137 7 29 m 19 rey 31 o7 02 39 45 iat aa a oa [1g _a25 dots oe) and impairment ‘Sng unprftabe sseodaod reorganize ‘he Untod States facturing lant alue Line Publishing, tober 2002 CCompettim between the :wo major players inthe industry, Home Depot and Lowe's, hasbeen heating up, especialy now thar they are operating in more of the same markets. Both companies care seeking new, but sia, ways to boost bok their tp and bot lines, incaling iniiatives aimed ar bewering customer senice, atracting professional customers, and erating a more favorable rmerchanuse mix. Stil, despite the growing competion Between them, over the lng term, we believe bth companies are poised wo beef fom additional make shore freed wf in this consoldanng industry Crore Galevtaore Value Line analy, July 2002 Sow 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 Depat 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 159 of sales; lumberyards, with 34% of sales; and the larger-ormat home centers, with $1% of sales. Annual growth “This cae was prepared by rofesoe Michael. Schill, with research asstance from Aimee Connolly ad the cooperation of Cae Galotafor of Vale Line Pblishing twas writen a a sis fr class cussion rater thant ilastrateffecsiveonetFeative handling ofan administative situation. Copyright © 2003 by the Univesity of Virgina Daréea School Foundation, Charles, VA. Al right reserved. To onder ‘copes, send an email sales @dardenbsinesspblishing com No par of ths publication maybe reproduced Stored ina retrieval stim, sed in Spreadsheet, or transmit n any form o by any means—electoni ‘mechanical photocopying, recording, or othensce without the permission ofthe Darden Schoo! Foundation Rev. LA 161162 Pat Tivo Facial 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 interes, rates and a robust housing-construction market provided ongoing strength t0 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 hhad had a profound impact on the industry. Independent hardware retailers were strug. sling 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 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 already experienced a substantial amount of consolidation. In 1999, Lowe's had acquired the 38-store, warchouse-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 Compans 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 lagest tukey supplier of flooring to the residential construction market." Professional Market Both Home Depot and Lowe's had recently implemented important initiatives 10 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 Store 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. ‘pyess Release, Home Depot 24 September 2002.strategies had ening of 1,136 we-format stores lers were strug- cations to high fer hours. Some Jetween the pro- xself customers 1 company data >'s would come dation. In 1999, aware in a $1.3- /d the plumbing eorgia Lighting. apply Company, >, Just last week, ies that “when hplier of flooring, int initiatives 10 merchandise in carrying profes: the “Pro Stores” n track to install (Case 10 Value Line Pushing, October 2002163 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 10 expand its reach in that market with 11 new-store openings in 2001, More recently, the Company had targeted the $12.5-illion home-improvement market in Mexico by acquir- ing the Mexican chains Total HOME and Del Norte. By the end of 2001, 10% 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 the professional customer with a section of its Web site: “Accent & Styl ‘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 land grill, tle and wood, window treatments, and appliances. Lowe's published Cre lative Ideas, Garden Club, and Woodworker's Club magazines to tanget customers with, certain hobbies. targeted offered 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 al-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 Lowe's had concentrated on rural areas. To maintain its growth trajectory, Lowe’s had beguh sys tematic expansion into metropolitan markets. The investment community was becom- ing increasingly concemed 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 concemed 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an-Two Financial Analysis and Forecssting product reviews, purchasing improvements, and an increase in the number of too). 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 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 stil 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 i eurentl 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 ing 3-10-5-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 activity. In ‘our view, this legitimizes our concerns that Home Depot is seeing diminishing returns from promotional efforts... . Our view that Lowe's is the most attractive investment ‘opportunity in hard-line retailing is supported by key mileposts achieved during 20°02. Highlights include superior relative EPS momentum, robust comp sales, expanding operating margin, improving capital eficiency, and impressive newstore productivity. Tmportantly, Lowe's outstanding performance raises the hurdle Home Depot must reach if is to ret to favor with the investment community.” Lowe's management had told analysts that it expected to maintain sales growth of 18% to 19% over the next two years. Lowe's planned to open 123 stores in 2002, 130 stores in 2003, and 140 stores in 2004, and fo 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 10 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 al around $37 a share, implying a total equity cap- italization of $29 billion. Donald Trott, an analyst at Jefferies, had recently downgraded Lowe's based on 1 forecast of a deflating housing-market bubble and a view that the company’s stock 5am Wewer and Lisa Fsabrooks, CIBC Woeld Markets, 20 August 2072. ear Sears, 20 August 2002. | Lofad with an Al restocking ‘growth (0 be fa, which neces flock was trading billion, Home Depot in any stages, the received positive only in place that accommo: ly ourper and inventory tial over the pot. Dan Wewer ‘onal activity In sshing returns e investment ducing 29°02 ‘expanding re productivity. pot must reach ain sales growth 3 stores in 2002, phasis on cities ind Los Angeles. to be successful fh new merchan we Northeast and total equity cap- Lowe’s based on company’s stock Case 10. Value Line Publishing, October 2002 165 price was richly priced relative to Home Depot's. Galeotafiore countered that Lowe’s had now shown that it could compete effectively with Home Depot. She justified the Lowe's valuation with an expeciation of ongoing improvement in sales and gross margins, Lowe's is gaining market share in the appliance category, ans transition into major met- ropolitan areas (which wil likely comprise the bulk of the company’s expansion in the next years) s yielding solid results. Alongside the postive sales trends, the homebuilding sup: plier’s botiom line is also being boosted by margin expansion, bolstered, in par, by lower inventory costs and product-mix improvements Galeotafiore’s financial forecast for Home Depot and Lowe's 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 macraeconomy, and 1 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 12.3% and 11.6%, 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 seties. Exhibits 7 and 8 feature Galeotafiore’s first-pass historical ratio analysis and financial forecast for Home Depot.(6 Pan Two Finacial Analysis ard Forecasting Sales (sbillions) Haraware 228 Home cantors| os. Lumber 515 Total markot 1308 ‘Share of Market Home Depot, ne: Lowe's Companies TruServe Corp, Menard, le Menatd ‘Soc Economist itigonce Unt 1997 EXHIBIT 1 | Sales Figures for Retail Bulding-Supply Industry 1999 1999 20002001 262 90 59.0 waz 2001 22.9% 108% 29% 15% 495 1597 1680 20026 262 919 60.1 waz 2006 260 1020 65.0 1940Case 10 Valu Line Publishing, October 2002167 EXHIBIT 2. | Historical Company Performance 19971998 20002001 Home Depot Number of stores" oY 488 1.998, $9, footage (milions) 6s Ge to i Number of transactions (millons) 550885797837 1.091 ‘Number of employees, 124,800 156700 201400 227,300 256.900 Lowe's ‘Number of stores 47 520578 B5D 78g ‘Sq. footage (mons) 40 4a ‘97 68 81 Number transactions (milions) «231.268 200842995 ‘Number of employoas 