Assignment 1-6-3 Equity Analyst Project

Team Analysis of Companies within an Industry Group

Home Improvement Stores

MBA 737-F3WW

BY

Daniel H. Lavely
Manuel Lopez
Kimberly Salva
Jill Shin
Tamia Stewart

For

Franklin University

Professor J. Cable

March 26, 2011

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Introduction

The home improvement industry dates back as far as the 1920s when several small

family-owned businesses began, as well as one of the nation’s best known home improvement

locations today - Ace Hardware. Since those early days several other companies have joined the

ranks of well-known home improvement locations. These include, but are not limited to, True-

Value, Lowe’s, Menard’s, Lumber Liquidators, and Home Depot. This portion of the equity

analyst project requires Team 2 to determine which public firm classified within the industry

should be selected as the most promising investment. Due to the fact that several of the

companies within the home improvement industry are not publicly traded, Team 2 has decided to

evaluate the following three companies: Home Depot, Lowe’s and Lumber Liquidators. Based

on the results of the financial statement analysis and stock valuation for each of the three

companies, a decision as to which company would be the best investment will be made.

Home Depot

Company Background

The Home Depot was founded in 1978 by Bernie Marcus and Arthur Blank (Home

Depot, 2011), and has become one of the world’s largest home improvement store chains. The

Home Depot has 1,972 convenient locations throughout the United States (including the

territories of Puerto Rico and the Virgin Islands), Canada, China and Mexico. Stores average

105,000 square feet with approximately 23,000 additional square feet of outside garden area.

When you consider that Home Depot’s competitors (such as Lowe’s) have been around for much

longer periods of time, the fact that Home Depot has been able to grow so successfully is no

small feat. The first two Home Depot stores were opened in August of 1979 in Atlanta, Georgia.
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In 1981, the company went public on NASDAQ and moved to the New York Stock Exchange in

1984. The 1980s and 1990s spawned tremendous growth for the company, with 1989 marking

the celebration of its 100th store opening. The company arrived in Canada with the acquisition of

Aikenhead’s Home Improvement Centers in 1994, and it began flying its flag proudly in Mexico

in 2001 with the acquisition of Total HOME. In 2006, the company extended its reach to China

by acquiring The Home Way, a 12-store chain.

Financial Statement Analysis

In order to make an educated choice as to whether Home Depot is a viable organization

to invest in for future growth and returns, an analysis of the financial statements must occur. The

following measures will be evaluated to determine if Home Depot will be recommended: current

ratio, total debt ratio, inventory turnover (including day’s sales in inventory) receivables

turnover, total asset turnover, profit margin and return on equity. By determining these measures,

an overall financial picture of the organization can be seen. These measures are based on Home

Depot’s reported results for the fiscal year ending January 31, 2010.

• Current Ratio – 1.34

• Total Debt Ratio – .526
• Inventory Turnover – 4.3 times
• Day Sales in Inventory – 84.88 days
• Total Asset Turnover - .55 times
• Profit Margin – 4%
• Return on Equity – 14%

Stock Valuation

The next area that requires evaluation in the effort to determine if Home Depot is a

worthwhile investment is the stock valuation. This analysis will focus on Home Depot’s stock
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and how it performed over the course of the past year. Based on Home Depot’s most recent

annual report, the following stock valuation information was found:

• Outstanding Common Shares (in millions) - 1,683

• Earnings per Share (EPS) - $1.58
• Diluted Weighted Average Common Shares (in millions) – 1,692
• Diluted EPS - $1.57
• P/E – 17.91

For the fiscal year ending January 31, 2010, Home Depot stock had an average four-

quarter high of $27.52, an average low of $22.61, and an average cash dividend declared of

$0.231. Further investigation reveals that the Home Depot stock has performed in a consistent

fashion when compared to the S&P 500 and the S&P Retail Composite (Appendix – Figure 1),

with all three averages reflecting the impact of the economic downturn of 2008 and 2009.

