Home Depot to close call centers, cut 950 jobs | Reuters

Home Depot to close call centers, cut 950 jobs | Reuters


Home Depot started to cut expenses to manage its earnings in a slowing revenue environment. While the expense management and cutting is a must in slower economic times, HD is cutting what it needs the most: customer service.

HD needs to boost its customer service efforts to fend off Lowes and maintain its market share. HD rationalized the move by shifting customer service point of contact to the local store. This is a good call, as you can attest that I do not want to talk to a call centre mile and miles away about a problem while the store I dealt with is just two blocks away. However, HD stores may lack the man power to handle this shift of service calls. HD over the last few years have cut labour hours at the store levels to streamline expenses. Lack of customer service may prove costly in this environment, where sales are hard to come by and any customer perceived weakness in retailer's effort to serve him could be the difference in losing the sale.

HD vs LOW- Valuation- Part 3

Valuation

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):

	LOW	HD
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.
   

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.

Management

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.

Conclusion

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.

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.