Lowe's Looks to Improve, Picks Orchard

TheStreet.com

NEW YORK (TheStreet) -- Last week, I wrote about the divergence that exists between rivals Lowe's and Home Depot .

Lowe's, which has been struggling for some time due to (among other things) lack of a merchandising strategy, was coming off a disappointing first quarter, for which management blamed the weather. Meanwhile, Home Depot post better-than-expected first-quarter results and raised guidance.

I warned that if Lowe's was serious about narrowing the gap with Home Depot that it needed to adhere to its own slogan and "never stop improving."

On Monday, the company revealed its plans by offering $205 million in cash for Orchard Supply .

One of my biggest criticisms of Lowe's had been the company's lack of a store-expansion strategy and management's unwillingness to take risks.

Even though Orchard, which filed for Chapter 11 bankruptcy protection, might also be struggling, this is a good move for Lowe's, which is looking to capitalize on the California housing recovery. But it's not as easy as it seems.

The fact that Orchard is under bankruptcy protection introduces complications to Lowe's bid. And "bid" is the right term to use here because Orchard's assets will be up for auction. Meanwhile, Lowe's offer will essentially become the "stalking horse," which will protect Orchard from low-ball offers. For Lowe's, though, this process is still far from a slam dunk. This is even though competing bids must be at least $12 million.

Given how badly Lowes wants/needs this deal to happen, I don't believe it will allow anyone else to step in and outbid it. I say this because $205 million is a pretty significant premium for Orchard. It values the company's shares at close to 20% more than their closing level of $1.88 on Friday. Plus, given Orchard's debt situation and less-than-appealing balance sheet, one can argue Lowe's is overspending.

Lowe's, which already has 110 stores in California, wants 60 of Orchard's 91 stores, which are considered to be located in "prime" areas. Orchard's stores are about one-third the size of Lowe's, which average about 113,000 square feet. Assuming that this deal goes through (I can't imagine why it wouldn't), Lowe's will also have smaller stores that rival the likes of Ace Hardware.

Of this deal Lowe's CEO Robert Niblock said:

"Strategically, the acquisition will provide us with immediate access to Orchard's high density, prime locations in attractive markets in California, where Lowe's is currently underpenetrated, and will enable us to participate more fully in California's economic recovery."

I'm inclined to agree with Niblock. Plus, this move should help Lowe's reach a different type of customer, the type who prefers a more "intimate" experience. I believe that this is one of the reasons why Lowe's plans to have Orchard operate as a separate, standalone business.

Still, I wonder whether this will be enough. Even after this deal, Lowe's will still trail Home Depot in the number of California stores by a meaningful margin.

Investors will be curious as to why Lowe's bid for only a portion of Orchard's stores and not all of them. But I believe it has to do with strategic overlapping. It wouldn't make sense to buy Orchard stores in areas where Lowe's already has a presence.

The struggles that Lowe's is experiencing are not going to be overcome overnight. The good news is that the company is willing to think outside the box and look for ways to leverage the things it already does well.

From an investment perspective it comes down to how much do investors believe in the housing recovery. This offer for Orchard suggests that Lowe's firmly believes in it.

At the time of publication, the author held no position in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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