HD vs. LOW: Is there any value? Part 1

Introduction:

In 3 part post, I evaluate Home Depot and Lowes business to understand if value exists in thier businesses, as the recent price drop may create a buying opportunity or it may be a value trap, where cheap price is evident of eroding business fundamentals. There will be a three part posting on the head-to-head comparison beginning with industry analysis, operational assessment and then valuation of companies worth.

General overview:

To begin my analysis in the space I will provide a general overview of the two companies.

	Home Depot (HD)	Lowe’s LOW)
Overview	HD is home improvement retailer. HD stores sell an assortment of building materials, home improvement and lawn and garden products and provide a number of services.	LOW is a home improvement retailer. The Company offers a line of products and services for home decorating, maintenance, repair, remodeling and property maintenance.
Market Cap $	57.5 Billion	36.98 Billion
Number of Sores	2,200	1,450
Total retail floor Sqr. Ft.	223 Million	161.6 Million
Revenues (Trailing 4 quarter) $	79.9 Billion	47.9 Billion
Net Income (Trailing 4 quarter)$	4.69 Billion	3.08 Billion
ROIC (trailing 4 quarters)	30.9%	29.5%
P/B	3.2 x	2.3 x
Earning Yield (NI/Mktcap)	8.15 %	8.3 %
Ent. value/ EBITDA	6.7 x	6.3 x

Home Improvement Industry:

Despite the recent turmoil in the housing market in the US, the long-term outlook for the home improvement products market is strong. Overall the retail home improvement industry will recover in the coming years with sales growth averaging 4-6% per year. Due to increasing economies of scale at Home Depot and Lowe’s, the industry should enjoy continued sustainability and slightly improving gross margins.

Total market growth in 2008-2010 is projected to average 5.0% per year in constant dollars – continuing to outpace the rate of overall economic growth. Estimated size of the market is $250-320 billion a year in a fragmented market across a number of traditional hardware, plumbing, electrical and home supply retailers, as well as other chains of warehouse home improvement stores and lumberyards in most of market areas. LOW and HD account for the dominant position in the market with LOW’s market share is 20% vs. HD 31% from the DIY market or retail home improvement.

U.S. Home Improvement Products Market: 2005-2010

	2005	2006	2007	2008	2009	2010
$ Billion	286.9	312.1	319	34.4	350.7	369.5
% Change	9.2	8.8	2.2	4.8	4.9	5.4

Independent mom-and-pop stores, smaller regional home improvement chains and independently owned and operated cooperative home improvement stores continued to struggle against big box and larger regional players in their fight to maintain market share and defend against declining revenues and cash flows.

Both HD and LOW enjoy a dominant position in the market evident by their revenue growth stability and consistent EBIT margins over the last 10 years. As seen in the graph below, HD enjoyed an average revenue growth of 16% while LOW fared a bit better with 17.4%. Their margins also exhibited consistent improvement over the years, although LOW enjoys better margins improvements than HD.

The stability of margins and revenues suggest that both retailers enjoy a competitive advantage over other more smaller and fragmented suppliers. It also indicates the existence of barriers to entry in the market as if it does not exist, it would deny HD and LOW the operational improvement. It also suggests that both retailers operate in a cooperative manner avoiding costly and unproductive price wars and competition.

The current economic drivers of the industry are deteriorating due to housing crises and tightening of credit. Housing starts and home ownership percentage have gone down in the last year. However the one indicator that continues to be positive for the industry is the median age of American house. Per the Joint Center for Housing Studies of Harvard University, the average age of a home in the United States is approximately 32 years and rising. This continual aging translates into perpetual demand for maintenance and remodeling projects that the retail home improvement industry must supply.

The remodeling segment of home improvement can hold the industry sales growth until the housing market corrects. As houses age and Americans are reluctant to relocate due to the housing problems, they will spend to improve their existing homes. The remodeling segment is $140 billion a year sub industry, although it may slow a bit due to little growth in consumer spending and slowing economic activity.

Moreover with increasing economies of scale of both HD and LOW, they can take bigger slice of the market share of the smaller players. Both HD and LOW continue expanding their big store format across the US and Canada, which allows them to crowd out smaller undercapitalized stores. HD and LOW can offer wider selection and better prices which will attract tight budget consumer who is will shop their floors to find better bargains and selection. HD and LOW will continue to grow although at a moderate pace due to remodeling and gaining market share due to their size.

This industry for the long term is a solid and predictable one. For as long as Americans have owned homes, they have longed to improve them through remodels, renovations and decoration. People will aspire to buy houses, fix houses, remodel houses and continue to maintain their houses. This is essential for picking a solid investment is the ability to easily predict customer behavior 10 years from now. And I do not see that behavior changing. The recent problems of the housing market are temporary regardless of how dire they at the moment. You have to remind yourself that this is a cycle and it will correct eventually.

In the next part I will analyse business economics and operations by both companies.