VALUE LINE PUBLISHING

VALUE LINE PUBLISHING, OCTOBER 2002 Case Analysis Report

I.

INTRODUCTION

The Retail Buildings Supply Industry in the US is estimated to be $175 billion in 2001 and is expected to reach as high as $194 billion in five years by 2006. It was divided into three: hardware stores, lumberyards and larger-format home centers. Low interest rates and robust housing-construction market provided an ongoing strength to the industry. Two of the major key players under the Retail Building Supply Industry are Home Depot and Lowe’s as of 2001. The two captured more than a third of the total industry sales wherein Home Depot holds 22.9% of the market share of the industry while 10.8% is held by Lowe’s. Both companies were seen as tough competitors and the penetration of the two companies made a great impact to other players of the industry. In the midst of 2002, Value Line publishing, an investment survey firm assigned analyst Carrie Galeotafiore to present a five-year financial forecast of Home Depot and of Lowe’s. According to her, the expected growth of Home Depot and Lowe’s was said to be coming from different sources. Both companies are seeking new but similar ways to boost both their top and bottom lines such as improving customer service, attracting professional customers and creating a more favorable merchandise mix. Although both are major players on the same industry, the two companies cater different markets. The Home Depot traditionally focused on large metropolitan areas whereas Lowe’s focused on rural areas. Home Depot had acquired several small companies for expansion and implemented ways to attract professional customers effectively including stocking merchandise in larger quantities, training employees and carrying professional brands. The company also developed a Home Depot Supply or “Pro-stores” to reach out small-professional market. The company also broadened its international presence by acquiring businesses in Canada and Mexico. Furthermore, Home Depot was also expanding into installation services by creating the “at home” business. On the other hand, Lowe’s has also acquired small companies and made ways to improve its professional market. While Home Depot expanded to international markets, Lowe’s did not yet have an international presence. Despite the differences, both companies maintained online stores. Lowe’s has its own website named “Accent and Style” that targeted professional customers while Home Depot developed new type of retail stores that offer products and services in a compact format. Because the two had already entered the same metropolitan markets, some worries it may intensify price competition. However, Home Depot’s CEO planned to make the company more competitive. His goal is to make store operations efficient, cut costs and increase stock prices. He also focuses on improving customer service as it has been the weak point of the company and hopefully helps in increasing sales. These changes in Home Depot were supported by Galeotafiore. In her report, Galeotafiore based her forecasts on historical performance, trends and ongoing changes in the industry and the economy and company’s strategy.

II.

STATEMENT OF THE PROBLEM To be able to publish the quarterly report on retail building-supply industry for Value Line Publishing, Carrie Galeotafiore has the following questions to answer: 1. Since Home Depot and Lowe’s are the two major players in the retail building-supply industry, who has the better management strategy? 2. What are the factors that Galeotafiore considered in the assumptions of the financial forecast of Home Depot? 3. What must be the financial forecast for Lowe’s?

1 Magbitang, Redilyn B. Papa, Richelle Angeline O.

Talucod, Regine Marie D. Tañedo, Pauline D.

III.

INDUSTRY ANALYSIS

SWOT Analysis

STRENGTHS

WEAKNESSES

- Consolidating industry - Large market size - Ability to sell online - New and unique retail formats

- Higher occupancy and operating costs due to expansion - Limited flexibility in pricing - Similar inventory offer

OPPORTUNITIES - Acquidistion from a variety of Sources - Professional Market Penetration - International Expansion

THREATS - Growing Price Competition - Economic Recession

Porter’s Five Forces Analysis

Porter's Five Forces Analysis Threats to New Entrants

6

Bargaining Power of Buyers

4 2 0

Bargaining Power of Suppliers

Threats of Substitute s

Rivalry Among Competit ors

LEGEND 0 - No threat to the industry 1 - Insignificant threat to the industry 2 - Low threat to the industry 3 - Moderate threat to the industry 4 - Significant threat to the industry 5 - High threat to the industry

2 Magbitang, Redilyn B. Papa, Richelle Angeline O.

Talucod, Regine Marie D. Tañedo, Pauline D.

