1. What do the financial ratios in case Exhibit 7 tell you about the operating performance of Home Depot? What additional information do the different ratios provide? Complete and compare a similar analysis for Lowes.

2. How sensitive is return on capital to the forecast assumptions in case Exhibit 8? What independent changes in Carrie Galeotafiores estimates are required to drive the 2002 return-on-capital estimate below Home Depots cost-of-capital estimate of 12.3%? Look specifically at gross margin, cash operating expenses, receivable turnover, inventory turnover, and P&E turnover. What effect does sales growth have on return on capital? Explain your findings.

3. Do you agree with Galeotafiores forecast for Home Depot? How would you adjust it?

4. How would your forecast assumptions differ for Lowes? Complete and recommend a five-year Lowes forecast to Galeotafiore.

Value Line Publishing Slow but positive economic growth, low interest rates, a strong housing market, rising unemployment, uncertain consumer confidence, and concern over corporate misdeeds- such was the economic environment in early October 2002. Carrie Galeotafiore had followed the retail building-supply industry for nearly three years as an analyst for the investment-survey firm Value Line Publishing. Next week, Value Line would pub- lish her quarterly report on the industry, including her five-year financial forecast for industry leaders Home Depot and Lowe's. The Retail Building-Supply Industry The Economist Intelligence Unit (EIU) estimated the size of the 2001 U.S. retail building- supply industry at $175 billion. The industry was traditionally divided among three retail formats: hardware stores, with 159a of sales; lumberyards, with 349c of sales; and the larger-format home centers, with 519c of sales. Annual growth This case was prepared by Professor Michael J. Schill, with research assistance from Aimee Connolly and the cooperation of Canje Galeotafiore of Value Line Publishing. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright 0 2003 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, sendane-mail to sales%dardenbusinesspublishing.com. Noparto d'this publication may be repmduced, stored in a retrieval sx-stem, used in a spreadsheet, or traii smitted in any form or by any ineaiis-electrnice inecluinicul, photocopying, recording, or otherwis'e without the permis'sigtio) the Durden 8'chool Foundation. Rev. 11/07. had declined thorn 7.79a in 1998 to 4.29a in 2001, yet was arguably still high con- sidering the recessionary nature of the economic environment in 2001. Low interest rates and a robust housing-construction market provided ongoing strength to the industry. The EIU expected the industry to reach $194 billion by 2006. Exhibit 1 pro- vides the details of the EIU's forecast. The industry was dominated by two companies: Home Depot and Lowe's. Together, the two players captured more than a third of the total industry sales. Both companies were viewed as fierce competitors whose rapid-expansion strategies had more than doubled own-store capacity in the past five years with the opening of 1,136 new stores. The penetration by the large Lowe's/Home Depot warehouse-format stores had had a profound impact on the industry. Independent hardware retailers were strug- gling to remain competitive. Some hardware stores had shifted their locations to high- rent shopping centers to attract more people or remained open for longer hours. Some of the smaller players were protected by segmentations in the market between the pro- fessional market that remained loyal to the lumberyards and do-it-yourself customers who were attracted to the discount chains. Esbibit 2 provides selected company data and presents recent stock-market perf nances for the two companies. Future Growth Opportunities for Home Depot and Lowe's Galeotafiore expected that future growth for Home Depot and Lowe's would come from a variety of sources. Acquisition/Consolidation The industry had akeady experienced a substantial amount of consolidation. In 1999, Lowe's had acquired the 38-store, warehouse-format chain Eagle Hardware in a $1.3- billion transaction. In the past few years, Home Depot had acquired the plumbing wholesale distributor Apex Supply, the specialty-lighting company Georgia Lighting, the building-repair-and-replacement-products business N-E Thing Supply Company, and the specialty-plumbing-fixtures company Your Other Warehouse. Just last week, Home Depot had announced the purchase of three flooring companies that when completed would instantly make Home Depot the largest turnkey supplier of flooring to the residential construction market. Professional Market Both Home Depot and Lowe's had recently implemented important initiatives to attract professional customers more effectively, including stocking merchandise in larger quantities, training employees to deal with professionals, and cai ing profes- sional brands. Home Depot had developed Home Depot Supply and the Pro Stores to reach out to the small-professional market. The company was also on track to install professional-specific desks at 950 stores by the end of 2002. International Expansion Home Depot had already developed some international presence with its acquisition of the Canadian home-improvement retailer Aikenhead in 1994, and it continued to expand its reach in that market with 11 new-store openings in 2001. More recently, the company had targeted the $12.5-billion home-improvement market in Mexico by acquir- ing the Mexican chains TotalHOME and Del Norte. By the end of 2001, 109c of Home Depot's stores were located outside the United States. In 2002, Lowe's did not yet have an international presence. Alternative Retail Formats Home Depot and Lowe's both maintained online stores. Lowe's specifically targeted the professional customer with a section of its Web site: Accent & Style" offered decorating and design tips on such subjects as kitchens and baths. Home Depot was developing new retail formats for urban centers, showcased by its recently opened Brooklyn store, which offered convenient shopping to densely populated markets. These 'Urban stores provided Home Depot products and services in a compact for- mat. The acquisition of EXPO Design Centers provided an additional format for Home Depot and expansion beyond the traditional hardware and building-supply retailer. EXPO Design Centers were a one-stop design and decorating source, with eight show- rooms in one location, highlighting kitchens, baths, carpets and rugs, lighting, patio and grills, tile and wood, window treatments, and appliances. Lowe's published Cre- ative Ideas, Garden Club, and Woodworker's Club magazines to target customers with certain hobbies. Alternative Products Both Home Depot and Lowe's were expanding into installation services. The at-home" business for Home Depot was currently at $3 billion. Home Depot expected its at-home business to grow at an annual rate of 309c in the near term. Head-to-Head Competition Home Depot had traditionally focused on large metropolitan areas, while Lowe's had concentrated on rural areas. To mai its growth trajectory, Lowe's had begun sys- tematic expansion into metropolitan markets. The investment community was becom- ing increasingly concerned about the eventuality of increased price competition. Aram Rubinson, of Bank of America Securities, had reported in August, Since Lowe's comps [comparable store sales] have been outpacing Home Depot's, we have been growing increasingly concerned that Home Depot would fight back with increased promotions and more aggressive everyday pricing." Financial Forecast for Home Depot and Lowe's Home Depot's new CEO, Bob Nardelli, had expressed his intention to focus on enhancing store efficiency and inventory turnover through ongoing system invest- ments. He expected to generate margin improvement through cost declines from product reviews, purchasing improvements, and an increase in the number of tool- rental centers. Recently, operating costs had increased owing to higher occupancy costs for new stores and increased energy costs. Home Depot had come under criti- cism for its declining customer service. Nardelli hoped to counter this trend