94070 72715 85,160 94,601 108,317, “Excludes Apex Surly orga Lighting, Maintenance Warehause, Your “Omer Wirehave, and Nationa ince. Spf e Pre Prepsssse es FPA IL ISI SSI SSSIJos Pa Two Financial Analysis and Ferceastng EXHIBIT 3. | Cost-of-Capital Calculation ‘Current yield on long-term U.S. Treasuries 48% Historical market-sk promium 55% Home Depot an Proportion of debt capital (market value) 2% INCOME STATEN CCost of debt (current yields of Aas-ated debt) eax Sales Marginal tax rate 306% Costat sales Cost of equity (bota = 1.4) 125% ‘Gross prot ‘Weighted average cost of capital 123% cash operating ex Depreciation & ant Lowe's on Proportion of debt capital (market valve) 12% ewocuning e% Cost of debt (current yields of Aerated debt) 73% Papelerrhane ‘Marginal tax rato 370% as Cost of equity (beta = 1.4) 12.5% —“ Wiejghted average costo capital 116% nom Net earings. BALANCE SHEE Gash and ST ive ‘accounts recelva Merchandise inve Otter curcent ase “otal current at Not property and er ass0t5 Tal assets Acpounts payab ‘cerve salaries ‘Shorttorm bora (Current maturie (Other cuenta Curent ait Long term dobt Deere income ‘Othe ong term Minority interest ‘Shareholders: “otal lab. and “des oparting + $522 mllonn 2001income STATEMENT sales ‘cost of sales ‘Gross prot . ‘cash operating expenses Geereraton 8 ameatization ett noneecuring expenses fotntorest expense est Net earnings BALANCE SHEET Gash and ST investments ‘accounts recelvable Morchandlise inventory Other eurent assets “otal event assets Net property and equipment Oner assets Total assots ‘Accounts payabie ‘accrued salavies and wages Shorform borowings Current maturities of long-term debt Other curentabltios Current libities Long-term dobt Deferred income taxes Other long-term lables Monty interest Shareholders equity ‘otal a and owners equity ws 6 3602 28 400 6500 Fis 1.398 312 ° 8 oa) 2.450 309 8 178 16 7098 T1209 Case 10. Valve Line Publishing, October 2002 1998 1999 2000 woz9 aaase 5,798 2128 = (26,560 1.486 ag7e || T8rd 14,082 5.835 7,603 91490 srs 463 ot 2870 3.808 ai9t ° ° ° 16 4 (26) 2654 ‘3aod 4217 soso 4,484 1698 1614 2320 2581 ee 170 1 489 587 835 4203, 5.489 6588 109 144 200 4833 6,300 777 a160 © 10227 13,068, 's72 464 ‘549 Faaes = Tost 21,385 1,506 1.993 1978 395 541 er ° ° 0 4 2 4 262 4,088 178 2a57 3.656 4.285, 11566 1545 85, 195, 208 245 9 " 8.740 15,004 Yades Tost 21,385 2001 53.559 see 1691 n218 _ 764 23043 6.501 11250 129 372 o 18.082 25394 “Teudes aperng lease paynets of $262 milo n 1997 $521 ron 298, $389 milion n 1999, $479 miter 200, end ‘822 non 2001Pa Two Financia Analysis and Forecasting EXHIBIT 5 | Financial Statements for Lowe's ($ millions) FiecalYoar a a a vos coral —_________— <___.Be a xorgor one INCOME STATEMENT FO on Cost of sales: 7.447 8,950 11,525, 13,486 15,743 flow Gross profit 2,690 3.205, 4,381 5.201 6,368 Industrial prod. (% Cash operating expences tes ate Baro amo 8 tous Sr Deprodaton&amerteaon BH oe S38 ‘to sot Gone sa eer 26 833 172 1,402 1.788 Cn ‘Nonrecurring expenses: 0 0 24 0 0 National unempicy Netierst expense 6 es 121 1 pak op bond 8 cor 8 7 ies zeta, fovea Moasury boom oe 201 26 00 om ot Sonn sry BALANCE SHEET foal GOP ‘Cash and ST investments. an 243 569 469 653 GDP price index poconts cede iis iat ue tet t68 Sencumer pice Other eurent aes” 68 % tee 248 at _Qustety Anna Toa eae cnet Zin) Bias Shs? «E800 Nat propery ee etuped Soe aura Pass : ‘Omer asets 104 114 165 162 eee Total ests zee sores 708 Real DF (19984 ecxria popetia ceo tse? Noweadental ‘cctodenates and wages eo Ns ree ‘ee at . Shorttom bowen 3 2 2 250 ‘00 inal pros Curent ratte fog term debt 2 & rs © 3 Howsg art Otrer con abies 28 oe so3 138 Ps Curent abe faa | ies © ese] © con | = aot ae Lengo det toe 123s ter ewe ‘ti pu Deter neome oes te 180 200 2st 08 q Minority interest 0 0 0 oO oO : Total ah ae owner ey S210“ wore 135813708 “nudes operating esse payments of $59 millon n 1997, $89 millon in 1998, $144 milion n 1988, 162 mon in 2000, and 180 maton 2001Case 10. Value Line Publishing, October 2002 1907 1908 1999 2000 20012002" 2003" m 2005-2007" Se rticpeai@ol) 8318 872 B27 98ts 100% Toa0 see raa8 consti rseresteh) iso