November 26, 2007

HD vs LOW- Valuation- Part 3


In part 2 we looked at the economics of the home improvement retailers and the conclusion was that LOW looks more favourably than HD. Indeed LOW is the more focused, better opportunities for revenue growth, operationally lean and efficient and have better management. In this section I will deal with the financial aspects of the business and their valuation.

First, a look at the financial leverage of the two companies. LOW have better financial flexibility than HD. HD have recently declared a whopping $22.5 billion share buyback program. To undertake the initiative, HD financed the buybacks with debt. However, they have recently announced they are halting the buyback due to the credit problems in the market. HD is under pressure from activist shareholders to create shareholder value, which might not be in the best interest of HD in the long run. So far all the value created as a result of this pressure was of the financial engineering flavour that has no lasting effects.

In a head to head comparison (Source: Reuters):

Current Ratio (MRQ) 1.22 1.12
LT Debt to Equity (MRQ) 0.35 0.65
Total Debt to Equity (MRQ) 0.35 0.71
Interest Coverage (TTM) 26.18 13.73

I prefer less leverage generally, but in a credit market that is about to shut down, I prefer companies with flexible balance sheets. In this case LOW has far more flexibility in its balance sheet to deal with adverse situations. HD has painted itself into a corner particularly in an an environment of slowing sales and credit. For more on this issue read the following blog posts here and here, as it provides some perspective on the troubles with HD leveraged balance sheet.

Valuation: Price Ratios

A head to head comparison between the two companies on all price ratio reveals a cheaper valuation for LOW ( source: Company Financial statements and Reuters):

LOW HD S&P 500
P/E Ratio (TTM) 11.26 12.56 20.12
Price to Sales (TTM) 0.68 0.72 2.89
Price to Book (MRQ) 2.04 3.28 4.32
Price to Tangible Book (MRQ) 2.04 3.52 8.62
Price to Cash Flow (TTM) 7.46 9.12 14.4
Dividend Yield 1.44% 3.11% 2.31%
Earning Yield 8.88% 7.96% 4.97%
Expected Return* 10.32% 11.07% 7.28%
Dividend Yield - 5 Year Avg. 0.33 1.03 1.83
Dividend 5 Year Growth Rate 35.78 31.76 11.1
Payout Ratio (TTM) 12.88 39.81 28.12
*Expected return=Earning yield (EPS/ Price)+Dividend yield

LOW is relatively cheaper compared to HD and the S&P, particularly on the price to sales ratio, which has a better predictive ability of future performance. Both companies are well off the S&P 500 price ratios; it represent almost 50% discount to the S&P. And both companies have better expected return than the S&P going forward. HD have slightly better expected return than LOW due to its dividend yield. However as discussed before HD has paid compromised its financial flexibility to sustain this high yield. LOW has better growth profile of dividends and earnings than HD, so it is wise to retain earnings to grow the business.

At this time I will move forward focusing on LOW's valuation primarily, as it is the more attractive business opportunity between the two. So far HD did not present me with a compelling case to continue its valuation.

Valuation: Discounted Cash Flow

I make the following assumptions to value LOW:

  1. LOW will grow its store base at 8-9% for the next 4-5 years. LOW's recent new stores represented 12.7% increase and its average store growth over the last 5 years was 14%. But to be conservative over the valuation period I will assume a slower growth.
  2. LOW will have a negative same store sales of -3% due to the housing market for the valuation period. This is a very conservative estimates considering its sales will recover once the housing market corrects. My valuation horizon is 10 years and to have a negative comps for 10 years is unrealistic but it is ultra conservative.
  3. Pretax cost of debt is 9% based on its debt load and weighted average of Low interest cost.
  4. Equity cost is 19.6% based on its beta and Low risk profile.
  5. Terminal value is 10 times earnings close to the current Low PE ratio.

LOW discounted free cash flow fair value is $41.25 per share. The value represents 87% premium over Low current price, so the margin of safety is satisfied. I have used owner's earning concept in calculating its value by discounting the free cash flow after accounting for capital expenditures and change in working capital to satisfy sales growth.