Lowe’s

Company Background

Similar to Home Depot, Lowe’s operates as a home improvement retailer in the United

States and Canada. The company offers a range of products for home decorating, maintenance,

repair, remodeling, and property maintenance. It provides a wide variety of home improvement

products, such as appliances, flooring, lawn and landscape products, hardware, seasonal living,

and home organization. The company also offers installation services through independent

contractors in various product categories. Lowe's serves homeowners and renters primarily

consisting of do-it-yourself customers and do-it-for-me customers, as well as others buying for

personal and family use, commercial business customers, commercial and residential property

management, and business maintenance professions. As of January 29, 2010, Lowe’s operated

1,710 stores, including 1,694 stores in the United States and 16 stores in Canada. The company
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also offers its products through electronic product catalogs and Lowes.com. Lowe's Company,

Inc. was founded in 1952 and is based in Mooresville, North Carolina (Lowe’s Annual Report,

2010).

Financial Statement Analysis

The consolidated balance sheets for January 2010 proved to be strong after a close

analysis. Merchandise inventory is high in the balance sheet, but normal in relation to the type of

business where most of the products are readily available in a brick and mortar building. In

addition, Lowe’s has an e-commerce site where purchases can be made online. The online store

has been able to increase sales with a minimum overhead compared to their physical locations.

Lowe’s is a company that has been affected by the “great recession,” but it has also been

preparing for the future by cutting costs and effectively using marketing campaigns, such as their

Creative Ideas magazine, internet searches and direct mail. In addition, their Everyday Low

Prices strategy continues to resonate well with customers. Such measured steps have helped them

leverage the marketing expense as a percentage of the sales. Furthermore, improving customer

service and inventory management have always been priorities, but it has been more critical

during the economic downturn.

The following data provide a more detailed look in to the financial aspects of the

company:

• Quick Ratio - .20

• Cash Ratio - .08
• Total Debt Ratio - .42
• Total Asset Turnover – 1.4 times
• Profit Margin – 3.7%
• Dividend Yield – 1.64%
• Sales Growth – 3.4%
• Debt to Equity Ratio - .36
• Net Profit Margin – 4.12%
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• PE Ratio – 18.76

Stock Valuation

As seen above, data obtained and analyzed from Lowe’s financial statements as of

January 30th, 2010, showed Lowe’s as a stable company that has been able to survive the

recession. However, the PE ratio of stock is 18.76. A high P/E suggests that investors are

expecting higher earnings growth in the future compared to companies with a lower P/E (Lowe’s

Annual Report, 2010). If we compare this to Home Depot’s P/E of 17.88, we can see that the P/E

ratios of both companies are about the same. This means that investors are willing to pay about

the same amount per dollar of earnings for both companies.

The outlook for the No. 2 U.S. home improvement chain was particularly surprising after

it reported stronger-than-expected quarterly results. Lowe’s forecasted second-quarter earnings

of 57 cents to 59 cents a share. The company reported an increase in big ticket items and some

analysts think that the increase will turn into more revenue during the quarter. While Lowe’s will

experience a solid demand throughout the remainder of the year, 2011 will be a year of transition

for the home building industry (Investorguide, 2010).

Lumber Liquidators

Started in 1993 by Tom Sullivan, Lumber Liquidators began when Mr. Sullivan

purchased and resold left over wood from other companies to be sold to trucking firm yards

(Lumber Liquidators, 2011a). This endeavor manifested into the company opening its first two

stores in 1996, followed by many more over the next 10 years (Lumber Liquidators, 2011a).

Lumber Liquidators currently has over 200 hundred locations and is headquartered in Virginia

(Lumber Liquidators, 2011a).

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Lumber Liquidators Holdings, Inc. operates as a specialty retailer of hardwood flooring

in the United States. The company offers an assortment of wood flooring products that include

prefinished domestic and exotic hardwoods, engineered hardwoods, unfinished hardwoods,

bamboos, cork products, and laminates, as well as resilient flooring products. The company

offers its products primarily under its private label brands, including the premium Bellawood

brand floors. It sells its products primarily to homeowners or to contractors on behalf of

homeowners. The company markets its products through integrated sales channels comprising of

stores, a call center, and a catalog, as well as through its Website, lumberliquidators.com. As of

December 31, 2010, it operated approximately 223 stores.

Financial Statement Analysis

Lumber liquidators intends to increase 2011 net sales and profitability through

strengthening their market position, gaining market share, and increasing store base counts in

both existing and new markets. The total expected growth rate is 12.8%; 3% is expected from

comparable store sales, and 9.8% is expected in new store sales (Lumber Liquidators, 2011).

The financial condition of the home improvement industry and results of operation have

and may continue to be affected by various economic factors. Deterioration of the current

economic environment could lead to reduced consumer and business spending. It may also shift

consumer spending to products that do not sell as profitably. Further, access to credit has and

may continue to adversely affect the ability of consumers to pursue home improvements,

purchase new homes, and/or purchase foreclosed homes that are in need of repair. If these

conditions deteriorate in 2011, the industry, business and results of this industry may be severely

impacted. Furthermore, companies within the home improvement industry are highly dependent
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on remodeling of existing homes and new home construction, which depend on a number of

factors that are beyond management control, such as:

• Interest rates
• Tax policies
• Employment Levels
• Consumer Confidence
• Credit availability
• Real estate prices
• Demographic trends
• Weather conditions
• General economic conditions

The above factors could impact sales for the home improvement industry if the national

or local economies weaken, interest rates rise, regions experience unfavorable demographic

trends, fuel costs or utility expenses increase, and housing price depreciation continues on a

declining trend.

Another potential negative impact involves importing raw materials due to the unstable political

environment in the Middle East. Several companies within the home improvement industry rely

on services and materials provided by companies residing in Asia. If these suppliers become

financially unstable or experience trade restrictions, this may cause the home improvement

industry to experience deterioration in net sales and operating results. Currency exchange

fluctuations and changes in local economies could also impact operating results for this industry.

Lumber Liquidators’ success will depend on their ability to attract, train, and retain

highly qualified managers who can successfully execute an integrated strategic plan for 2011.

This market is highly fragmented and competitive, which competes on the basis of price,

customer service, location, and quality. Increased competition could result in price declines and a

decrease in the demand for products, which can impact the market share for Lumber Liquidators
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(Lumber Liquidators, 2011). Their success will depend on the continued effectiveness of their

strategic and advertising strategy.

The home improvement industry is dependent on home-related discretionary spending,

which in turn is influenced by a number of complex economic and demographic factors. Lumber

Liquidators expects economic weakness to continue in 2011, with only a gradual improvement

throughout the year when compared to 2010. Lumber Liquidators is also expecting to obtain

growth through store based expansion and only a slight realized growth in same store sales. The

following are the most current financial ratios for the company:

• Current = 3.58
• Quick Ratio = .76
• Cash Ratio = 1.26
• Debt ratio = .23
• Asset Turnover = 2.56
• Profit Margin = 4.2%
• Dividend Yield = 0
• Debt to Equity = .31
• Outstanding shares: Basic = 27,384,095 EPS Basic = $0.96; Diluted = 28,246,453
EPS Diluted = $0.93
• Stock Price at YE: $27
• P/E Ratio: 26.35
• P/E G = 1.05
• Sales growth: 2010 (2.4%) 2011 - 12.8%; 9.8% from expansion in store base and
3.0% from same store sales increase.

Stock Valuation

Lumber Liquidators does not pay dividends, instead they reinvest owner equity in the

hopes of maintaining and growing market share and earnings. Data obtained and analyzed from

Lumber Liquidators’ financial statements show that there was an overall increase in earnings, but

current economic conditions have impeded growth severely. Lumber Liquidators appears to have

stable operations and reasonably survived the recent strains on the economy, real estate crisis,

and financial market decline.

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The P/E ratio of stock is 26.35, suggesting that investors are expecting higher

earnings growth in the future compared to companies with a lower P/E. If the P/E ratio is

compared with major competitors, such as Lowe’s and Home Depot, who have ratios of 18.76

and 17.91 respectively, we can see that the P/E ratios of the competition are lower. This statistic

is consistent with the projected growth and sustainability that Lumber Liquidators has promised.

Summary

Home Depot has shown excellent performance and it should be able to maintain this in

the future. It has the highest margins and value in the home improvement industry. Although not

showing signs of improvement, the ROA and gross profit margins remain high.