aos gos Sor Sais ‘nae ‘See toms fs neo) Mr Seer See oo aarr eor ere | “Sasr einen (sox) aoe ise ies tase tas hwo ta Tass wins cmos smateed) 69 81 37 45 37 3883 ag so4 ‘ear sales rit uns) fea) set] ove ene fadeeraaleseab een 8 eal savings ate (6) 42 47 27 28 23 35 34 15 a Te me) «teas tt ie rake bond ao) 73 08 70 78 71 34 75 1.625, ‘10-Vear Treasury note rate (%) 64 53 58 60 50 48 ot 62 tor et ey ome Mo 8 a 8 ae Annual Rates of Change fondue Aa 4g 4s 98 0323 gat oss ps nx Sue we Bs fad seer te x ois) aa oy eee eee ee oan cual Anmalze ats ote 201s 4,920 2 Ist 2nd* 3rd" 4th" tst®2nd* 3rd? ath* fe ees donate poe tog 10307 1047s 1090 1075610901 1.060 11270 a Serco io Suess) So: ‘Sams ‘ewe ‘sare ‘Saas nest ‘aro gan ‘Malemerton 8) tie con sow ea Goll Go Grao ees i768 ASromasieetmerseny Saas ties iad ica Saxe Saw taro ais x a Indstialprodicion (change, anuaized) 26 48 90 50 «85. 55 50 50 0 ‘ings fat sat) S825 € 2.45 8 2 Se Si i oo ee sor mae ad Suc: Valo Line PubicingFa Pac Too Financial Analysis and Foresing EXHIBIT 7 | Ratio Analysis for Home Depot 1997 ‘Working capil (CANIBCL") 2ora Fixed assets 6769 “ata captal ae Tax rae 38.9% NOPAT (EBIT x (1-2) 1.158 PROFITABILITY Return on capital (NOPATMAGtal capital) 132% Return on equty (nat earringss.equiy) 16.3% MARGINS Gross margin (gros profs 202% Gash operating expensesisaies 202% Depreciaton/sales 12% Depreciaion/PRE 43% (Operating margin (EBITisales) 73% [NOPAT margin (NOPATIsalos) 40% ‘TURNOVER “otal capital turnover (slesoal capita) 28 PRE turnover (sales!PBE) 37 ‘Werking-captl turnover (salesWC) 120 Receivable turnavor (sles/AA) 34 Inventory turnover (COGSim. inventory) 47 Sales per stor ($milions) 387 Sales per sq, oot (8) 355.0 Sales per transaction (8) 439 GrowTk Total sales growth Sales growth for existing stores Growth in new stores Growth in 2g footage per store LEVERAGE Total captavequity 124 2,090 asa2 10,622 2% 1623 15.3% 185% 207% 19.6% 12% 46% Bam 54% 28 a7 145 eas 49 oar 373.41 454 25.1% Fiscal Year 1999 2.763 105891 ra.4s4 39.0% 2.323 3% 188% 209% 18.8% 12% 45% eam 0% 29 139 655: 48 43 a 482 272% 41% 222% 1.0% 2000 3.396 13,608 17,008 388% 2.565 15.1% 172% 312% 207% 46% ene 56% 27 135 548. 403 3719 488 19.0% 316% 14% 50% 92% 57% ar 35 139 582 54 402 2668 49.1 17.1% 049% 175% 10% 110 “Non etorest beating cuant abi. 1 Fina JgguMPTIONS own i new stores Grim grat Fr exis Seal sales growth ross arin en operating expe Cpreciatn’sales freometax tS cash & ST invisalos ecoivable turnover frventory twmnOver PRE turnover payablesICOGS finer our. Nab ale FORECAST Number of stores Not sales (Cost of sales ‘Gross profit cash operating exp Depreciation & amc err NOPAT ‘cash and ST inves ‘Accounts receivabt Merchandise inven tner curent asse “otal curtent ase ‘Accounts payable ‘acorued salaries ¢ Other current ab Nomin.-bearing Working capital Net property and other asses ‘otal capital _ Fieturn on eapialCase 10 Valve Line Publishing, October 2002 ve Fiscal Year .suMPTIONS oi 2000 —<2003E ——~2008E = ‘sown v0 sr vou 150% «132% == Goer Gane encing toes -0ae 30ND 8H BON re ‘Soa sles own win iowa 7% BSR TB oss margin a1 IK SAH SRS SH crs met exorsessaes 20mm «Mok «(MOT «20a BOSH DS “ Sopesatonsales ms ws a a 6 182% otra ae sak aa STROKER STEN 5 os cash & ST ivisales tay «50% 50% SH TK : faced trove" wes sso, 30S ate fectory tumover sh 88 BBO “7 “7 son PoE tener 358388 33 33 * 14%. Peyables/COGS 94% 94% ONAN 94% 9% “ 5 a ther curr, liab/sales 4.4% 4.4% 44% 44% 44% 46% S 8m FORECAST umber of stores 1908 ter 2028 notsales 53359 aoe 100,349 e 27 Cast of sales “s8717 67.801 5 35 ‘ros rit eis “es ca Cash operating expenses ‘e067 203881 ssa Seprecaton& smorteaion “zo eo ee alt aes? To. 9 366.8 NOPAT 5,823 6618 8 ad cash and ST investments 4a 5.08 pcounts recite te 2008 1, Narciso veriery tis 14388 fe Otrr cue assets 170 170 i “oil cure aseats Teo = Fiaoe : acco patie $505 690 Accoad sles nd wages 77 mn ter cure labites foo _4nee 4.988 3130 Nonint-bearing event ab Toes | Tas | “12520 Working eal 660 7900 T0421 aes Net propery and equipment 18375 zosot 0a 45M Other assets __ss8 oar Total capa! faa Gs “Hass__ aha 62% Team 160% 160% our on capital