The Wolfpack
Corporate Finance – MBA 8020
Summer 2016

Value Line Publishing, 2002

Executive Summary

Analyst of Value Line Publishing, Carrie Galeotafiore, was put in charge of the company comparison and developed a comprehensive forecast model that could be used to gauge future success. Historical performance, costs of capital, current financial statements, and macroeconomic trends were all used in creating assumptive ratios and growth rates. With five year projected financials, Galeotafiore applied these projections to current company metrics in an effort to publish an accurate forecast. Before finalizing these projections, it is recommended that Value Line produce a detailed qualitative analysis to support the numbers.

The purposes of this analysis are to 1) provide detailed forecast analysis for hardware giants Home Depot and Lowe’s. 2) compare these assumptions to the industries previous and potential performance 3) provide a judgment for Value Line readers for potential stock investment actions.

Although these two companies have risen to the top of this industry it is recommended that investors hold their current investment position on both companies, as opposed to buy or sell.

Problem Formulation

As Galeotafiore prepares to release Value Line’s forecasts, there are several important factors that must be taken into consideration. Primarily, are the numbers used in the models for Home Depot, found in Exhibit 7, dependable? Can both companies be expected to achieve similar growth rates or has market saturation been reached? Next, is Galeotafiore properly accounting for macroeconomic trends? In the near future, interest rates are predicted to rise and new housing starts are expected to decline. Both companies perform better when these trends are moving in the opposite direction so current sales forecasts may be too aggressive. Lastly, what impact can international sales have on both companies? Home Depot currently has an overseas presence but Lowe’s does not. Galeotafiore’s task is difficult as both firms are closely aligned but diverging strategies may ultimately set them apart.

Information, Evidence, & Assumptions

The fact that both Lowes and the Home Depot have experienced tremendous growth over the past several years indicates that both companies are fairly well managed. There are a couple key indicators that highlight the cumulative effect of the differences in managements approach at these the two companies. When we compare the ROIC between The Home Depot, with excess returns at 5.8%, and Lowes, with excess returns at .1%, the efficiency differences between their respective management teams’ approach becomes clear. Based on this information the bottom line is that The Home Depot is the better-managed firm at this time.

Exhibit 1

When comparing the Home Depot forecast to Lowe’s it would be safe to say a lot of the same assumptions can be made. Year over year sales growth between these competitors are almost identical. The notable difference between Home Depot and Lowe’s is the growth of debt on Lowe’s balance sheet. While Home Depot’s debt has stayed relatively the same the debt for Lowe’s has grown faster than their sales. Below you can see both companies debt compared to income statement growth. When you consider that Lowe’s is trying to move into more urban locations that compete directly with Home Depot it may be reasonable to expect that future growth may not be as profitable as historic growth.

Exhibit 2

Below is a comparison of some key financial ratios for Home Depot and Lowes. You can see that these companies are almost identical with a few exceptions. They grow at about the same rate; they can get roughly the same profit margin as well as their earnings per share. Where they differ is how they structure their equity and the market perception of value. Lowes is using more debt to finance its growth, being one of the few differences the assumption can be made that investors are not in favor of this.

Exhibit 3 Exhibit 4
Analysis

This ratio analysis for the Home Depot shows some interesting and potentially concerning trends. While the sales per transaction overall margins are increasing, which indicates that its professional sales efforts are taking root, the overall sales growth has dropped tremendously over the last two years. Same store growth has declined by 2.4% in 2000 and by .4% in 2001. Also, growth in new stores is much lower at 17.5% compared to historical results for new stores that are closer to 22%. This indicates that organic future growth prospects for the firm may be challenging when combined with the data from the overall market in exhibit 8. Real GDP is declining due to decreased industrial output.

Exhibit 5 shows ROC sensitivity analysis conducted for the assumptions in exhibit 8. Estimate numbers for 2004 were selected for the sensitivity analysis model, and a 5% growth target was used to determine how sensitive the return on capital is to the forecasted assumptions in exhibit 8. Initial results of the sensitivity analysis indicate that return on capital is most sensitive to the gross margin and cash operating expense over sales. A 5% growth in gross margins resulted in a positive 2.4% change in ROC, while a 5% growth in cash operating expenses over sales resulted in a negative 1.6% change. Following these two categories, P&E turnover seems to be the next assumption ROC is most sensitive to, with a positive 0.6% change as a result of the 5% growth.

