Year End 2005 Update and Company Reports

 

Lowe’s (LOW $64) and The Home Depot (HD $40) are the “category killers” in home improvement retailing.  Excellent management and home ownership growth has led both companies to track records of double-digit growth, which is anticipated to continue in the future.  Home Depot is the third largest retailer in the U.S., while Lowe’s is eleventh.

 

Business at Lowe’s and Home Depot depends on the health of the consumer.  Economic figures that measure the pulse of the consumer include:

 

1.       Growth in real household earnings, net of energy price effects

2.       Employment gains

3.       Housing turnover – new and existing home sales

4.       Growth in home ownership – the vast majority of home improvement customers are homeowners

5.       Consumer confidence

 

The U.S. economic outlook continues to be favorable, although real income growth and housing turnover are slowing appreciably.  Homes are aging, driving more refurbishment.  A major demographic shift is underway in the U.S.  “Generation Y,” the 72 million Americans born since 1978, is entering the household formation stage of life.  Generation Y is eventually expected to grow to 100 million people.  An interesting demographic development is that home ownership amongst minorities is setting records.  Hispanic home ownership grew three times faster than total home ownership, and immigration is projected to be a significant driver of household formation.

 

As specialty retailers, a primary growth driver is duplication of the store concept, achieved by steadily opening new stores in new locations.  The locations are limited, in that the minimum population concentration that can support these large stores is 500,000.  It is estimated that there are 2,000 such sites in the U.S.  A significant difference between the growth prospects of the two companies is that Home Depot has already picked the low hanging fruit by positioning stores in the 1,738 best locations in the U.S.  Lowe’s, with 1,170 stores, still has many market opportunities.  Accordingly, Lowe’s plans to open 150 stores per year, compared to 100 for its larger competitor.

 

At some point in this proliferation of stores, market saturation sets in, and new stores take longer to become as productive as mature stores.  Home Depot has reported that its new stores cannibalized approximately 20% of existing stores.  In recognition of that, Home Depot is turning its geographic growth toward smaller stores in smaller markets, competing with Ace Hardware, True Value, and independent hardware stores.  However, smaller stores are less productive and less profitable.  Also, Home Depot has embarked on international expansion with 49 stores in Mexico and 126 in Canada.  Home Depot is preparing to open stores in China, following the model used in Mexico of acquiring an existing local home improvement retailer.  Management views its budding Mexican business as being exceptionally successful.  Meanwhile, Lowe’s contemplates its first international foray with the opening of ten stores in Toronto in 2007.  Investing in foreign expansion is somewhat more risky and less predictable than domestic.

 

There are additional long-term drivers for the home improvement retailers.  Sales in existing stores, called comps or comparable store sales, can be grown several ways.  The amount a customer spends per visit, called “ticket,” can be increased by driving special order sales such as fashion plumbing fixtures, adding new products such as Home Depot’s lithium ion battery powered tools, and by offering installation.  Both Home Depot and Lowe’s are finding great growth in adding the DIFM (do it for me) customer to the DIY (do it yourself) customer.  Home Depot and Lowe’s guarantee installations will be done right.  DIFM customers trust these big names more than small contractors when it comes to backing up the work.  Both companies are installing kitchens, flooring, water heaters, fencing, roofing, cabinetry, molding, and outside lighting.  The installation business alone grew 28% in 2004 for Home Depot and 27% for Lowe’s, and has the potential to become a huge business for both companies.

 

The Home Depot cannot reach its five year 10-14% revenue growth projection through organic growth alone.  It is using acquisitions to jumpstart the growth of its installation business and to expand into related businesses.  Recently acquired Chem-Dry is the nation’s largest carpet and upholstery cleaning company.  Over the past ten years, Home Depot grew from selling a negligible amount of flooring to being the largest installer of flooring in the U.S.  Chem-Dry is a natural extension of this service.

