4 Ways To Improve This Company

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When a company seems to struggle against its competition, it’s simple to bash the stock and move on. However, many companies are just a step or two away from being much better investments, and things can change quickly. Lowe’s (NYSE: LOW) has been under-performing Home Depot (NYSE: HD) for a few quarters, and many investors seem to believe that this trend will continue. If Lowe’s management is willing to work on a few specific issues, this stock could go from zero to hero very quickly.

Strong Demand In The Sector
There are a few economic factors that are providing positive tailwinds for Lowe’s. First, there’s little question that the housing market is getting stronger, as many home builders are reporting strong double-digit increases in their backlogs. Second, home prices have been improving, which should lead to stronger demand for both building materials and home improvement supplies.

What’s ironic, is though Home Depot reported a 7.4% increase in overall sales, Lowe’s reported overall sales decreased by 0.5%. If we look at other companies in the sector, we find that specialty stores like Lumber Liquidators (NYSE: LL) and large retailers like Wal-Mart (NYSE: WMT) are each trying to steal sales that previously would have gone to the “big two" in home improvement. However, we can clearly see that Home Depot and Lumber Liquidators are growing much faster than their peers, and Lumber Liquidators led the way with total sales up more than 22%.

Spending Too Much, Selling Too Little
The first problem facing Lowe’s is something that management will have to make hard choices in order to improve. The simple fact is, the company is spending too much on selling, general, and administrative expenses, and cost-cutting is clearly needed. Their main competitor Home Depot spends 21.87% on SG & A. Wal-Mart by comparison, spends just over 18% on SG & A, and the only company spending a greater percentage than Lowe’s is Lumber Liquidators at 29.3%.

Lowe’s is currently spending 24.62% on SG & A, and given that the company is far more established than Lumbers Liquidators, the company’s expenses are too high relative to revenue. In addition, since both Lowe’s and Home Depot have almost the exact same gross margin, it only makes sense that their SG & A expenses should be similar.

The second challenge for Lowe’s is maintaining an appropriate level of inventory relative to sales. Both of Lowe’s more established competitors have much lower percentages of inventory to current quarter sales. Lumber Liquidators is much smaller, and expanding, so a higher level of inventory is to be expected. This company currently has about 91% of their current quarter sales in inventory.

By comparison, Home Depot carries about 62% of current quarter sales in inventory, and the ultra-efficient Wal-Mart has just 34% of sales in inventory. Considering that Lowe’s is sitting on over 78% of current quarter sales in inventory, this suggests the company is overestimating the company’s sales growth.

Mortgaging Their Future for Current Results
A third problem, is Lowe’s cannot continually use cash it does not have to repurchase shares. In the short term, this may help results, but in the long term the damage to the company’s balance sheet is problematic.

On the surface, it looks impressive that Lowe’s has retired almost 10% of their diluted shares in the last year. However, most of their competitors have made share repurchases as well. For instance, Wal-Mart retired 3.12% of their shares, and Home Depot retired 3.5% of their outstanding shares. Even the faster growing Lumber Liquidators managed to repurchase 2.5% of their diluted shares in the last year.

The big difference between Lowe’s and their competition, is each of their peers’ retired shares without significant damage to their balance sheet. Lowe’s on the other hand, saw total cash and investments decrease by $2.47 billion or almost 63%, while long-term debt only decreased by about $500 million. It’s one thing to retire shares from free cash flow, it’s a whole different ballgame when companies start spending money they don’t have.

Last but not least, investors in Lowe’s may be misled by the company’s seemingly low free cash flow payout ratio. If you look at Lowe’s core free cash flow (net income + depreciation - capital expenditures), the company only used about 25% of their free cash flow on dividends. Relative to Home Depot’s payout ratio of almost 42%, Wal-Mart’s ratio of about 50%, or Lumber Liquidators' repurchase ratio of roughly 27%, Lowe’s looks like a great option. However, when you realize that Lowe’s payout ratio is actually 170% if you include share repurchases, you can see that management is being too aggressive in buying back shares with debt.

In the end, most of the issues facing Lowe’s are within management capability to change. However, with the stock trading at a forward P/E ratio of about 19.5, this stock is only slightly cheaper than Home Depot at about 21 times earnings. Considering that Home Depot is growing sales at a much better rate, it’s hard to recommend Lowe’s at this time. While all four of these companies should benefit from a better economy, and stronger housing market, Lowe’s management is risking missing the upturn if they can’t solve these four problems.

Chad Henage has no position in any stocks mentioned. The Motley Fool recommends Home Depot, Lowe's, and Lumber Liquidators. The Motley Fool owns shares of Lumber Liquidators. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus