AAM THOUGHT LEADERSHIP
A Tale of Two Retailers
In this thought leadership piece, we analyze the home improvement sector of the retail industry. The two
largest competitors in this segment, Home Depot and Lowe’s, have been battling it out for years. Given the
size of the U.S. home improvement market (estimated as $570 billion1), they are also two of the largest
retailers in the world. Also, we will review the current and expected prospects for the industry, compare and
contrast the two companies, and finally, disclose which company we believe is the better opportunity for
corporate bond investors.
Industry Overview
One thing is for sure, home improvement retailers have been impacted by the downturn in the housing
market. In addition to a bad real estate market, credit is tight, consumer confidence is historically low, and
unemployment is high. Management at both Home Depot and Lowe’s agree that their companies’ growth has
decoupled from the housing market and is now more reliant on GDP growth. These retailers’ allocation of
sales to more expensive, discretionary type purchases (major remodel projects) has come down to about
30% of the total. The Cost vs. Value survey conducted by Remodeling Magazine, which estimates the return
of remodeling projects, continues to show a downward trend (Exhibit 1). One good sign is that remodeling
costs are beginning to come down, as contractors become more competitive and consumers look to scale
down on quality and/or options. Unfortunately, home values continue to fall, making it less attractive and/or
financially feasible for home owners to remodel. This should keep the ratio low for the foreseeable future
since we believe that it will be years before we experience a sustained recovery in home prices.
Exhibit 1
Smaller scale replacement projects, like putting in
a new garage door or adding a wood deck, are
expected to be the primary source of growth until
we see the housing market return in the U.S..
After all, for most Americans, our house is our
largest asset. It needs to be kept up and it’s fairly
easy, these days, for the typical homeowner to
take on a small to intermediate sized project. In
addition, consumers will continue to spend on
maintenance items including light bulbs and
garbage bags.
Cost vs. Value 8-Year Trend
Source: “Cost vs. Value Report”; www.remodeling.hw.net
While Home Depot and Lowe’s have struggled through the recession, there are some signs that home
improvement spending has, at least, stabilized. Various economic indicators, while weak, are off the lows
seen in early 2009. A look at Bloomberg’s survey of Real GDP growth shows a gradual increase to 3% over
the next couple of years for the U.S. The Remodeling Market Index (RMI), created by The National
Association of Home Builders, shows a slow improvement in remodelers’ perception of the current and
future market for residential projects (Exhibit 2). The RMI is created through a combination of current
remodeling activity and indications of future activity.
___________________________
1
Lowe’s 10-K, December 31, 2010 (pg. 5)
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AAM THOUGHT LEADERSHIP
A Tale of Two Retailers
An RMI of under 50 still means that more remodelers report market activity is lower than report it is higher,
compared to the previous quarter.
Exhibit 2
RMI
Remodeling Market
Index (RMI)
70
RMI
60
50
(%)
40
30
20
10
0
1st Qtr 3rd Qtr 1st Qtr 3rd Qtr 1st Qtr 3rd Qtr 1st Qtr 3rd Qtr 1st Qtr 3rd Qtr 1st Qtr 3rd Qtr 1st Qtr 3rd Qtr 1st Qtr
2004
2004
2005
2005
2006
2006
2007
2007 2008
2008
2009
2009
2010
2010
2011
Source: “Remodeling Market Index”; http://www.nahb.org/fileUpload_details.aspx?contentID=137354
A historically high share of homeownership, an increasing age of housing stock, improving demographics
(i.e., growth strong in the 55+ age of households, gen-Xers are reaching peak earning years, female home
ownership is up), along with the expectation of improving household income bode well for home
improvement spending in the future.
Store Results
The trends in the economy are evident in the same store sales numbers for Home Depot and Lowe’s. Home
Depot has outperformed Lowe’s for the last eight quarters (Exhibit 3). Home Depot has done this mostly
through increased traffic. One of Home Depot’s big initiatives was to improve the look and layout of its
stores and to increase its customer service. Home Depot has a reputation for lower prices and more profriendly atmosphere where Lowe’s is trying to capture the traditional do-it-yourself customer. Lowe’s tries to
attract the female customer, who the company claims, is responsible for 80% of home improvement
decisions.
