Tuesday, June 7, 2011

Lowe's Shareholder-Friendly Buyback Plan

Shares in Home Depot (HD) and Lowe's (LOW) are, respectively, selling at 15x and 14x current year earnings.

That's not exactly expensive but other retailers, the likes of Wal-Mart (WMT) and Target (TGT), are even cheaper selling at more like 11.5-12x this year's expected earnings and some even lower.

Costco (COST), an excellent business, in contrast sells at an earnings multiple north of 20x (though if you take the rather conservative balance sheet into account, the $ 3 billion of net cash, it looks a bit less expensive).

On a forward earnings basis, Home Depot and Lowe's look a bit more reasonably priced.

While forward estimates vary, and are naturally less reliable, 12-13x earnings next year doesn't seem a stretch. What makes their valuations somewhat more compelling is the continued weakness in housing.  If they remain as profitable as they are in this environment, I'm guessing they will be doing just fine several years down the road when the housing market begins to improve.

I happen to like Lowe's slightly more than Home Depot but both are fine businesses in my view.
(Lowe's has been in Stocks to Watch and the Six Stock Portfolio since their inception.)

Lowe's, which has struggled somewhat more than Home Depot, appears to be acting in a very shareholder-friendly manner. Home Depot also seems to be doing some very smart things including improved execution in recent years.

This article in MarketWatch highlights Lowe's plan to reduce shares outstanding via its buyback plan. Over five years Lowe's expects to repurchase $ 18 billion of its common stock. As a result, at least near current prices, its share count would be more than cut in half.

Lowe's is expected to earn $ 2.0 billion this year and $ 2.5 billion next year. If share count is reduced by half from the current 1.33 billion shares over the next five years, Lowe's earning per share would grow to $ 3.75/share even if net earnings does not grow beyond next years expected level.

At a 12.5x multiple of those $ 3.75/share in earnings (it currently sell for a ~14x multiple) in 2016, Lowe's would sell at ~$ 47/share. The stock currently sells at $ 23/share. That's more than a 14% annualized gain (total return would be even higher when you include 2.4% dividend).

The problem is I don't consider that buyback realistic.*

In the real world, odds are the stock will go up before they can accomplish the buyback near current prices. So it would be surprising if they end up being able to complete all $ 18 billion in five years at attractive prices. That means share count will likely drop less even if still by a material amount.

Let's look at an only somewhat more reasonable scenario. If they were able to buyback $ 15 billion of shares for an average price of $ 25/share (shares currently selling at ~ $23/share), the company's shares outstanding would still drop from 1.33 billion to .733 billion over five years. This buyback could also be accomplished with a more manageable amount of incremental debt and interest expense.

At that share count, Lowe's earnings per share would grow to $ 3.40/share using, again, next year's expected level of earnings (including interest expense from incremental debt). I will say that it's likely Lowe's will be earning much more than that five years from now.

At that reduced share count, assuming a 12.5x earnings multiple of those earnings, Lowe's would still sell at $ 42.50/share in 5 years. With the stock currently selling at $ 23/share, that's still slightly more than a 12.6% annualized gain (if you include the 2.4% dividends more like a 15% annualized total return).

In both cases, those returns come about using modest growth assumptions and a relatively low multiple of earnings.

It's worth asking the question: what if the multiple shrinks? Well, the answer is different for someone who's investing strictly over short time horizons versus an investor with some patience. For the patient long-term investor, if the multiple shrinks the company gets to buy back more the stock at lower prices ultimately resulting in even better returns. So, if the stock were to rally meaningfully above that $ 25/share average repurchase price, overall returns will end up being lower over the long haul. Shareholders who don't plan to sell for many years shouldn't be so pleased when the shares of a good business (with the capacity to buyback at a discount) rally in the near-term.

The near-term, and even intermediate-term, rally purely benefits the trader and hurts the long-term owner. On the other hand, if it gets closer to the time that the shares are going to be sold -- and after many years of well-executed buyback -- the stock were to end up selling at a high multiple of earnings, that'd be a very good thing.

This obviously doesn't quite fit with some of the more hyperactive trading strategies. In that more speculative world, I'm guessing 1-2 months would be a considered a long time. Yet, I think, a little time with a simple spreadsheet reveals the folly of trying to figure out how something will perform in three years or less when the average annual return becomes so compelling if the investor increases their investing horizon by at least a few more years.**

This fact seems lost of those involved with investing over shorter time horizons. The only way this ends up not working out is if something materially negative happens to economic moat of the business or management starts misallocating capital.