You can see all materials regarding the LOW free cash valuation valuation here.

For comparison sake I computed HD discounted free cash flow valuation using the same assumptions and risk premiums as for LOW, however adjusting for slower growth rate in stores count and increase of leverage due to buybacks, I arrived to a valuation price of $33 per share, representing only 14% premium to current stock price. Hardly the margin of safety required for a value idea.

Valuation: Earning Power Value

To ascertain to LOW valuation arrived above, I will use another valuation technology called Earning Power Value. Earning power value concerns itself with two issues: 1. replacement value that a competitor have to pay to regenerate the producing or the operating assets of the business, and 2. the current present value of zero growth in the company's current earnings on a perpetual basis.

First, I will begin by adjusting the book value of LOW's assets to what a new entrant to the market will pay in order to compete. Some of the current assets will have no adjustments due to the liquid nature of these assets. The biggest adjustment will be in its store assets and brand name value.

LOW owns the majority of its real estate. The price of real estate have appreciated some what than what historical prices on its balance sheet shows. A new entrant to the industry to compete with HD and LOW will have to pay current market prices for its stores. A simple way to do this is to find LOW's recent store opening costs, the book value of recent real estate transactions plus capex needed to prepare for a new store, and multiply it by the number of stores LOW owns. This approach, I will argue, is conservative for the simple reason that older location will have appreciated much more in value as they are harder to find and replicate than recent stores. The value of these real estate holdings come to $54 billion; the book value after depreciation is $18.9 Billion. The number is large but it is what a new competitor have to pay to gain access to the market.

The second adjustment I make is to the brand value of the business. Any new entrant to compete effectively have to establish the equivalent of LOW brand name. LOW have been in business since the early 1950s. LOW have build a huge brand through the years but I will assume that 3 years expenditures on advertising is what a new entrant have to spend in order to build a similar brand. That figure will come to $1.7 Billion a low number but to err on the side of caution.

The combination of the two adjustments increases the book value per share from $10.7 to $37.29. The $26.59 per share difference is what a new entrant to the market will have to spend more than what LOW did to gain entry to the market and replicate LOW producing assets now.

The second part of EPV calculation is to calculate the value of its earning stream. I assume no growth so I will have to strip all incremental money LOW makes to grow it business. Usually any business makes addition capital expenditure than the maintenance capex needed to maintain a stable earnings level. So I add the accounting depreciation, strip these extra capex amounts and only deduct maintenance capex. An additional adjustment is to adjust for advertising expenditure of LOW. A business spends on advertising to grow its business, but in this case I will have to add those amounts back to its earnings. The figure is discounted on a perpetual basis using 12%.And I add the adjusted book value to the value of its discounted earning to arrive at EPV.

You can find the detailed calculation here.

LOW value using this method comes to $50 per share. This figure is close to the discounted free cash from the previous section of $41. Both figures give a satisfactory margin of safety to LOW current price level. Using a validation valuation technique has assured me that the value in LOW's business combined with its competitive position and economies of scale represent a good investment opportunity.

Investment Conclusion

LOW is value idea and I am initiating an ownership position in the company. The risk to this position stems from the current housing market. Most housing recessions in the US have corrected with 18-24 months, this may take a bit longer or shorter , a call I am not smart to make. I base my decision on the following:

  1. LOW have solid management that knows its customer and its business.
  2. LOW enjoys a solid competitive position to HD in the eyes of customers.
  3. LOW have an economies of scale to compete effectively and shortly will match the convenience of HD to its customer in terms of its store locations.
  4. LOW have lean and efficient operations.
  5. LOW have a steady and predictable earning stream. And the industry is predictable in nature for the next 10 years.
  6. The pricing in this current environment is attractive and provides me with a margin of safety. The market crowd is abandoning all housing related businesses that makes a very good opportunity to buy for the long run.

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