Threats of New Entrants - LOW The industry was dominated by two major key players which are Home Depot and Lowe’s acquiring a third of total industry sales. Due to this, independent hardware retailers were persisting to remain competitive wherein some hardware stores shifted their locations to high rent shopping centers. Although founding stores with low capital to set up is not impossible to overcome, it is the fact that being competitive and difficulty in establishing company identity lead to decreasing number of independent retailers. This is why it is safe to assume that threats to new entrants for the said industry are low. An industry congested by major competitors and small players are really hard to enter unless you will invest a large capital requirement enough to finance large number of inventories, rapid expansion and aggressive promotional activities. Threats of Substitutes - LOW Since retail industry’s inclination is to offer a wide range of products and services, there is a low threat for substitutes. It is because retail industry sells what manufacturing industry produces and part of this production are the substitutes which can be their inventory as well. Customers are also loyal in products and services which both Home Depot and Lowe’s offer and can be easily accessed due to increasing number of stores and expansion to different market segments like professional and international markets . Installation services which can be a substitute is already penetrated by the two major players wherein Home Depot has its “at home” business and expected to grow at an annual rate of 30%. Bargaining Power of Buyers - HIGH It is assumed that there is a high bargaining power of buyers for retail building supply-retail industry because of a tight competition between companies. This is also increased by retailers having the same products and services which can be applied to Home Depot and Lowe’s. The tendency is that customer’s loyalty can be switched depending who offers the least cost and best quality at the same time since there are lots of options available. Bargaining Power of Suppliers - LOW There is a low bargaining power of suppliers since retailing industry is composed of many readily available suppliers and companies engaged to this can choose their own supplier whichever offers least cost and best quality since based on the information given, companies in this industry are also welleducated of the products and services they offer. Retailers are also price sensitive because their inventories are undifferentiated. Usually, they purchase product in high volume and these purchases covers large share on the sales of the suppliers. Rivalry among Competitors - HIGH Retail building-supply industry has been an overcrowded market mainly because of the escalating competition between the two major companies, the Home Depot and Lowe’s. Both are producing much effort to be able to capture larger market share resulting to slow market growth. There is also substantial amount of consolidation and most retailers offer no differences in products and services. These trigger increasing price competition and therefore decreasing customer loyalty because it is easy to switch suppliers depending on the costs and quality. Expansion is used by both companies to generate margin improvement wherein they entered professional and international markets. Home Depot focused on large metropolitan areas while Lowe’s is on rural areas but already expanding into metropolitan markets. Each has its competitive advantage over the other wherein Home Depot offers added services like Service Program Improvement that has already enjoyed labor productivity benefits and received positive feedback from customers while Lowe’s highlights are superior relative EPS momentum, robust comp sales, expanding operating margin, improving capital efficiency, and impressive new-store productivity.

3 Magbitang, Redilyn B. Papa, Richelle Angeline O.

Talucod, Regine Marie D. Tañedo, Pauline D.

IV. ALTERNATIVE COURSES OF ACTION 1. Home Depot vs Lowe’s: who has the better management strategy? In 2001, comparing the return on capital of the two companies based on Exhibit 7, Home Depot reported a Return on Capital of 15.2% while Lowe’s reported an ROC of only 10.1%. Relative to their respective Weighted Average Cost of Capital (WACC) calculated in Exhibit 3, Home depot accounted for 12.3% while Lowe’s has 11.6%. This shows that Home Depot is performing well because it has lower cost compare to its return while Lowe’s ROC on the other hand is below in its WACC which signifies that the company incur more cost compare to its return. Using Exhibit 7 as basis in calculating Lowe’s ratios which is shown in Appendix 2 and by comparing the operating performance of the two companies, it shows that Home Depot has outperformed Lowe’s on an operating basis in 2001. However, in terms of stock-market performance, Lowe’s had considerably perform better than Home Depot. The reason is shareholders appear to have lost confidence that Home Depot can maintain its profit-and-growth trajectory given the magnitude of its retail space and its ability to find new markets. In summary, Home Depot remained to have better management strategy as management performance is best measured by the impact on future cash flow. The strategies of Home Depot with regards to investing in more profitable investments were better since value is represented by the spread of 2.9% while Lowe’s just lost value amounting to 1.5% of their investments.

2. Factors that Galeotafiore considered in the assumptions of the financial forecast of Home Depot In her report, Galeotafiore based her forecasts on historical performance, trends and ongoing changes in the industry and the economy and company’s strategy of Home Depot. Galeotafiore’s forecast was based on her confidence in the successful roll-out of the strategy to attract the professional market. Her forecast is reasonable if the analyst believes that Home Depot and Lowe’s will be successful in capturing large share gains from the lumberyards and other professional retailers while maintaining margins with an improved product mix. Some would be the factors considered by Galeotafiore in: Using Exhibit 8, Existing-store sales growth has not been greater than 4% and 8.3% The assumption requires a successful deployment of the company’s strategy to capture more of the professional market.

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Will the competitive pressure of the industry allow Home Depot to expand gross margin and reduce operating expenses? Bob Nardelli claimed that product reviews and operating-efficiency investment would provide for such gains, but what impact will the competitive environment have on margins?

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How should depreciation be allocated? Should it grow with sales or assets?

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Gale Galeotafiore allocated depreciation in terms of sales as

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What suggests that asset productivity will decline? Galeotafiore’s forecast of declining inventory turnover is particularly relevant to the forecast. Should we expect inventory to grow faster than sales?

4 Magbitang, Redilyn B. Papa, Richelle Angeline O.

Talucod, Regine Marie D. Tañedo, Pauline D.

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Many of the line items are relatively small. The class should make the point that the analyst should invest little time in forecasting receivable turnover, for example, because it generates little impact on the magnitude of the numbers. Those assumptions that generate important differences are called “value drivers.”

3. What must be the financial forecast for Lowe’s?

IV. RECOMMENDATION

5 Magbitang, Redilyn B. Papa, Richelle Angeline O.

Talucod, Regine Marie D. Tañedo, Pauline D.