The company was very attractive to investors in the 1990’s, but unless it adapts to more

aggressive growth strategies, it will have difficulty in attracting future investors with its steady

but slow growth. In addition to focusing on the competitive pressures from Lowe’s, it should get

ready for the strong rivalry from Wal-Mart, as well. Home Depot has transformed the home

improvement industry, but Wal-Mart could very well take it over as it did for the other price

sensitive retailing industries.

Lowe’s has serious debt burden that increases its risk level drastically. An average 130%

debt to equity is too much for any industry, not to mention for retailing where the growth and

margin levels are relatively lower compared to other industries such as high-tech. We are

expecting Lowe’s to slow down its impressive expansion and start paying down its debt. This

could be a smarter move, considering the expected slowdown in the housing market in the short

term due to higher interest rates.

Lowe’s has caught a lot of attention in the investor community with the help of its

impressive performance in the recent years. Although it has grown a lot, it is still only half the
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size of Home Depot. To continue growth, Lowe's has to battle Home Depot on its home turf,

expanding into big markets such as Boston and New York. This could be a risky strategy, but

there seems to be plenty of room to grow: Lowe's now has only 50% of its stores in metro

markets, so there is still a considerable market share to gain. As soon as Lowe’s fixes its debt

ratio we are expecting its stock to perform much higher than its industry average.

According to our analysis we had a very clear picture of Home Depot and Lowe’s being

the major players in this industry; however, Lumber Liquidators has the most room for

sustainable growth and, therefore, healthy returns on investment. During the past decade, Home

Depot was the most successful retailer of the home improvement industry. However, starting

from the end of the 1990’s, Lowe’s, Lumber Liquidators and Wal-Mart have adapted very

aggressive and risky strategies of rapid expansion especially in areas that Home Depot occupies.

Since Lumber Liquidators does not pay dividends and does not plan to pay dividends, their

expansion needs will be financed through shareholder investment.

This risky strategy has a very low tolerance for any negative developments and failure.

Fortunately, the home improvement industry enjoyed a rapid expansion even in the recession

years of 2001 and 2002 due to historically low interest rates. Therefore the risky move of

expansion in economically tough times is projected to pay off for Lumber Liquidators.

The home improvement industry is still growing and will continue with the help of an

improving housing market. Analysts agree that low rates will keep the market growing for the

time being; however, they are not so optimistic for the near future where the rates are expected to

move upwards as the economic expansion continues and FED abandons its position on low rates

policy. Overall, the home improvement industry will enjoy a satisfying growth level as the

number of homeowners increase in the US. This is dependent on three factors:

1) Mortgage rates
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2) Growing population
3) Increasing personal income

As long as these factors are maintained in preferable levels, the housing market and

related industry of home improvement will keep on growing. Our prediction for the industry is

very positive as we expect the U.S. population to maintain its 1.0% population growth, fueled by

constant immigration, as well as the high volume of growing families. We are expecting the

interest rates to increase from rock bottom levels of below 6% for 30 year mortgages to levels of

around 7.0%, based on the FED’s recent predictions. This should put pressure on the housing

market, but we believe the increasing levels of personal income will compensate for it.

Ultimately, the growing economy should help improve the amount of discretionary funds able to

be spent in this industry.

Conclusion
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References

Home Depot. (2011). Our history. Retrieved March 16, 2011 from:

http://corporate.homedepot.com/wps/portal

Investorguide. Lowe’s Nails down Q1 Profit; Provides Cautious Outlook (LOW). Retrieved on

March 15, 2011. http://www.investorguide.com/article/447/lowes-nails-down-q1-profit-

provides-cautious-outlook-low/

Lumber Liquidators. (2011a). About Us. Retrieved March 15, 2011 from

http://www.lumberliquidators.com/cus...FOOTER_AboutUs

Lowe’s Annual reports. Retrieved on March 15th, 2009 from

http://www.lowes.com/AboutLowes/AnnualReports/annual_report_09/pdf/Lowes_2009A

R_bookmarks.pdf

Yahoo Finance (2011). The home depot, Inc. Retrieved March 16, 2011 from:

http://finance.yahoo.com/q?s=HD

Yahoo Finance (2011a). Lumber Liquidators Holdings, Inc. Retrieved March 17, 2011 from

http://yahoo.brand.edgar-online.com/...l/EDGARpro.dll.
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Appendix A

Figure 1.