with an initiative to help employees focus on customers during store hours and restocking shelves only aiier hours. Home Depot management expected revenue growth to be 159c to 189c through 2004. Some of the growth would be by acquisition, which neces- sitated the company's maintaining higher cash levels. Home Depot stock was trading at around $25 a share, implying a total equity capitalization of $59 billion. Galeotafiore had been cautiously optimistic about the changes at Home Depot in her July report: Though the program (Service Performance Improvement) is still in the early stages, the do-it-yourself giant has already enjoyed labor productivity benefits, and received positive feedback from customers....The Pro-Initiative program, which is currently in place at roughly film of Home Depot's stores, is aimed at providing services that accommo- date the pro customer. Stores that provide the added services have generally outper- formed strictly do-it-yourself units in productivity, operating margins, and inventory turnover. Home Depot shares offer compelling price-appreciation potential over the coming 3-to-5-year pull. Other analysts did not seem to share her enthusiasm for Home Depot. Dan Wewer and Lisa Estabrooks observed, Home Depot's comp sales fell short of plan despite a step-up in promotional ac-tixity. In our view, this legitimizes ourconcerns that Home Depotis seeing diminishing returns from promotional efforts... Our view that Lowe's is the most attrac-tive investment opportunity in hard-line retailing is supported by key mileposts achieved during 20'02. Highlights inc-lude superior relative EPS momentum,robust comp sales, expanding operating margin, improving c-apital efficiency, and impressive new-store productivity. Importantly, Lowe's outstanding performance raises the hurdle Home Depot must reach if it is to return to favor with the investment community.2 Lowe's management had told analysts that it expected to maintain sales growth of 18ho to 199c over the next two years. Lowe's planned to open 123 stores in 2002, 130 stores in 2003, and 140 stores in 2004, and to continue its emphasis on cities with populations greater than 500,000, such as New York, Boston, and Los Angeles. To date, the company's entry into metropolitan markets appeared to be successful. Lowe's planned to continue improving sales and margins through new merchan- dising, pricing strategies, and market-share gains, especially in the Northeast and West. Lowe's stock was trading at around $37 a share, implying a total equity cap- italization of $29 billion. Donald Trott, an analyst at Jeiteries, had recently downgraded Lowe's based on a forecast of a deflating housing-market bubble and a view that the company's stock price was richly priced relative to Home Depots. Galeotafiore countered that Lowe's had now shown that it could compete effectively with Home Depot. She justified the Lowe's valuation with an expectation of ongoing improvement in sales and gross margins. Lowe's is gaining market share in the appliance category, and its transition into major met- ropolitan, areas (which will likely comprise the bulk of the company's expansion in the next years) is yielding solid results. Alrangside the positive sales trends, the homebuilding sup- plier's bottom line is also being boosted by margin expansion, bolstered, in part, by lower inventory costs and product-mix improvements. Galeotafiore's financial forecast for Home Depot and Lowe's would go print next week. She based her forecasts on a review of historical performance, an analysis of trends and ongoing changes in the industry and the macroeconomy, and a detailed understanding of corporate strategy. She had completed a first-pass finan- cial forecast for Home Depot, and was in the process of developing her forecast for Lowe's. She estimated the cost of capital for Home Depot and Lowe's to be 12.3ho and 11.69a, respectively (see Exhibit 3). Exhibits 4 and 5 provide historical financial statements for Home Depot and Lowe's. Exhibit 6 details the historical and forecast values for Value Line's macroeconomic-indicator