November 24, 2007

LOW vs. HD Economics- Part 2

The home improvement industry is suffering some setback due to the housing market. But I would rather call it as an industry returning to normalcy after the speculating house flippers existed real estate. Please see part 1 for the analysis.

Now I want to look at the micro level of the two retailers. I want to look at the economics of their operations. Any successful retailer can be evaluated based on how good they manage 6 critical aspects of their operations mainly:

· Brand Management

· Site Selection

· Supply Chain and Merchandising

· Management and customer service

Brand Management

HD brand is associated with being an industrial store and can be intimidating for the uninitiated in home improvement. Also what reinforces this feeling is the store format; it is contractor friendly or perceived that it is designed for contractors. LOW on the other hand is characterized by its helpful employees; clean and friendly store format and a better female oriented shopping experience, as most home improvement decisions are made by the lady of the house. LOW understood its customer base and the decision making dynamics and therefore applied the appropriate store format.

HD strategy has been to cannibalize its stores by over saturating any geographic area by as many stores as possible to prevent competition. Therefore a deterioration in availability of employees in older stores is noticeable. HD purposely cuts labour hours in older stores and allocates them to newer ones. As a result of these cuts to its labour force the image and brand of HD has suffered. The University of Michigan's annual American Customer Satisfaction index shows Home Depot slipped to dead last among major U.S. retailers, 11 points behind Lowe's.

HD does a worse job at brand reinforcement than LOW, as HD advertising has lagged behind LOW. HD spends considerably less than LOW as seen in the chart displaying advertising expenditure as percentage of sales over the last 5 years. The recent trailing 4 quarters saw HD spends 1.21% on advertising as percentage of sales, while LOW spends 1.86%. The affect is noticeable if we construct a chart displaying the year over year change in sales with the year over year change in advertising. The relative advantage of advertising expenditure for LOW may explain the year over year change in sales advantage it enjoys over HD as seen in chart 3.

Overall LOW does a better job in managing its brand and its focus on the shopping experience of its customers and reinforces this by spending on advertising and promotion. HD have been distracted by its foray into the HD supply division and its more commercial aspect of building its business that neglected the retail shopping experience and allowed store formats to go stale hurting its brand image with customers. HD has recently sod HD supply to refocus on its retail operations, its road to recovery will be slow as retail turnarounds is slow by nature.

Site Selection and Management

HD has more store locations than LOW. As of the end of the latest fiscal year HD had 2147 stores compared to LOW's 1385. HD also has more geographic reach than LOW in Canada, Mexico and China. LOW has just began its expansion into Canada and Mexico. The number of stores and the size is of a significant advantage for HD. Customer convenience in the home project is paramount. Consumer in the midst of a project need a close location to buy the necessary items to carry on with their project, even though they know that a better shopping experience can be fond in LOW.

LOW have been increasing its pace to match HD store count as its pace in opening new stores is higher than HD curently. One can argue that HD had reached a saturation point in the US for new stores and this is a valid arguments. Chart 4 compares number for new stores opened in the last 5 years between the two retailers. LOW has overtaken HD in absolute number of new store openings and this trend is expected to continue. LOW has more room to grow the number of its stores than HD.

Another issue in site management is store appearances and updates. Although LOW is the smaller of the two, LOW spends more on the updating store layout than HD. Store format is such a critical aspect of retail that it can sour the shopping experience for the customer. We can measure store update and attention to appearances by the magnitude of CAPEX each store receives. LOW CAPEX per store is much higher than HD; in fact LOW spends on average $2.82 million annually on each store it owns compared with $1.65 million for HD based on latest financials, this number includes store opening expenditure and is used to illustrate the magnitude of the difference between the two. HD chronically underspend LOW on store updates as seen in chart 5. Even worse the trend point to an overwhelming deterioration in this category for HD, while LOW has opted to increase its spending. This explains the difference in the strong yr-over-yr sales change for LOW at the expense of HD. The discrepancy between the expenditure might explain also why LOW stores appear neater and more friendly to its customers.

Overall the convenience of HD locations have helped the company, but LOW is closing the gap and has better handle on a more critical aspect of retailing in the customer shopping experience and store format.