 

Home Depot has become the largest wholesale distributor in the U.S. through multiple acquisitions.  White Cap and Contractor’s Warehouse are suppliers to professional contractors.  Hughes Supply, Inc. and National Waterworks are leading distributors of construction, repair and maintenance products and services to institutions, such as electric utilities and municipalities.  Home Depot has the capital and geographic reach to make these much bigger businesses, projecting the growth of its wholesale distribution business from $3 billion to $23 billion over the next five years.

 

Lowe’s has better organic growth opportunities and is not dependent on acquisitions to grow.  It has just completed investment in a supply chain initiative called R3, Rapid Response Replenishment.  It is already achieving better in-stock levels, faster inventory turns, and lower inventory carrying costs, while assuring that products the customers need are in the store when they are ready to buy.  Seventy percent of products sold now go through the R3 distribution network.  In the third quarter, sales were up 17% while inventories were only up 13%, leading to strong cash earnings growth.  The efficiency of the network reduces “safety stock” and allows leveraging of the inventory, driving accelerated free cash flow growth.  By contrast, inventories grew 18% over the past 12 months at Home Depot, somewhat faster than 11% sales growth.  Lowe’s management projects operating margin will expand 20-30 basis points per year, although improvement so far in 2005 is 40 basis points.  Home Depot management projects a slightly lower profit margin in 2006 because of the acquisitions, followed by modest improvement over the subsequent four years.

 

Factor of Comparison

Lowe’s

The Home Depot

Annual sales per square foot in 2004

$294.8

$375.3

Annual sales per store in 2004

$33.6 million

$38.7 million

Average ticket (customer spend/visit)

$68.81

$58.92

Total square footage 3rd quarter 2005

134.2 million

208 million

Store count at end of 3rd quarter 2005

1,170, all in U.S.

1,738 U.S., 126 Canada, 49 Mexico

Sales in billions, 2004

$36.5

$73.1

Sales growth rate, last 10 years

17.5%

20.1%

EPS growth rate, last 10 years

25.5%

23.5%

Comparable stores sales growth rate Q3

6.2%

3.6%

Gross profit margin

33.7%

33.4%

Operating profit margin

10.5%

11.4%

Net profit margin

6.0%

6.8%

Return on capital

13.2%

17.1%

Return on equity

25.1%

20.7%

Earnings sustainability past 5 years

Excellent

Excellent

Employee count end 3rd quarter 2005

170,000

325,000

Sales per employee

$214,700

$224,900

Returned to shareholders in 2005 (Dividend + shares repurchased per share)

$0.97

$1.78

 

Both Home Depot and Lowe’s address large growth opportunities.  However, Home Depot’s acquisitions add complexity and make future growth less reliable than that of Lowe’s.  Analyst consensus earnings growth over the next five years for Lowe’s is 17% compared to 13% for Home Depot.  Consensus estimates for the period from fiscal 2005 to 2009 for Lowe’s are $3.39, $3.95, $4.62, $5.41, and $6.33, respectively.  Consensus estimates for the same period for Home Depot are $2.67, $3.00, $3.42, $3.90, and $4.44.  I estimate Lowe’s intrinsic value is in the high $60’s and Home Depot’s is about $40.  Both companies face a relatively easy comparison in the first quarter of 2006, as cold weather in the first quarter of 2005 kept people home.  Fear of consumer slowdowns and/or recessions crop up regularly and unpredictably, providing opportunities to acquire these quality companies at reasonable prices.

 

Steven L. Ré, CFA                                                                                            January 25, 2006

 

This report contains the current opinions of the author and such opinions are subject to change without notice.  It has been distributed for information purposes only and is not to be construed as a recommendation to purchase or sell securities.  The information contained herein is from sources deemed reliable but is not guaranteed.  It should not be assumed that investments in any of the above-mentioned securities will be profitable, and past performance is no guarantee of future results.  Earnings projections often miss, and markets go up and down.  The employees and families of Quality Growth Management, Inc. may own the above-mentioned securities in their own accounts, and may trade them at any time without notice.