Growth Target 2004E Growth Target 2004E | 5.0% | | | | 5% growth | New ROC | Change in ROC | Sales | 18.2% | 15.8% | 0.0% | Gross Margin | 33.9% | 18.2% | 2.4% | | | | | Cash OE/Sales | 21.8% | 14.2% | -1.6% | Depreciation/Sales | 1.5% | 15.7% | -0.1% | Income Tax Rate | 39.4% | 15.3% | -0.5% | Cash & ST Inv/Sales | 5.4% | 15.7% | -0.1% | Receivable turnover | 54.6 | 15.8% | 0.0% | Inventory turnover | 5.25 | 16.0% | 0.2% | P&E Turnover | 3.465 | 16.4% | 0.6% | Payables/COGS | 9.8% | 15.9% | 0.1% | Other curr liab/Sales | 4.6% | 15.9% | 0.1% |
Exhibit 5

After recognizing some of the potential future problems as indicated by current performance of Home Depot we must also compare its future cash potential against its current stock price. Exhibit 6 are excerpts from the discounted cash flow valuation of Home Depot. This is most often used for acquisition but still provides context to the aggressive sales projection initially made by Galeotafiore. Even with the continued growth Home Depot equity value falls short of the current price.

Exhibit 6
Recommendation

Home Depot and Lowes have opportunities to gain additional market share in global growth and in possible consolidation of other retail building-suppliers. However, due uncertainty in the housing market and expected higher interest rate, projected growth expectation for both firms are maybe a bit optimistic. The recommendation is for Carrie Galeotafiore to suggest a hold decision versus a buy or sell for both firms at this point in time. Home Depot has had great growth the past few years due the firm’s focus on service performance improvements, well utilized ROIC, and having early international success. Conversely, Impact from increased competition as Lowe’s is now looking to expand aggressively into the metropolitan areas growth will likely slow. In addition, an expected housing bubble and potential rise in interest rates, and growth in the overall retail supply industry will be difficult. Lowes has momentum in growing EPS, comp sales, expanding operating margin, improved capital efficiencies and new store productivity. Lowes needs to keep the already working plans in place as they look to expand into the metropolitan areas to expand and compete closer to Home Depot. However the firm must be careful as it expands into the Metropolitan areas. With Lowes plan to open 393 additional stores by 2004, there are rumblings on an impending price war. Home Depot’s larger cash flows better position them for this head to head competition. When comparing metrics, Lowes stock can be perceived as pricy compared Home Depot. Additional reliance on debt for further capital investment will be unfavorable to the firm’s shareholders.

Alternative Solutions/ Perspectives

Looking at Home Depot’s historical numbers in exhibit 7 below, Galeotafiore’s forecast seems to be reasonable if not a bit optimistic. New store numbers are forecasted at well below the average shown in exhibit 7. This is good, because as the competition heats up between Home Depot and Lowe’s, and the market gets more saturated, historical growth rates will become unsustainable. Galeotafiore’s overall forecast is sound, however it does not take into consideration the effects of a potential price war on gross margins as both Home Depot and Lowe’s start encroaching on each other’s territories. As seen in exhibit 5, ROC is very sensitive to gross margins. If Home Depot engages in a price war with Lowe’s, which is likely, forecasted gross margin and ROC numbers will be far off.

Analysis results point to the strength of both Home Depot and Lowes. The two companies have been able to grow at a steady pace, taking advantage of low interest rates and healthy market trends. However, there is much uncertainty for both companies as they chart a path forward for growth. Lowe's’ is expanding into metropolitan locations while Home Depot is expanding to suburban/rural locations, creating an environment in which fierce competition and potential price wars might ensue. Both companies are also pursuing similar strategies for growth by targeting the professional market. While a hold option seems ideal for the analysis of both companies, the alternative would be to sell due to the uncertainty brought on by the changes being pursued for growth.

Exhibit 7