Category: Featured

In-depth analysis or commentary on companies, securities, or the economy

Is it Time to Buy Cruise Stocks? Pt 2 $CCL $NCLH $RCL #COVID19

It’s always a pleasure to share these pages with like-minded people. Today’s post was written by a very smart, very diligent guy — who just so happens to be a long-time friend of mine. During COVID-19, he’s scrutinized one of the most “center of the storm” sectors: the cruise line stocks . I was thrilled when he accepted the invitation to share his thoughts and work on the blog. I know you will be, too.


With almost five months of lockdown behind us, logic would tell most that the outlook for the cruise industry has gone from bad to worse. As you’d expect, most cruise lines have spent the last few months pulling together survival dollars for what could be the worst storm to hit while not sailing. But even in the darkest of times, could there be light at the end of this tunnel? Article #Is it Time to Buy Cruise Stocks? Intrinsic Value Impact from Coronavirus identified what I think is a very counterintuitive point – even when some of the most horrific events have hit cruise lines, their demand has been remarkably resilient in the following year(s).

For those who like bottom lines up front – I think CCL probably has best chance of survival, and a lot of assumptions used in this analysis are pretty conservative. This is a big gamble, and I’m not expecting any potential pay off until 2022 at the earliest (although reckless day traders may create some wild ups and downs along the way), but the payoff could be exceptional.

The case for strong demand recovery

So what happened after a massive pandemic hit, confining people to their homes in March and April…see Carnival swamped with cruise bookings after announcing August return or What pandemic? Carnival Cruise bookings soar 600% for August trips. When CCL announced cruise returns in August 2020, bookings shot up, with the spike reflecting a 200% increase in bookings over the same period in the prior year.

Who are these people making these bookings? Will these spikes in demand last? Even if there is strong demand, won’t governmental restriction stymie all chances for recovery here?

All great questions. The first two cannot really be answered definitively. If the past can be used to determine the future, it is fair to say that cruise demand has historically come back strong even after disastrous events. Further, many people seem to be of the mindset that Covid is here to stay, and are accepting its spread while hoping for a low death rate (whether this is an ethically acceptable position is an entirely different discussion and far out of the scope of this article’s analysis).

The last question is probably the most important here – where does governmental restriction fit in all of this? In my opinion, it is the most important final step in the recovery. If demand is there, but governments forbid sailing, then demand becomes irrelevant. Your guess is as good as mine here, but demand assumptions for the rest of this analysis are:

  1. No more cruises will sail in 2020 – only revenue accumulated was Q1’20, with a complete halt to revenue for the remainder of the year.
  2. Demand in 2021 is 50% of what it was in 2019.
  3. 2022 resembles normal operations – EBITDA falls somewhere between the min and max annual EBITDA generated in 2017, 2018, and 2019.

After diving into the financials of CCL, RCL, and NCLH (“The Big 3”), it looks like these three cruise lines have the ability to survive into next summer with no cruise activity. While some of these may be able to last longer, failure to resume sailing in the peak season for cruises (i.e. the North American summer months) would likely be a final dagger for these businesses. CCL looks best poised to survive of the three, so more of the below will focus on them. Note that as of date of this post, cruises in the US will not resume until October for The Big 3; however, some European cruises are still scheduled to go ahead as planned.

Survival – what does liquidity look like over the next year?

Let’s start by getting perspective on what debt looked like on the balance sheet for The Big 3 pre-Covid. Looking at Net Debt to EBITDA and FCF as a % of Debt (avoid using equity in this kind of assessment, as companies can mess with it via share repurchases, dividends, etc):

CCL looks best capitalized coming into this mess, and has traded cheaper in comparison to the other two – EV/EBITDA ratio is ~20% less than the other two at the end of 2019.

As you’d expect, over the last few months The Big 3 have moved quickly to build up liquidity to survive this next year, drawing down revolvers and issuing new debt. Some of the debt issued at CCL and NCLH are convertible notes, so assuming these companies recover I think it’s important to factor dilution into any analysis that you run. NCLH also took in additional equity investment from both the public and via PIPE from L Catterton.

Now let’s put together some pro formas for CCL. What does a projected income statement look like?

As expected, these next couple years look rough, but I’d like to reemphasize that 2020 assumes no additional revenue, and 2021 assumes 50% demand – unless Covid goes from bad to worse than we could have ever expected, these feel conservative. This analysis also does not bake in the benefit of reduced fuel prices that may stick around these next couple years.

Where does this get my cashflows?

Using rough numbers here, analysis projects that $7.3bn of financing is needed over next couple years ($3bn in 2020 and $4.3bn in 2021). The good news (depending on how you look at it) is CCL pulled $3bn from revolvers in March and issued $5.75bn of new debt in April (some of which is convertible, and should be assumed converted if CCL recovers), meaning they’ve already achieved the financing needed based on these projections. My above cashflow projections also assumes all treasury shares are reissued at approx. 80% loss, and per the below, 62.5m of the 190m shares have already been reissued.

