Value

Line
Applied Corporate
Finance
Publishing
Abdullah Ahmed

Muhammad Waqas ARIF

Rida Azam

Ahsan Butt

Group: 5

The Case:
This case follows the performance review and financial-statement-forecasting decisions
of a Value Line analyst for the retail building-supply industry in October 2002. Home depot and
Lowe are merchandising companies which operate in the same market including initiatives
aimed at bettering customer service, attracting professional customers and creating a more
favourable merchandise mix. The case contrasts the strong operating performance of Home
Depot with the strong stock-market performance of Lowe's. The historical-performance
comparison suggests that investors are sceptical of the ability of Home Depot to maintain its
performance trajectory, yet they project sustained improvements for Lowe's. Moreover, the
strong-growth assumptions for Home Depot relative to the modest-growth forecast for the
industry suggest that the company can be expected to capture massive and perhaps unreasonable
market share in the near term..
Financial Ratios Analysis:
The gross margin of Home Depot shows a higher 5 year average as compared to Lowes. For
Home Depot, it is 30.5% while for Lowes it is 27.6%. The gross margin represents the percent
of total sales revenue that the companies retain after incurring direct costs with producing the
goods and services sold. The average operating margin of Home Depot is 9% as compared to
that of Lowes 7.2% but in Graph 3 we can see that Lowes is showing a steady increase in its
operating margin as compared to fluctuating behavior shown by Home Depot. This can also be
seen in Graph 2 where NOPAT margin fluctuated for Home Depot but showed a steady increase
in Lowes. This is consistent with Galeotafiore remarks that Lowes entrance into metropolitan
areas is expected to provide solid results. The average operating cash expenses over sales of
Lowes were better than that of Home Depots. So, here Lowes shows more strength than Home
Depot as it was stronger in improving operating efficiencies. Additionally if we look at the return
on equity of both companies then currently it shows higher ROE for Home Depot than Lowes.
But in Graph 5 it can be seen that after year 1999 Home Depot has shown a decreasing return on
equity as compared to increasing trend shown by Lowes. Although the 5 year average of Lowes
is around 3% lower than Home Depots but the difference between the two Returns is decreasing
because of the opposite trends shown by two companies. In year 2001 it was 15.3% for Lowes
while 16.8% for Home Depot. This improvement is expected to continue in future due to positive
sales trends and product mix improvements so a rational investor is expected to invest in Lowes.
Sensitivity Analysis:
To achieve 12.3% of cost of capital Carrie Galeotafiores estimates need to be changed a
bit. As it could be seen in Exhibit 2 Table 1, we applied solver to return on capital, by changing
values of gross margin, cash operating expenses, receivable turnover, inventory turnover and
P&E turnover. We could infer that we need to decrease home depot gross margin from 32% to
30.8%. Cash operating expense to sales are to be increased from 21% to 21.5% as we are aiming

to decrease the return on capital to reach a breakeven point on 12.3%. Other changes that are
necessary are decrease in Receivable turnover from 55 to 54.97, Inventory turnover from 5.26 to
5.24 and P&E turnover from 3.3 to 3.27. Current estimates show that Home Depot is performing
better than the minimum required rate.
To study impact of sales growth in changes in return on capital we used scenario
manager. Findings could be seen in Exhibit 2 Table 2. We changed the sales growth rate by 10%
and 15% both increase and decrease and found that sales growth is not sensitive to return on
capital because the returns are based on margin and with increase in sales expenses would
increase proportionately thus it would not affect return on equity to a large extend.
Citical Assumptions of Galeotafiores:
Galeotafiores forecast seems to have some valid points and a drawback as well. First of all, the
assumption about the growth of sales at a decreasing rate shows a realistic picture of Home
Depot. According to our analysis, we have come to the conclusion that the forecasted sales are
increasing at a decreasing rate showing the sign of market maturity as the case mentions that
annual growth had declined from 7.7% in 1998 to 4.2% in 2001.
Secondly, Galeotafiores assumption about the relatively constant gross margin also seems to
hold some grounds. The forecasted gross margin is relatively constant showing that author has
taken into account the presence of fierce competition between Home Depot and Lowes as the
prices cannot be changed significantly by the competitors due to price-war.
Thirdly, the assumption about the growth of Home Depot stores seems to be realistic. It shows a
declining trend in the growth of stores indicating that she has taken the industry cycle into
account.
However, the forecast doesnt provide a picture of increasing operating expenses. According to
the case, operating costs had increased owing to higher occupancy costs for new stores and
increased energy costs. So according to our analysis, rising operating costs should be taken into
account in order to forecast it more precisely.
Assumptions for Financial Forecast of Lowes:
Growth in New Stores
Lowes planned to open 123 stores in 2002, 130 stores in 2003 and 140 stores in 2004. After that
we have assumed that the Lowes grows at an average of these numbers since it plans to continue
its emphasis on cities with populations greater than 500,000.
Growth in Existing Stores
Weve taken the growth of houses in the industry from exhibit 6 and have applied the growth rate
for the house starts in the market.
Gross Margin

Gross margin is assumed to be almost constant for Lowes since the gross margin of Home
Depot is also relatively constant. Due to the intense nature of competition between these two
market leaders, we can reasonably assume that the gross margin of Lowes will also be almost
constant because of the price war with Home Depot.
Cash Operating Expenses/Sales
As it showed a fluctuating behavior in last 5 years so the average of 18.1% is assumed to be a
reasonable assumption.
Receivable Turnover
Weve linked it with the total sales growth as it is assumed that the receivable turnover rate will
increase proportional to sales.
Conclusion:
To sum up, we have come to the conclusion that Lowes will perform better than Home Depot in
the future. Firstly, The Price to Earnings Ratio of both the companies shows a marked difference.
The P/E ratio of Lowes is 28.34, approximately 50% higher than of Home Depots; 19.38. The
higher P/E ratio shows an increased willingness of an investor to pay to Lowes. This also
indicates that the investors are anticipating a higher growth in future for Lowes than Home
Depot and in turn there would be an increased inflow of funds into the company. This could in
turn harm Home Depot substantially since almost all of its capital (98%) is dependent on equity
and decreased investment into their stocks could cause problems in covering up expenses and
carrying out further expansion.

EXHIBITS

EXHIBIT 1:
Graph 1:
32.0%
30.0%
LOWE GM

28.0%

HOME DEPOT GM

26.0%
24.0%
1997

1998

1999

2000

2001

Graph 2:
3500
3000
2500
2000
1500
1000
500
0
1997

LOWE NOPAT
HOME DEPOT NOPAT

1998

1999

2000

2001

Graph 3:
12.0%
10.0%
8.0%

LOWE Operating margin

(EBIT/Sales)

6.0%

HOME DEPOT Operating

margin (EBIT/Sales)

4.0%
2.0%
0.0%
1997

1998

1999

2000

2001

Graph 4:
20.0%
15.0%
LOWE Return on
capital

10.0%

HOME DEPOT Return

on capital

5.0%
0.0%
1997

1998

1999

2000

2001

Graph 5:
20.0%
15.0%

LOWE Return on
equity

10.0%

HOME DEPOT Return

on equity

5.0%
0.0%
1997

1998

1999

2000

2001

Exhibit 2:
Table 1

Table 2

EXHIBIT 3

Exhibit 4: