The “Big-box Challenge” and why Lowes is closing stores

The big-box hardware retailer Lowes has announced that it will soon close 51 “underperforming” stores. The financial comparison of Lowes with its competitor Home Depot provides an interesting look at what I call the “Big-box Challenge,” the risky financial bet that has been a boon to many chains, but at the same time has dragged others, like Borders bookstores and Sports Authority, down in “hard crashes.”

The first post-acquisition shoe to drop

In 2016, Lowes acquired the market-leading Canadian hardware retailer Rona for twice its market value, after a failed attempt at the same target several years earlier. Despite a management letter at the time of acquisition promising continuity (never believe the “continuity” press releases invariably put out by acquiring companies), all but 20 of the stores tagged for closure are Rona locations.

The math here is simple. When you pay twice as much for an asset, then any cashflow you derive from that asset looks half as good. Despite promises, and even if the locations are low-growth but reliable “cash cows,” they are making some manager’s numbers look really bad in comparison, and so they will be jettisoned.

The lesson of Barnes & Noble

I read a second issue in the Lowes financials lingering over the last several years, however. This has to do with what I call the “Big-box Challenge,” the financial trap that has enveloped several chains in this market sector.

While there are several “creation stories” in “Big-box Retailer” history, I point to the Barnes & Noble bookstore expansion of the 1980s and 1990s as a significant “industry re-think.” Rather than the traditional bookstore’s “curated” inventory of locally-selected books, Barnes & Noble intentionally recreated a giant “retail library” where the “library patron” could comfortably browse among a massive selection of books and publishers. Wide aisles, lots of sofas, and a coffee bar created a “destination experience.”

Financially, the “bet” was (and is) this: if we can get our suppliers (the book publishers in this case) to “finance” most of our inventory, we can quickly ramp up new stores, each with its own comprehensive, wide-interest, stock on the “library shelves.” Throughout the 1990s and into the early 2000s, the publishers financed, through liberal credit and return policies, well over 60% of the value of the stock in each store. Credit terms from suppliers were, on average, an amazing 85 days, meaning that suppliers were essentially “buying shelf space” in B&N stores.

These liberal credit terms were not always due to the beneficence of the suppliers. I was working in the publishing industry at this time, and our company had to regularly send an accounting task force to B&N headquarters to “wheedle” some payment out of them. They regularly used the aggressive return of books plus detailed, time-consuming, line-by-line challenges of supplier invoices to delay payments, and they allegedly threatened several uncooperative publishers with the loss of shelf space in the stores.

In effect, Barnes & Noble, through their “alpha dog” position in the industry, was effectively able to run their inventory as a “consignment” business, paying for much of the inventory only after it had been sold. Borders tried to copy this strategy, but not being the “alpha” in the supplier relationship caused that ship to run aground by 2010. And life is much harder overall in the book business these days, with B&N’s last 10-K showing credit terms from suppliers down to a more normal 65 days.

Lowes versus Home Depot

A key lesson from Barnes & Noble is that an aggressively-growing retailer can stock a big-box store with inventory using capital from the inventory suppliers as the major source of “funding.” But to keep this ball rolling, you need to turn over your inventory to generate the cash to pay the suppliers. If you are the “alpha” in the relationship, this strategy works, but if, like Sports Authority, you begin to lose that power, “the supplier now owns you,” and the game collapses quickly upon itself. The huge asset investment in big stores and inventories can suddenly turn into a liability and cash drain.

Lowes and Home Depot have taken two different approaches in recent years to the “Big-box Challenge.” While both store chains finance well over 50% of their inventory with supplier capital through accounts payable credit terms, Home Depot has been able to maintain a shorter pay-off period to those suppliers, around 40 days, versus Lowes, who stretches this (with many of the same suppliers as Home Depot) to over 50 days, and sometimes as high as 57 days on average.

At the same time, Home Depot manages to turn its inventory over on an average of five times per year, while Lowes only gets about four inventory turns. This means that the average Lowes item sits on the shelf for 15 days longer than at Home Depot.

In effect, Home Depot has consistently run a lower-risk big-box strategy than has Lowes. They turn their inventory over faster and appear to have more “headroom” to work with suppliers on payment terms than does Lowes. And this higher-risk strategy has appeared to come to a head at Lowes, where the bottom end stores on the performance scale need to be jettisoned, rather than “fixed,” in order to get the averages up into more sustainable territory.

While Lowes’ sales growth over the last six years has been over 5% annualized, this past year’s top-line growth has been down from prior years, and overall Lowes has been consistently lagging a percent behind Home Depot’s top-line growth rate, which runs a bit over 6% annualized over the last six years. This is a significant difference in the long-term. A 6% growth rate means the company doubles in size every 12 years, but it takes 14.4 years for the 5%-growth company to double.

The interesting thing to watch with Lowes will be whether this selective trim of locations allows faster expansion into new markets, or whether it portends even more “culling of the herd.”

One thing we have yet to see with any big-box store chain is a graceful transition from “growth” to “mature cash cow.” Rather than a “soft landing,” we see more “downward spirals.” That is the subject of an upcoming post. You can subscribe to this blog by entering your email address in the box to the left of this text, or clock on the Facebook or Twitter icons to get notified of new postings.

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