That's why I happen to think, besides buying with an appropriate margin of safety, investing successfully is mostly about understanding and monitoring the sustainability of competitive advantage and management capital allocation skills.

What are the threats to the advantages that drive the core economics of a business?

Is the management doing smart things with capital?

As I mentioned, Lowe's and Home Depot have been able to earn a healthy amount in what is a terrible environment for housing. An environment that is likely to persist for quite a while yet certainly not forever.

Some time down the road a housing recovery of some sort will kick in and earnings will likely be substantially higher. If that does happen, the price to earnings multiple will also likely expand.

Consider that as upside.

A very attractive scenario for long-term investors in Lowe's would be:

1) The stock stays low, for several years, allowing a large number of shares to be bought back using the least amount of capital possible, followed by 2) a normal housing boom (i.e. not a bubble) kicking into gear.

That will make the stock so-called "dead money" and some will no doubt try to time it. My premise is that if you try to time it you end up with the risk of owning "an eyedropper" (or none) of something when you wanted to own a substantial amount. I'm not saying Lowe's as an investment is all that unique. It's just a good example. There are no doubt better investment opportunities. In fact, quite a few very good low multiple businesses currently have very similar shareholder enriching buyback opportunities.

It's just that when investors decide they like a business, and the price it is available at is fair, it makes no sense to try and time it because of fear that it will be so-called "dead money". I realize this doesn't fit the ethos of the fast money world we live in.

Some final thoughts on Lowe's.

One real possibility is that Lowe's stock goes down further in the short-term. From a buyback (and, of course, long-term returns) perspective that would be a good thing. Stock traders may hate this but investors should welcome it.***

Lowe's near or intermediate term stock performance could easily continue to be unimpressive. Yet, as long as the business continues to have solid core economics, the longer that underperformance in the stock persists the better returns will likely be for shareholders with a long-term investment time horizon.

So with any investment, monitor those things that may adversely impact the long-term economics. Focus on the source of durable competitive advantage and what may be a threat to it.

Otherwise, the arithmetic of what returns will be ends up being five year plus down the road is pretty simple.

Adam

I have long positions in LOW and WMT

* It's clear they would have to take on some $ 6 to $ 8 billion in additional debt to accomplish this within 5 years at current expected earnings and free cash flow levels. I think their balance sheet gives them the room to do so but it does add risk. In this example, we are basically assuming that operating earnings could grow enough to pay the incremental after-tax interest expense. Not a foregone conclusion but, at the same time, seemingly not a stretch either. It's important -- assuming they remain financially and competitively strong -- that they only buyback shares when selling at a plain discount to per share intrinsic value. So meeting that $ 18 billion expectation should take a back seat if the stock gets rather expensive. Also, whether a buyback makes sense will naturally depend upon whether the cash could be bettered used building/strengthening the business (or maybe to make a smart acquisition). Maintaining and strengthening the moat is paramount. That should always take priority over a buyback and, well, pretty much everything else. In all cases, the decision should come down to what will produce the highest returns on capital, with all risks carefully considered, over the long haul. Pursuit of growth that's high risk/low return should be avoided. This seems like it should be obvious but, even with good intentions, growth initiatives too often end up producing lower returns at greater risk compared to simply buying back a cheap stock.
** Average annual return is all that matters even if much of the return ends up back-end loaded. Some will try to time it. Best of luck. That's a recipe to miss perfectly sound long-term investments. You don't get great prices unless something is going to be dead money or, in fact, declining for a quite a while. If you are an institutional investor, pressure will probably prevent you from being allowed to invest in this manner. Individuals with a long-term investing horizon only impose that pressure on themselves.
*** What's an exception to this? Here's a scenario to consider: unfortunately, there's the very real risk that, while the stock is down, a buyout offer comes in at a premium to market value but a discount to intrinsic value. If enough owners are okay with the gain that will have occurred compared to the recent price action, the deal may be approved. If too few have conviction about longer run prospects, the deal may get approved. When too many owners of shares are in it for the short-term or, at least, primarily to profit from price action, the chance of this happening increases. Well, those that became owners because of the plain discount to intrinsic value and the company's long run prospects will likely get hurt in this scenario.
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