On May 22, the Wall Street Journal, among others, reported that Bill Ackman (Trades, Portfolio)’s Pershing Square Capital had taken a $1 billion stake in Lowe’s Companies Inc. (LOW, Financial). The Journal says the position is expected to be a friendly one.
There’s no word on how long he has been building the stake in the $80 billion Lowe’s, but word about the position did get out after Ackman spoke at a New York conference. And, there are several interesting timeline issues to consider.
The news came out one day after Lowe’s announced the hiring of a new CEO, retail veteran Marvin Ellison, who had been attracted away from JC Penney Co. Inc. (JCP, Financial). The Financial Times also reports Ellison earlier spent 12 years at Home Depot (HD, Financial), where he was the executive vice president of U.S. stores. Ackman has said he supports Ellison.
Earlier this year, another activist firm took a position in Lowe’s: D. E. Shaw & Co. According to CNBC, D.E. Shaw is concerned about Lowe’s underperformance when compared with its peers (more on that below). These competitors include Home Depot in hardware and building supplies, and with IKEA U.S. and Wayfair Inc. (W, Financial) on home appliances and other products. D.E. Shaw was able to get three new directors on Lowe’s board.
Pershing Square is not commenting on the Lowe’s investment, and the home improvement retailer is saying little about Ackman except to acknowledge they have seen reports of his interest.
If Ackman—and D.E. Shaw—can wrestle some gains for Lowe’s, it will help get Ackman back into contention as a manager who can deliver returns for his hedge fund clients. In the Pershing annual report for 2017, Ackman concedes up front that 2017 was the third year of portfolio losses; he adds those losses were modest, but not satisfactory considering how much the market had gained over the same three years. What’s more, Pershing shares continued trading at a significant discount to net asset value.
As for Lowe’s, the following chart shows how it (green line) has been a poor cousin to Home Depot over the past decade:
To get more specific, we turn to the Macpherson Model (information about the model available here and here).
The model uses five financial metrics to assess a company’s moat and its financial strength, as well as one valuation metric.
The first issue is the strength of a company’s moat; it is also called “pricing power” and “competitive advantage.” This table shows Home Depot holds a significant edge over Lowe’s on both measures used to assess the competitive moat: return on capital and return on tangible equity):
As noted at InvestingAnswers, “A firm's return on capital can be an excellent indicator of the size and strength of its moat. If a company is able to generate returns of 15-20% year after year, it has a great system for transforming investor capital into profits.” It also calls ROC especially useful for companies that invest a lot of capital upfront, such as big-box stores.
The second issue is a company’s financial strength, measured with return on assets, ROC and return on equity. In addition, it considers the amount of debt; in this comparative case, we use the debt-to-equity ratio:
Note the question mark for debt-to-equity in the "Advantage" section. While Lowe’s has a lower ratio, it may also be argued that Home Depot has used debt effectively, to grow the company and its share price. Generally, the financial strength question edges toward Home Depot, but the ultimate answer will rest on investors’ views on debt.
Finally, the model assesses valuations of the two companies by examining their earnings-based discounted cash flow numbers:
According to this metric, Lowe’s is overvalued (significantly), while Home Depot is fairly valued and, thus, a better buy.
Overall, this evidence suggests Lowe’s is the poor cousin to Home Depot. Its share price and several key metrics give the advantage to Home Depot; true, it does have a heavier debt load, but it has used that leverage to build its brand and, subsequently, its share price.
The bigger issue is whether the struggling activist and the struggling Lowe’s can find strength in a common cause. Part of that may depend on how well Ackman can get along with the other activist investor, D.E. Shaw. Of course, Ackman made his commitment well after D.E. Shaw’s initiative was announced, so Ackman must have based his decision, in part, on that knowledge.
This is shaping up to be an interesting mix, with not only two new activists, but also most of the existing board and a new CEO all trying to get more out of Lowe’s. Can they work together? Many reputations rest on that answer.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