Supply Chain & Merchandising

Supply chain is another critical element to a retailer success. Supply chain management is not about cost control but it is about increasing revenue to the retailer. Good management of a supply chain can be the difference in availability of hot product for sale or matching a retail promotion that the company undertakes. For this category we look at some indication of a good supply chain management between the two mainly: inventory turns, cash to cash cycle, inventory as % of sales and percentage of products shipped from the company distribution centres.

LOW ships much more products from its distribution centres than HD. This is a sign of better and superior management of merchandising as the retailer can assure that stores get the merchandise it needs much quickly and avoids empty shelves and customer turning away. The higher the ratio the better. LOW currently ships 75% of it merchandise from its distribution centres as oppose to HD's 40%. This would explain why many HD customers complain that store shelves are empty from the products they need.

HD has fared better than LOW in the inventory management as evident in the percentage of sale ratio and inventory days, a measure of how many days inventory is held before being sold, the lower the number of days the better for the company. However, LOW has undertaken a supply chain initiative called R3 to improve its operations and as a result it has closed the gap on HD in this regard as seen in Chart 6 below. More importantly I think both ratios indicate a slowing sales environment for both. However HD has fared worse than LOW in the slowing environment. HD ratios have deteriorated much worse than LOW. In the trailing 4 quarters ratio HD inventory days has shot up significantly to out pace LOW and it inventory as percentage of ales have shot up more than LOW.

The cash to cash cycle time, a measure of the number of days a company takes to turn its investment in inventory into on hand cash, a measure of lean operations and efficiency, indicated that LOW fares better than HD. LOW has improved its cash-to-cash ratio in recent quarters better than HD. LOW's ratio stands at 43 days while HD is 46. LOW has improved its operations significantly compared to HD as seen in chart 8.

The ratios overall indicate several things:

  1. A slow sales environment in the future. The increasing inventory on hand for both companies, as they are not able to move it as fast as it used to.
  2. LOW is paying attention on its operations and exercising more control. this will lead to better expense management.
  3. HD is the lesser efficient operations of the two.


LOW's Management came from within. The CEO and other executives came through the ranks of LOWs. Most of the management is seasoned and have spent years with LOW. An organic management is a strong plus for this company as they hold an understanding of the company’s operations and customers. The CEO has been with LOW for 12 years and his compensation is far below averages for the industry.

HD had a newer management team that came with ex CEO Nedrelli from GE. Over the years with the new CEO seems that some store and district management increased its turnover. Since 2001, 98% of Home Depot's 170 top executives are new to their positions. A high turnover create a discontinuity in retail initiatives and customer research and knowledge.

HD's new CEO Frank Blake is a lawyer by trade and has limited experience in retail. He like Nardillie came from GE. He is not the leader you want at the helm if you want to change things, that off course i HD board sees there is no need to make any changes. You can read a Business Week story regarding Blake here.

Another indicator to the superiority of LOW management is revenue and income per employee. LOW management know how to utilize resources better than HD. LOW generate far more revenue and income per employee than HD. The following compares latest trailing year revenue and income per employee between the two retailers:

Revenue/Employee (TTM) LOW: $307,707

Revenue/Employee (TTM) HD: $219,416
Net Income/Employee (TTM) LOW: $19,191

Net Income/Employee (TTM) HD: $12,250

To illustrate the difference between the two managements and their knowledge of retailing, I will give you an example of how the two see the self checkout technology. HD insists on the notion that self checkout as expense reduction in labour and staff hours. They have highlighted this initiative in all their conference calls and presentations to investors over the last few quarters.

LOW on the other hand saw the self checkout as a customer service initiative and not a cost saving play. In a conference call the CEO has highlighted this to analysts by saying" we do not see this as an expense reduction but as a customer play". If you have visited the store you would know that unless you have small sized items, the self checkout will work fine. However if you have a large sized items, you need a cashier and the line ups in some HD stores are irritating as less cashiers are open.


To conclude this part of the analysis, LOW emerges with the better operations than HD. LOW has better associated brand image with its customers, invests more in its operation with a focus on customer experience, and has a leaner and more control on its operations and mechanizing. All of these factors are good to increase its market share and maintain profitability particularly in a slowing sales environment. The excellent infrastructure in LOW enabled it to improve margins even in slowing sales environment as in chart below.

In part 3 I will look at the valuation of both companies.

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