Peter McMurtry, B.Com, CFA, Financial Writer for Do-It-Yourself Investors
Monthly Investment Newsletter https://mcmurtryinvestmentreport.ca
We all buy stocks that for one reason or another disappoint shareholders by reporting a dismal earnings report. I have met several people who tell me they have never lost money on a stock and always sell before the share price falls. I know perfectly well that this is simply not true and that these people are only fooling themselves.
Share prices fall for a multitude of reasons, many of which are simply out of our control no matter how much research we undertake.
Recently I personally invested in Lowes, the hardware competitor of Home Depot. Both companies have registered strong revenue and earnings growth over many years. Lowes was trading at a lower PE multiple and offered comparable growth prospects.
Several weeks ago, Lowes reported strong revenue growth, but disappointed on their earnings.
The share price collapsed falling more than 10% in one day.
Putting on my analyst hat I began researching the problems of the company.
The first thing I did was to determine if Lowes earnings issues were an industry problem or specific to the company.
Its largest rival, Home Depot has not experienced the same earnings and operating margin concerns. Overall revenue growth and same store sales have been strong for both companies.
However, Home Depot’s operating margins and earnings growth remains robust, differing markedly from what Lowes is doing.
Industry wide sales in the home improvement market remain strong. This industry is also benefitting from the strong US economy and recent US tax reform. The majority of the industry sales are North America with virtually nothing globally. So far the industry has been somewhat immune from Amazon’s grasp.
Based on this initial research I have concluded that Lowes earnings and cost issues are principally company specific and not industry wide.
The next step is to determine if Lowes’ problems are easily fixable in the short term.
The quarterly press release highlighted the company’s cost concerns, but stated that lower margins would continue into 2018 by an additional 30 basis points.
Cost of goods sold as a percentage of revenues is stable and virtually the same for both companies.
However, selling, general and administrative costs as a percentage of revenues are over 22% for Lowes in 2017 while only slightly less than 18% for Home Depot. This represents a considerable advantage for Home Depot.
Taking into account that revenues are still growing nicely, it appears that the company is incurring more costs to sell its merchandise in the midst of stiff competition from Home Depot.
Secondly Lowes is not spending the same % of its revenues on technology like its competitors are doing. This is clearly evidenced over the last three years by the total capital expenditures as a percentage of revenues growing for Home Depot and shrinking for Lowes. It is very obvious that Home Depot is spending heavily on technology in terms of inventory control systems and the like to keep their overall costs down.
Recently an activist investor has been demanding better performance from the company on an earnings front. I am not sure what the company management is doing with this activist investor or if this investor has requested to be part of the Board of Directors. Normally activist investors eventually influence corporate management as evidenced by what is currently going on with Proctor and Gamble and Nelson Peltz.
My conclusion is that Lowes problems will not be easily fixed in the short term. However, the current management is very much aware of these issues and this combined with additional pressure from the activist investor will ultimately lead to improving fundamentals over the next 12-18 months. Spending more of its free cash flow on capex and less on stock buybacks is a fairly easy solution to improve its cost concerns.
After the dismal earnings report, I sent several emails to the investor relations department requesting answers to how they plan to solve their cost problems.
Unfortunately, I have yet to receive any response. This also concerns me.
However, I cannot be the only disgruntled shareholder and need to exercise patience before I react negatively by selling my stock.
Currently Lowes is trading at under 16 times this year’s earnings, a substantial discount to Home Depot’s 19.2 times. The company is still expected to grow its EPS at a 25% clip year over year. This appears a rather aggressive and overly optimistic earnings projection given their current problems. Assuming the company only grows at half their projected rate this year or 12.5%, the PE on forward EPS rises to 17.7 times. This is still cheaper than Home Depot, but the latter company’s earnings are rising at a much faster rate.
Given all these issues an easy solution is to simply sell the stock.
On the other hand, the share price is now discounting all the current earnings issues.
Any efforts by the current management to correct these issues combined with the activist shareholder continuing to put pressure on the company to react faster, will ultimately lead to a positive solution for the company.
I will continue to monitor the company closely to ensure that corporate management remains on the right track.
My recommendation is to hold the stock but not to purchase any more shares at this time.