Closing the Valuation Gap with Leon's Furniture

How share repurchases can help accelerate returns for the furniture retailer

I’ve been thinking about how Leon’s can help close the [massive] gap between the current price and intrinsic value, outside of what the company is currently doing.

Continued market share gains will help. Earnings growth will help. Monetizing their vast portfolio of real estate will also help. So will strong capital allocation.

Below is a snippet of a memo I shared with management, outlining how share repurchases can materially bolster EPS and free cash flow per share figures during the next four years and beyond.

Now, I’m partial to management teams who keep their heads down and focus on operating their businesses. But I also want to invest alongside killers. When your stock is trading well below intrinsic value, do you repurchase? Are insiders buying as much as they can? We’ve seen some of both with Leon’s management, and I appreciate the company repurchasing 10% of shares in one quarter during 2022, along with some of the insider buys I’ve seen. But with the stock selling off -20% toward the end of last year, and with minimal reinvestment needs, now is an excellent and opportune time to be aggressive once again.

Now, I would not complain if an opportunity arises to purchase another asset like The Brick in the near future. However, more can be done as it relates to repurchasing stock. Buying back stock is a frictionless way to create value, as Leon’s would be buying more of a business they already know well, while benefitting from the accretion of the current free cash flow yield, estimated at nearly 12.5% based on current year free cash flow. When compared to investments in store optimization and centralized distribution (the returns of which are unknown at this stage), I believe buybacks represents the best use of capital in the near term. The good news is that repurchases can also be made in conjunction with other value-creating operating initiatives.

It’s obvious that when factoring in the value of the real estate portfolio, including unmonetized land assets, Leon’s stock is incredibly undervalued. I believe by a factor of 100%. If the value of those assets – both the retail business and real estate – are not being accurately reflected through the valuation, steps can be taken to accelerate the process of increasing intrinsic value.

Long-Term Value Drivers

Fellow fund manager John Huber has written extensively about the ways companies can drive long-term value, and I suggest you read his thoughts on the topic, which are excellent.

Pulling from John’s work, the long-term value drivers of a business consist of the following:

Earnings growth

Payment of dividends and the reduction in shares outstanding

The change in valuation multiple

In the case of Leon’s, using this formula looking out to 2028, if earnings grow at 3.0% per year, the multiple changes from 12x to 15x, and you factor in the 2.7% dividend yield, intrinsic value would be CAD $40/share, or 54% higher than today’s price of CAD $26/share. The math is as follows:

1.03 x 1.027 x 1.037 = 9.6% growth per year for four years

2028 EPS at 3.0% growth per year = $2.28/share

This simplistic exercise obviously assumes a constant share count. However, as described above, a reduction in outstanding shares can have a drastic effect on company valuation. I estimate Leon’s can grow earnings per share by an additional 13.6% by repurchasing a small amount of stock annually through 2028. Furthermore, EPS growth could eclipse 21% by repurchasing a larger number of shares.

Using the same valuation math above, only this time assuming a reduction in shares outstanding of 2.5% per year for the next five years, intrinsic value would be $45/share, or 25% additional upside from the example above. Obviously, the math gets more favorable the more shares are repurchased. Importantly, this only requires a small change in multiple, meaning Leon’s can control its own valuation destiny. This example also attributes zero value to the real estate portfolio.

This is not just a theoretical discussion. Almost two decades ago, Home Depot (HD) took the cash from reduced store openings and margin improvements and funneled it partly into share repurchases, reducing their share count by -30% during the past ten years alone. As a result, on the back of just mid-single digit revenue growth, earnings per share compounded at 15% per year while the stock delivered a 14% CAGR during the same period.

Murphy’s USA (MUSA), a convenience store operator, experienced negative revenue growth during 6 of the last 10 years. Yet, Murphy’s stock has compounded at 22% per year, by reducing their share count from 46mm to 20mm shares, allowing EPS to compound at 17% per year for a decade.

AutoZone (AZO) is perhaps my favorite example of a share cannibal. During the past 20 years, AZO reduced shares outstanding by 80% (!), from 85mm to 17mm, growing EPS from $6/share to over $150/share. AutoZone’s stock has compounded at 20% per year for two decades.

