it was at the cyclical top of the market in 1999-2000, over the long run as well.
Thanks for reading and sharing any comments you wish to contribute.
Disclosure: I am/we are long LOW, HD, TOL, MDC, AMZN, SPY. 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.
Additional disclosure: Not investment advice. I am not an investment adviser.