Wednesday, January 4, 2012

Predicting The Future

Forecasting Lowe’s Destiny Via Its Balance Sheet
One of the ways investors can make gains is to predict the future and trade upon their predictions.  Of course, nobody can really predict the future with any degree of certainty unless they have insider information (which is both highly unethical and illegal).  Since most of us wish to stay out of the pokey, we have to settle for putting together the pieces of the puzzle as best we can and inferring what might be likely to happen in the future.  In some cases, this is quite difficult.  For example, given all the uncertainty that seems to be out there, what is the likely change in consumer spending between 2011 and 2012?  Econometricians will build complicated models to attempt to forecast such numbers, but they typically have a wide margin of error and are all too frequently flat-out wrong.  This isn’t intended to be a knock on econometricians; rather it is an illustration of something that is extremely difficult to forecast with any degree of confidence.

In contrast, sometimes it isn’t too hard to figure out what might lie in the future.  As an example, I will pick on Lowe’s (LOW), the second largest home improvement retailer in the US behind Home Depot (HD).  LOW and HD are effectively a duopoly, with other competitors generally far smaller and focused on a particular niche (such as Ace which competes on the basis of high service levels) or geographic region (such as Menard’s which focuses on the upper Midwest).  As both LOW and HD are publicly traded and more or less similar size and scope, investors frequently compare and contrast the two companies.  Given the liquidity of both equities and the trivial stock trading commissions charged by most brokerages, investors of virtually any size can go long one name and short the other just about any trading day.  As can be seen in the chart below, HD’s share performance has considerably outpaced LOW’s despite the fact that these are two very similar companies both operating in a challenging retail and housing market. 
LOW’s significant underperformance has been underpinned by the relative fundamentals of the two companies.  While LOW has posted flat to down same store sales, HD has eked out positive single digit same store sales gains and improved profit margins.  Although LOW has done a few reorganizations in the past few years, the company’s actions have been incremental and largely focused on reducing costs in the face of the worst US economic recession in decades and the most disastrous housing market environment in the post-War era.  In contrast, after a management change in 2007, HD sold its wholesale division to a consortium of private equity firms for $13 billion and added significant leverage to its balance sheet (resulting in a downgrade to BBB credit ratings), both of which funded restructuring and a massive share buyback program.  In 2008 and 2009 HD moved ahead with store closures and wound down its entire Expo chain of higher end stores.  Subsequently, HD appears to have invested some resources in improving the in-store experience.  In 2010 and 2011, HD has been reaping the rewards of these painful and expensive transformative steps even as the housing market and the US economy sputter.
LOW’s underperformance has caused many analysts to downgrade the stock and investors to sell.  Personally, I see opportunities for the company and I expect LOW to catch up to HD’s stock performance.  How can I predict such a thing in the face of moribund same store sales, a slow moving management team, and continued weakness in the housing market (and perhaps the US economy)?  By assembling pieces of the puzzle and making (hopefully) reasonable assumptions about the parts that cannot be directly observed.
A good place to start is with LOW’s balance sheet.  LOW has consistently run at relatively low leverage levels, under 2X debt to earnings before interest, taxes, depreciation and amortization (EBITDA), resulting in a solid investment grade rating (A3/A-) even after recent downgrades by the rating agencies.  I estimate that LOW could maintain a Baa/BBB (low investment grade) rating even if the company reached leverage levels of 3.5X EBITDA, or almost twice current levels.  As a large, investment grade issuer LOW has the ability to issue long term (up to 30 years), fixed rate debt with modest coupons and no required repayment of principal until maturity.  The company has also outright purchased the vast majority of the real estate its stores occupy, with relatively little leased or financed (on the order of 10%).  What this adds up to is a strong balance sheet with significant flexibility and lots of hard assets underpinning the company’s ability to raise cash as needed.  Furthermore, as is typical of investment grade public bond issuers, LOW’s bonds have negligible covenants or other restrictions (see ) aside from prohibitions on sale/leasebacks or mortgaging of the company’s tangible assets.    What all of this adds up to is a company which could add significant leverage to its balance sheet if management and the Board wished to do so (thus far they have not done so in any meaningful fashion).  From the equity investor’s perspective, the potential to leverage the balance sheet and deploy the proceeds into shareholder friendly actions (e.g. share buybacks, special dividends, transformation of the business, etc.) provides the possibility of management taking steps to drastically improve the performance of the stock.  The balance sheet strength of LOW is further buttressed by the fact that the business requires relatively modest maintenance capital (store count is not growing) and therefore generates significant free cash flow.
So the balance sheet and free cash flow generation provide opportunity.  What about motive?  Due to the existence of large activist hedge funds, even companies of LOW’s size (market cap of approximately $33Bn) are subject to the attention of activist investors.  Not surprisingly, activist hedge fund Pershing Square showed up late in 2011 as a significant and growing shareholder.  LOW evidently felt this was important enough to mention in the prospectus for their recent bond issue, and the bonds included a “poison put” provision which specifies that LOW must offer to buy back the bonds if the company is taken private (presumably via a leveraged buyout):
On November 14, 2011, Pershing Square Capital Management, L.P. (“Pershing Square”) filed its report on Form 13F for the quarter ended September 30, 2011 with the SEC disclosing that as of that date Pershing Square had shared investment and voting power over 8,819,824 shares and sole investment and voting power over 12,420,477 shares of our common stock. The aggregate number of shares, 21,240,301, represents approximately 1.7% of our outstanding shares of common stock. A representative of Pershing Square recently contacted us and requested information concerning our annual investor conference to be held in December.” – Quote from LOW bond prospectus

