Some investors believe that you should add share repurchases to dividends to get the “yield” a company is returning to its shareholders. This approach works fine as long as the company is spending free cash flow. However, when a company goes into debt to buy back shares, stockholders should worry that they are chasing short-term performance. When a company barely beats earnings even with significant share repurchases, investors should be downright concerned. This is exactly what has been going on at Lowe’s Companies, Inc. (NYSE:LOW).
Improving Home Improvement, But Losing
In light of the fact that the housing market seems to be on the mend, and the employment picture has improved over the last few years, naturally you would expect Lowe’s results to improve as well. The company’s primary competitor The Home Depot, Inc. (NYSE:HD) just posted an impressive quarter, with sales up nearly 14%, and same-store sales up 7%. Wal-Mart Stores, Inc. (NYSE:WMT) has been buoyed by an improved economy, and earnings were up 10% recently. Amazon.com, Inc. (NASDAQ:AMZN) has been on a tear, ringing up 28% growth in general merchandise sales in the last three months. All of these companies compete with Lowe’s for home improvement dollars–so how did Lowe’s do?
Honestly, Lowe’s Companies, Inc. (NYSE:LOW) didn’t do well at all. In the last three months, the company’s sales were down 5% overall, even though same-store sales increased 1.9%. What had to be really disappointing to investors was diluted EPS was flat on a year-over-year basis.
Lowe’s seems to be stuck between a rock (Wal-Mart and Amazon) and a hard place (Home Depot). Lowe’s has tried to be both a home improvement warehouse that could cater to professional contractors, as well as an inviting place for the casual home improvement project. The problem is, their competition is beating them at both ends.
For the casual home improvement project, customers can choose to buy their paint, tools, and small project needs from Wal-Mart or Amazon. For the serious contractor, Home Depot’s consistent reputation, and superior locations, seem to argue for their continued dominance.
A Margin By Any Other Name
Wal-Mart and Amazon both compete in many product lines and have gross margins of about 24%. Between the convenience of shopping at over 4,000 domestic Wal-Mart locations, or ordering online through Amazon, Lowe’s becomes just another stop.
Home Depot, on the other hand, has a gross margin of 34.89%, which is actually slightly higher than Lowe’s at 34.27%. However, there is a big difference right below the gross margin line. Home Depot’s SG&A expenses were 23.11% of revenues, whereas Lowe’s SG&A expenses were 25.43%. In short, Home Depot is significantly more efficient with their spending. Lowe’s management needs to take a good look at why this line item is so different between the two companies and fix the issue quickly.
Buying Back Shares To Accomplish What?
While Lowe’s Companies, Inc. (NYSE:LOW) SG&A expenses are one of the company’s issues, the other two problems are equally company specific. Lowe’s has spent billions over the last two years to retire shares, and normally this should be a very bullish sign. However, this is a case of share repurchases gone terribly wrong.
In the last year, Lowe’s has added nearly $2 billion in long-term debt to their balance sheet. The majority of this debt is tied directly to share repurchases, with diluted shares down over 10% year-over-year. Even with all of this additional debt, Lowe’s only managed to beat earnings expectations by 6.25% on average in the last year. Imagine what earnings would have looked like without 10% of the shares being retired.
If the company were repurchasing shares from free cash flow, this would show investors that they believe in the value of their shares. However, the fact that company’s need to run up debt and harm their balance sheet to buy shares smacks of desperation.
Real Value
While Lowe’s Companies, Inc. (NYSE:LOW) could theoretically turn around their operations, the company looks set up to fail compared to the competition. While Amazon certainly won’t win a prize for best value, their over 40% expected EPS growth rate speaks to the disruptor the company has become. As long as Amazon wants to sell items at cutthroat prices, everyone else better adjust accordingly. The company hasn’t figured out a way to knock Home Depot off in home improvement, but it seems apparent they have Lowe’s number.
Where Wal-Mart is concerned, the company gets 200 million visitors into its stores worldwide every week. The convenience of buying paint and small project needs from Wal-Mart, instead of making another stop at Lowe’s, is a problem Lowe’s Companies, Inc. (NYSE:LOW) can’t easily fix.
If investors are looking for an alternative, I would suggest the rule that if you can’t beat them, join them. Home Depot looks like the stronger stock, has more impressive revenue and earnings growth, and a more efficient model. The bottom line is that Lowe’s needs to stop chasing performance. Only by using free cash flow to fund dividends and share repurchases can the company improve their shareholder’s fortunes.
The article Share Repurchases Are Killing This Company’s Future originally appeared on Fool.com and is written by Chad Henage.
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