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AAM THOUGHT LEADERSHIP
A Tale of Two Retailers
Exhibit 3
SameSame
Store
Sales
Store
Sales
6
4
2
0
(%)
-2
1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11
-4
-6
-8
-10
HD
-12
LOW
-14
Source: Christopher Horvers, “What We Learned from 1Q”, JP Morgan,
May 17, 2011, page 10 (Lowe’s) page 11 (Home Depot).
Big ticket item sales for both have been weak. This makes sense given the slowdown in major renovation
activity that we wrote about earlier. Having said that, there have been some signs of life. In the fourth
quarter of 2010, Home Depot’s big ticket category was up 10% from a year ago (Exhibit 4). Consumers took
advantage of tax credits in higher efficiency products including appliances, windows, and HVAC. This is not
a trend we expect to continue as evidenced by First Quarter 2011 results.
Exhibit 4
Big Ticket
Big Ticket
SameSSS
Store Sales
15
10
5
(%)
0
1Q09
2Q09
3Q09
4Q09
1Q10
2Q10
3Q10
4Q10
1Q11
-5
-10
HD (>$900)
-15
LOW (>$500)
-20
Source: Matthew Fasler, “Living To Find Another Day; Still Prefer HD”, Goldman
Sachs, May 17, 2011, page 6.
Home Depot or Lowe’s
In terms of financial performance, Home Depot has outperformed. Operationally, Home Depot has followed
through on its initiatives to improve its supply chain logistics and merchandising efforts. While both
companies have improved margins and growth, Home Depot has executed at a higher rate (Exhibits 5 and
6). Not only is Home Depot improving the bottom line because of operational enhancements, but it is also
SECOND QUARTER 2011
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AAM THOUGHT LEADERSHIP
A Tale of Two Retailers
increasing market share given efforts to drive the top line.
Exhibit 5
Exhibit 6
EBIT Growth
EBIT Margin
EBIT Margin
60%
10%
40%
8%
20%
6%
0%
EBIT Growth
Fe
b08
M
ay
-0
8
Au
g08
N
ov
-0
8
Fe
b09
M
ay
-0
9
Au
g09
N
ov
-0
9
Fe
b10
M
ay
-1
0
Au
g10
N
ov
-1
0
Fe
b11
12%
-20%
4%
HD
2%
LOW
HD
-40%
LOW
-60%
Fe
b08
M
ay
-0
8
Au
g08
N
ov
-0
8
Fe
b09
M
ay
-0
9
Au
g09
N
ov
-0
9
Fe
b10
M
ay
-1
0
Au
g10
N
ov
-1
0
Fe
b11
0%
Source: Margin & Growth data from Capital IQ
Leverage (adjusted for rental expense) and coverage have been steady for both Home Depot and Lowe’s.
Over the past five years both companies have decided to add leverage to their balance sheets to benefit
shareholders via sizable share buybacks. Home Depot has had a more dramatic change in credit profile, as
exemplified by credit ratings which fell from low double-A to high triple-B in 2007. Home Depot announced
a $22.5 billion share repurchase plan and sold its HD Supply business. Home Depot decided to put the
share repurchase plan on hold as management became concerned with the economic landscape. A leverage
target of 2.0 – 2.5 times (X) was put in place. At the end of 2010, Home Depot had approximately $10
billion still available under its share repurchase plan. In the first quarter of 2011, the company issued $2
billion of senior unsecured bonds. Of that issue, $1 billion was used to repay upcoming debt and the other
$1 billion was used to repurchase stock. We would expect Home Depot to continue to use debt to buyback
stock so long as the company stays within its leverage guidelines. Lowe’s recently increased its leverage
target to 1.8X from 1.5X. In the first quarter of 2011, Lowe’s repurchased $1 billion of stock. The company
has $1.4 billion available under the current repurchase plan. When you compare adjusted leverage and
coverage for both companies, Lowe’s has been operating with a more moderate balance sheet. Through the
economic recession both companies managed their cash flow in a very conservative manner by halting new
store openings and freezing share repurchase plans.
