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 and has become

one of the world’s largest home improvement store chains (Home Depot, 2011). 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. In 1981,

the company went public on NASDAQ and moved to the New York Stock Exchange in 1984.
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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

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:

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 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 that buy 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

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).
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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%
 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.
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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, 2011). This endeavor manifested into the company opening its first two stores in

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

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

Liquidators, 2011).

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
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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 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
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 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 (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
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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.

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.
 1-6-3 Equity Analyst Project 9
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 significant attention in the investor community with the help of its

impressive performance in the recent years. Although it has grown considerably, it is still only

half the 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.
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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
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
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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

After thorough financial analysis of the home improvement industry we have decided that

our investment choice is Lumber Liquidators. This company has one of the most profitable

business models in the home improvement market and its financial picture looks remarkable. The

level of profitability has allowed Lumber Liquidators to expand entirely from its own

operating cash flow, with no need of debt. Lumber Liquidators has strong expansionary plans

and it is only halfway to its goal of 400 stores in the U.S. The company plans to open 30 to 40

stores per year over the next several years and it has also began international expansion into

Canada. Lumber Liquidators stock usually trades at its premium, but unfortunately the housing

market decline has drown stock prices by 30% and creates an opportunity for us to apply the

basic rules of investing into the stock market; buy low, sell high. Comprehensive financial and

business environment analysis equipped us with the information to be certain that Lumber

Liquidators Inc has best potential among industry competitors that will result in the highest

returns within the next 12 months. With current expectations that the housing market will

recover, we are looking at a highly undervalued company with a lot of room for growth. The

company has a strong brand in the home improvement market which is ready for consolidation.
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Lumber Liquidators ability to generate cash gives us confidence that our investment choice will

definitely be lucrative.
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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 from http://www.investorguide.com/article/447/lowes-nails-down-q1-

profit-provides-cautious-outlook-low/

Lumber Liquidators. (2011). 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

Figure 1.