series. Exhibits 7 and 8 feature Galeotafiore's first-pass historical ratio analysis and financial forecast for Home Depot. Cumulative Stock Returns ($1 lavested in Dec 1996) $7 The Horre Depot 5 4 Love's 3 S&P 500 2 Jan-02 May-02 Sep-02 Jan-01 May-01 Sep-01 Jan-00 May-00 Sep-00 Jan-99 May-99 Sep-99 May-98 Sep-98 Sep-97 Jan-98 Jan-97 May-97 1 EXHIBIT 3 Cost-of-Capital Calculation 4.8% 5.5% 2% Current yield on long-term U.S.Treasuries Historicalmarket-risk premium Home Depot Proportion of debt capital market value) Costof debt (current yields of Aaa-rated debt) Marginal tax rate Costof equity (beta = 1.4) Weighted average cost of capital Lowe's Proportion of debt capital (market value) Cost of debt (current yields of Aa-rated debt) Marginal tax rate Costofequity (beta = 1.4) Weighted average cost of capital 6.8% 38.6% 12.5% 12.3% 12% 7.3% 37.0% 12.5% 11.6% EXHIBIT 4 Einancial Statements for Home Depot ($ millions) *Includes operating-lease payments of $262 million in 1997, $321 million in 1998, $389 million in 1999, $479 million in 2000, and Fiscal Year $522 million in 2001. 1997 1998 1999 2000 2001 24,156 17.092 7,064 4,885 2813 1,896 0 (2) 1,898 738 1,160 30,219 21.241 8,978 5,935 373 2,670 0 16 2,654 1.040 1,614 38,434 26.560 11,874 7,603 -463 3,808 0 4 3,804 1.484 2,320 45,738 31.456 14,282 9,490 601 4,191 0 (26) 4,217 1.636 2,581 53,553 36.642 16,911 11,215 764 4,932 (25) 4,957 1.913 3,044 INCOME STATEMENT Sales Cost of sales Gross profit Cash operating expenses' Depreciation & amortization EBIT Nonrecurring expenses Netinterestexpense EBT Income taxes Netearnings BALANCE SHEET Cash and ST investments Accounts receivable Merchandise inventory Other currentassets Totalcurrent assets Netproperty and equipment Other assets Total assets Accounts payable Accrued salaries and wages Short-term borrowings Current maturities of long-term debt Other current liabilities Current liabilities Long-term debt Deferred income taxes Other long-term liabilities Minority interest Shareholders' equity Totalliah, and owner's equity 174 556 3,602 128 4,460 6,509 260 11,229 1,358 312 0 8 778 2,456 1,303 78 178 116 7.098 11,229 62 469 4,293 109 4,933 6,160 372 13,465 1,586 395 0 14 862 2,857 1,566 85 206 9 6.740 13,465 170 587 5,489 144 6,390 10,227 -464 17,081 1,993 541 0 29 1.093 3,656 750 87 237 10 12.341 17,081 177 835 6,556 209 7,777 13,068 540 21,365 1,976 627 0 4 1.778 4,385 1,545 195 245 11 15.004 21,385 2,546 920 6,725 170 10,361 15,375 -658 26,394 3,436 717 0 2.343 6,501 1,250 189 372 0 18.082 26,394 EXHIBIT 5 | Financial Statements for Lowe's ($ millions) acudet operating-lease payments of $59 million in 1997, 5B 9 million in 1998, $144 million in 1999, $162 million in 2000, and $188 million in 2001. Fiscal Year 1997 1996 1999 2000 2001 10,137 7.447 2,690 1,825 241 624 0 66 559 201 357 12,245 8.950 3,295 2,189 272 833 0 75 758 276 402 15,906 11.525 4,381 2,870 338 1,172 24 85 1,063 390 673 18,779 13.488 5,291 3,479 410 1,402 0 121 1,281 472 810 22,111 15.743 6,368 4,036 534 1,798 0 173 1,625 601 1,024 INCOME STATEMENT Sales Cost of sales Gross profit Cash operating expenses Depreciation & amortization EBIT Nonrecurring expenses Net interestexpense EBT Income taxes Netearnings BALANCE SHEET Cash and ST investments Accounts receivable Merchandise inventory Other currentassets Totalcurrentassets Net property and equipment Other assets Total assets Accounts payable Accrued salaries and wages Short-term borrowings Current maturities of long-term debt Other current liabilities Current liabilities Long-term debt Deferred income taxes Other long-term liabilities Minority interest Shareholders' equity Totalliak, and owner's equity 853 166 3,611 291 4,920 8,653 162 211 118 1,715 65 2,110 3,005 104 5,219 969 83 98 12 286 1,449 1,046 124 0 243 144 2,105 94 2,506 3,637 122 6,345 1,133 113 92 99 328 1,765 1,283 160 0 0 3.136 6,345 569 148 2,812 164 3,693 5,177 142 9,012 1,567 164 92 60 503 2,366 1,727 200 4 469 161 3,285 243 4,157 7,035 166 11,358 1,714 166 250 42 738 2,911 2,698 251 3 0 5.495 11,358 13,736 1,715 221 100 59 922 3,017 3,734 305 2.601 5,219 4.695 9,012 6.674 13,736