As shown in Exhibit 7, both companies demonstrate strong liquidity.
Exhibit 7
Liquidity Profile
Home Depot
$4,644
$1,128
$1,573
$1,943
Lowe's
$3,539
$1,359
$589
$1,591
Balance Sheet Cash
$1,806
$1,841
Credit Facility Availability
$2,000
$1,750
$43
$38
Total Liquidity
$5,706
Source: Capital IQ and Company 10-K Reports
$5,144
Cash from Operations
- Capex
- Dividends
= Free Cash Flow
Short Term Debt
SECOND QUARTER 2011
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AAM THOUGHT LEADERSHIP
A Tale of Two Retailers
Lowe’s $1.75 billion credit facility matures in June 2012. Lowe’s next debt maturity is not until 9/15/12
($550 million). Home Depot’s $2.0 billion credit facility matures in July 2013. Home Depot’s next debt
maturity is not until 12/16/13 ($1.25 billion). Also, both companies own a large percentage of their
stores/real estate with very limited secured financing in place. Lowe’s owned about 89% of its stores with a
net book value of $22.1 billion at the end of 2010. Home Depot owned 89% of its stores with a net book
value of $25.1 billion at the end of 2010. This is an important asset for bondholders, although we have
seen with other retailers (e.g., Target) that real estate ownership can attract active shareholders who want to
monetize the assets. Having said that, Home Depot is in a better defensive position given its already large
debt position, triple-B credit rating, and large market value.
Both companies are very well diversified across the U.S. with a presence outside of the US as well.
Exhibit 8
Exhibit 9
Lowe’s Store Locations
Home Depot Store Locations
Home Depot has a larger footprint than Lowe’s except for the Southwest region (see exhibits 8 & 9). Home
Depot has a significantly larger presence in major metropolitan markets in California, Illinois, Minnesota,
New York, Massachusetts, and Florida. California and Florida are two of the states most adversely impacted
by the housing crises. Home Depot has 10% (231 stores) of its stores in California and 7% (153) of its
stores in Florida while Lowe’s has 6% (109) in California and 7% (118) in Florida. We expect that Home
Depot’s larger exposure to these markets will, at some point, provide a bigger uplift to Home Depot’s results.
Also, in an effort to catch up with Home Depot, Lowe’s will need to be more aggressive in terms of new store
openings which will be a larger drag on free cash flow.
Home Depot is currently rated Baa1/BBB+/BBB+ and Lowe’s is rated A1/A/A. Based on our analysis we
believe these credit ratings are too far apart. We would expect the ratings to converge somewhere around low
to mid single-A as the overall retail environment improves. Given the current operational momentum at
Home Depot and our expectation that leverage stays within guidelines, we believe ratings will get upgraded
into the single-A category. Management at Lowe’s says they want to keep their A1/P1 commercial paper
rating which would equate to a A2/A long term rating. We think Lowe’s leverage target will continue to be
loosened, as equity holders push for more share buybacks and leverage.
__________________________
All financial data from Capital IQ and Company 10-K Reports
SECOND QUARTER 2011
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AAM THOUGHT LEADERSHIP
A Tale of Two Retailers
Home Depot 10-year bonds (HD 4.4% 4/1/21) are offered at a spread of +118/10 year. Lowe’s 10-year
bonds (LOW 3.75% 4/15/21) are offered at a spread of +80/10-year. Over time we believe that this 38
basis points difference between the two credits will shrink to 10 basis points or so. One interesting thing to
note is that both credits trade on top of each other in the credit default swap (CDS) market, which reflects
only credit risk. After analyzing these two retail giants, we believe that Home Depot offers the better
opportunity for bondholders.
Written by:
Michael J. Ashley
Vice President, Corporate Credit
For more information, contact:
Joel B. Cramer, CFA, Director of Sales and Marketing
joel.cramer@aamcompany.com
Greg Curran, CFA, VP, Business Development
greg.curran@aamcompany.com
30 North LaSalle Street
Suite 3500
Chicago, IL 60602-2508
312.263.2900
www.aamcompany.com
Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange
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