While Pershing Square has yet to make any public efforts to influence management, the initial position they have taken is clearly sufficient to catch management’s attention.  Activist investors routinely use a variety of tactics to goad management teams into actions which they believe will enhance shareholder value, ranging from levering up the balance sheet, to waging a proxy fight to remove the existing management and Board of Directors, to forcing the sale of a company.  Most management teams do not wish to be ousted from their lofty positions.  If they feel their positions are potentially weak versus the activists, they will frequently start taking action before the activists can force their hand.  It comes as no great shock that in the fourth quarter of 2011 LOW unveiled a new website which allows customers to store things such as paint colors by room for their homes, etc. and followed this with the purchase of a small online home goods retailer in late December which will presumably help LOW continue to upgrade their customer experience.
So we now have opportunity and motive.  How do we use this to produce the future?  LOW has seen a steadily rising share price since the beginning of October 2011 as Pershing Square’s involvement is taken into account, management moves more aggressively to close underperforming stores and upgrade the business, and LOW continues to buy back stock in the open market.  I think that over the medium term (perhaps 3 years), LOW will continue to increase its leverage and the proceeds will be used to buy back stock and possibly increase cash dividend payouts.  It is also fairly clear that management will continue moving more aggressively to take some of the transformative steps that HD took 2 to 3 years ago, such as improving the in store experience, rationalizing the store base, and finding ways to make customer relationships more “sticky.”  I’d much rather have LOW store my home’s paint colors for me and be able to whip up a quart for touch-ups than store a dozen mostly empty gallon paint cans or try to get a chip to match what is already on the wall.  The part of the forecast where the crystal ball becomes a bit fuzzy is whether Pershing Square and/or another activist will seek to sped things up and goad management into more rapid action.  LOW is large enough that there aren’t too many feasible potential acquirers, but an activist could certainly push for a leveraged recapitalization, special dividend payout, large stock tender offer, or even a management change.  All of these actions could rapidly vault the share price higher, at least in the short term.  Note that none of this portends good things for owners of the company’s bonds, since greater leverage and the risks of brinksmanship with an activist generally degrade a bond issuer’s credit quality.

Disclosure: I am long LOW equity.

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