Value Line Publishing, October 2002 Case 10

Value Line Publishing, October 2002

Competition between the two major players in the industry, Home Depot and Lowes, has been heating up, especially now that they are operating in more of the same markets. Both companies are seeking new, but similar, ways to boost both their top and bottom lines, including initiatives aimed at bettering customer service, attracting professional customers, and creating a more favorable merchandise mix. Still, despite the growing competition between them, over the long term, we believe both companies are poised to benefit from additional market share freed up in this consolidating industry.

Carrie Galeotafiore

Value Line analyst, July 2002

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 Lowes.

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 15% of sales; lumberyards, with 34% of sales; and the larger-format home centers, with 51% of sales. Annual growth

This case was prepared by Professor Michael J. Schill, with research assistance from Aimee Connolly and the cooperation of Carrie 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 2003 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying, recording, or otherwisewithout the permission of the Darden School Foundation. Rev. 11/07.

Financial Analysis and Forecasting

had declined from 7.7% in 1998 to 4.2% 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 EIUs forecast.

The industry was dominated by two companies: Home Depot and Lowes. 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 Lowes/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. Exhibit 2 provides selected company data and presents recent stock-market performances for the two companies.

Future Growth Opportunities for Home Depot and Lowes

Galeotafiore expected that future growth for Home Depot and Lowes would come from a variety of sources.

Acquisition/Consolidation

The industry had already experienced a substantial amount of consolidation. In 1999, Lowes 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.1

Professional Market

Both Home Depot and Lowes had recently implemented important initiatives to attract professional customers more effectively, including stocking merchandise in larger quantities, training employees to deal with professionals, and carrying 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.

1Press Release, Home Depot, 24 September 2002.

Case 10 Value Line Publishing, October 2002 163

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, 10% of Home Depots stores were located outside the United States. In 2002, Lowes did not yet have an international presence.

Alternative Retail Formats

Home Depot and Lowes both maintained online stores. Lowes 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. Lowes published Cre- ative Ideas, Garden Club, and Woodworkers Club magazines to target customers with certain hobbies.

Alternative Products

Both Home Depot and Lowes 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 30% in the near term.

Head-to-Head Competition

Home Depot had traditionally focused on large metropolitan areas, while Lowes had concentrated on rural areas. To maintain its growth trajectory, Lowes 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 Lowes comps [comparable store sales] have been outpacing Home Depots, 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 Lowes

Home Depots 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

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Financial Analysis and Forecasting

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 after hours. Home Depot management expected revenue growth to be 15% to 18% through 2004. Some of the growth would be by acquisition, which neces- sitated the companys 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 55% of Home Depots stores, is aimed at providing services that accommo- date the pro customer. Stores that provide these 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 Depots comp sales fell short of plan despite a step-up in promotional activity. In our view, this legitimizes our concerns that Home Depot is seeing diminishing returns from promotional efforts. . . . Our view that Lowes is the most attractive investment opportunity in hard-line retailing is supported by key mileposts achieved during 2Q02. Highlights include superior relative EPS momentum, robust comp sales, expanding operating margin, improving capital efficiency, and impressive new-store productivity. Importantly, Lowes outstanding performance raises the hurdle Home Depot must reach if it is to return to favor with the investment community.2

Lowes management had told analysts that it expected to maintain sales growth of 18% to 19% over the next two years. Lowes 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 companys entry into metropolitan markets appeared to be successful. Lowes planned to continue improving sales and margins through new merchan- dising, pricing strategies, and market-share gains, especially in the Northeast and West.3 Lowes stock was trading at around $37 a share, implying a total equity cap- italization of $29 billion.

Donald Trott, an analyst at Jefferies, had recently downgraded Lowes based on a forecast of a deflating housing-market bubble and a view that the companys stocK price was richly priced relative to Home Depots. Galeotafiore countered that Lowes had now shown that it could compete effectively with Home Depot. She justified the Lowes valuation with an expectation of ongoing improvement in sales and gross margins.

Lowes is gaining market share in the appliance category, and its transition into major met- ropolitan areas (which will likely comprise the bulk of the companys expansion in the next years) is yielding solid results. Alongside the positive sales trends, the homebuilding sup- pliers bottom line is also being boosted by margin expansion, bolstered, in part, by lower inventory costs and product-mix improvements.

Galeotafiores financial forecast for Home Depot and Lowes would go to 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 Lowes. She estimated the cost of capital for Home Depot and Lowes to be 12.3% and 11.6%, respectively (see Exhibit 3). Exhibits 4 and 5 provide historical financial statements for Home Depot and Lowes. Exhibit 6 details the historical and forecast values for Value Lines macroeconomic-indicator series. Exhibits 7 and 8 feature Galeotafiores first-pass historical ratio analysis and financial forecast for Home Depot.

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. 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. Do you agree with Galeotafiores forecast for Home Depot? How would you adjust it? How would your forecast assumptions differ for Lowes? Complete and recommend a five-year Lowes forecast to Galeotafiore.

Exhibit 2 VALUE LINE PUBLISHING, OCTOBER 2002 Historical Company Performance Fiscal year 1997 1998 1999 2001 The Home Depot Number of stores ( 1 Sq. footage (M) Number of transactions (M) Number of employees 930 I00 1134 123 937 624 761 81 1333 146 1091 1244005600 20140O227300256300 550 Lowe's Number of stores Sq. footage (M) Number of transactions (M) Number of employees 520 650 744 47.795 56.98 .77480.702 231 268.232 299.225 342.173 395.141 6407072715 8616094601 108317 39.8 (I) Excludes Apex Supply C y. Georgia Lighting, Maintenance Warchouse, Your "other" Warchouse, and National Blinds and Wallpaper Stores Growth HD Stores Growth L 21.96% 19.91% 22.21% 19.22% 21.94% 18.94% 17.55% 19.08% Employees Growth HD Employees rowth L 25.96% 13.49% 28.53% 18.49% 12.86% 9.80% 12.76% 14.50% Exhibit 2 VALUE LINE PUBLISHING, OCTOBER 2002 Historical Company Performance Fiscal year 1997 1998 1999 2001 The Home Depot Number of stores ( 1 Sq. footage (M) Number of transactions (M) Number of employees 930 I00 1134 123 937 624 761 81 1333 146 1091 1244005600 20140O227300256300 550 Lowe's Number of stores Sq. footage (M) Number of transactions (M) Number of employees 520 650 744 47.795 56.98 .77480.702 231 268.232 299.225 342.173 395.141 6407072715 8616094601 108317 39.8 (I) Excludes Apex Supply C y. Georgia Lighting, Maintenance Warchouse, Your "other" Warchouse, and National Blinds and Wallpaper Stores Growth HD Stores Growth L 21.96% 19.91% 22.21% 19.22% 21.94% 18.94% 17.55% 19.08% Employees Growth HD Employees rowth L 25.96% 13.49% 28.53% 18.49% 12.86% 9.80% 12.76% 14.50%