Accelerated Share Repurchases

Sometimes, frustratingly, this can be a difficult hurdle for management to step over. I’m not speaking specifically about Leon’s, but I’ve heard every excuse in the book for why a company isn’t repurchasing stock below intrinsic value. Share repurchases are considered ‘financial engineering’ (sacrilege to business operators), they reduce liquidity, they are difficult to execute, the company would be better off holding cash etc. Luckily, these things are studied, albeit imperfectly, by other smart people, the results of which can help companies better understand the positive effects of consistent buybacks.

It is a misconception among small public companies that share repurchases hinder or reduce liquidity. In fact, it is quite the opposite. Multiple studies conducted by various universities as well as the US Chamber of Commerce, conducted in 2021, found that buybacks not only enhance liquidity but also provide some overlooked price stability when strategically utilized. The effects of buybacks when done inside of a value framework (purchasing shares below intrinsic value), further amplifies their benefits.

The key takeaways from analyzing buyback activity among 10,000 US firms were as follows:

1.) Greater liquidity: Companies repurchasing stock provide substantial liquidity that facilitates orderly trading and reduces transaction costs for retail investors.

2.) Reduced volatility: Stock buybacks significantly reduce realized and anticipated return volatility.

3.) Retail investors benefit: Stock buybacks generate an economically large benefit for retail investors. Since 2004, buybacks have saved retail investors $2.1–4.2 billion in transaction and price impact costs.

4.) Proactive repurchase activity: Managers utilize market-based estimates of future volatility to inform their buyback decisions. When volatility is expected to be higher, managers increase their buyback intensity to stabilize stock prices, thus reducing costs for retail investors.

5.) Response to uncertainty: Studies show that economic policy uncertainty increases stock price volatility and illiquidity. Managers respond to elevated policy uncertainty by strengthening their buyback activities.

6.) Strategic liquidity supplier: Managers expand stock buyback activity during critical periods when investors sell relatively large amounts of shares. Thus, managers use buybacks to actively mitigate price pressure during periods of net selling pressure.

Today, I estimate that Leon’s would be able to repurchase 15% of the TSX-listed shares outstanding for a cost of CAD $265mm, using cash on hand and modest balance sheet leverage to enact a substantial change in the share price.

In terms of implementation, below you will find two tables outlining two different scenarios for share buybacks. Scenario A considers repurchasing 2.5% of shares outstanding per year, resulting in a free cash flow per share CAGR of 5.5% through 2028. Scenario B considers using modest leverage to repurchase 15% of shares outstanding during 2025 (and then 1% per year thereafter), resulting in a free cash flow per share CAGR of 6.5% through 2028, or nearly 20% higher than Scenario B.

Scenario B also results in a valuation greater than two full multiple turns lower through 2028, while providing substantial annual accretion through 2028. Obviously, these are approximate numbers and projections but help illustrate my point as to how value creative pursuing a buyback may be for Leon’s. Importantly, it would send a massive signal to the market that management believes shares are undervalued. In addition, given Leon’s self-funding status and free cash flow generation, the debt funded buyback would not meaningfully stretch the balance sheet, and if intrinsic value is close to CAD $50-60 per share, the company should be repurchasing as many shares as possible.

Although Leon’s doesn’t have the same liquidity profiles as the examples listed above, there are some levers to pull outside of continued strong business execution that can help the market wake up to this story. I appreciate management and the Board’s willingness to put their heads down and run the business as they have been doing, and those efforts should not go unnoticed. I have found that in the small company space, good operators tend to put capital market related items on the backburner. I don’t believe that describes Leon’s management. However, the market’s greatest businesses and strongest managers have demonstrated histories of incredibly strong capital allocation, alongside their tremendous operating abilities. Significant shareholder returns, like the ones I think Leon’s can achieve, do not take place without both elements.

Adam Wilk is the Founder and Portfolio Manager of Greystone Capital Management LLC, a small cap focused investment firm.

Adam can be reached at adam@greystonevalue.com

Disclaimer: Adam Wilk and clients of Greystone Capital Management own shares of LEFUF. The purpose of this post is for informational and educational purposes only and should not be construed as a recommendation to purchase or sell any security. Do your own due diligence and seek counsel from a registered investment advisor before trading in any security mentioned.