Other comments on cashflow:

  • 2020 sales of shipsCCL plans to sell 13 ships in 2020 (approx. 10% of its fleet). I assumed $150m sale price per ship in my above cashflow estimates. I don’t think this is actually that alarming, as (1) these ships are probably older, and needed to go at some point anyway (who wants to ride an old cruise ship), and (2) 10% of fleet isn’t that bad given that they are the biggest cruise operator with ~45% market share. Competitors have also done and/or will probably do the same.
  • Cash outlays for ship orders- I’ve assumed that commitments for new ships will be wiped out over next few years. I think it’s fair to assume that CCL is probably under contract to take them, but in this environment they’ll probably tell the shipbuilders to pound sand the next couple years. It’s probably in the interest of the shipbuilders to suck it up as well if they do think CCL can recover – way worse trying to get paid if CCL gets forced into bankruptcy.
  • Credit vs cash refunds- so far, approx. 60% of customers have elected a to receive a future cruise credit rather than cash refund for their postponed cruises – definitely a positive sign for pent up demand

  • Breakeven point- the CCL Q220 earnings call transcript may be worth a read. David Bernstein (CCL CFO and CAO) notes that the breakeven point on an individual ship basis is generally 30-50% of capacity. He estimates that they’d need to run approx. 25 ships for cashflow to breakeven (approx. 25% of fleet). I view this as validation that my analysis is conservative, as I’m anticipating a cash shortfall in 2021 with 50% demand.
  • Debt covenants- I found some of the debt covenant specifics for RCL (net debt to capital ratio, fixed charge coverage ratio, min networth, etc); wasn’t able to find these for CCL and NCLH, but it looks pretty clear that The Big 3 will struggle to meet these. But similar to view on new ship orders, creditors will probably be willing to grant leniency if there is a light at the end of the tunnel – most lenders want to avoid seizure of assets and bankruptcy proceedings.

Other Considerations

  • Bankruptcy- while I definitely see potential upside in an investment in CCL, it is definitely risky. If Covid continues to unfold in a horrific way into 2021, The Big 3 could be pushed into bankruptcies. But important to consider impact to CCL if RCL and/or NCLH go down while it stays afloat. RCL is the 2nd biggest behind CCL – if it files Chapter 11 and is relieved of some of its debt payments, it could suddenly have the opportunity to compete more aggressively. If RCL drives its prices down, it could force CCL to follow, driving CCL into bankruptcy. Takeaway here is that bad news for the other two could ironically lead to bad news for CCL.
  • NCLH differentiation- while NCLH’s balance sheet looked bad going into Covid, two points that I think help its survival case:
    • (1) It historically focused on cruise routes that the other two were not focused on. See snipit from 2019 10-k:

    • (2) its ships are significantly smaller (~30+%) than RCL and CCL. This could come in handy if governments put official caps on the number of people that can be on a cruise at a given time (regardless of ship size).
  • Cruises sailing in 2020analysis assumes no cruises again until 2021, but if some of these carry on (unlikely in the US, but maybe more likely in Europe), it will be very important to track the outcomes and potential regulatory responses.

Bottom line

If betting on the survival and recovery of cruise lines is something that you’re interested in, I think CCL is the best bet. Back in March the market priced death into the Big 3 stock prices, and stock prices of these at the time of this post are not far from those March prices. Applying the lowest PE ratio from the last 10 years (excluding Covid) to this analysis’ EPS estimate shows a sizable ROI is in the cards. By no means should you view this as a real way to project the stock price, but point is that there’s a lot of potential upside here if you can handle the risk.

Caveat emptor. Hope you find this helpful!

Walmart and Shopify Team up – Watch Out Amazon $WMT $SHOP $AMZN

Walmart announced a new partnership with e-commerce platform Shopify. Shopify is used today by over 1 million small-to-medium sized businesses, offering services “including payments, marketing, shipping and customer engagement tools to simplify the process of running an online store.”  The partnership clearly makes sense for sellers if they can get cheap access to Walmart.com’s 120 million monthly visitors.

I covered Amazon’s third-party marketplace in a previous post, but if you’ve been on Walmart.com recently, you’ve probably seen third-party listings such as the one pictured below. In fact, a cheap-o like me has started to notice that Walmart’s prices in many cases are cheaper than Amazon (with no Prime membership either).

So if Walmart already allows third-party players to sell on its site, why is partnering with Shopify important?

  1. This is Walmart’s first real foray into allowing small-and-medium sized businesses access to its platform. Currently when you shop on Walmart’s site, you’ll see merchants such as Autozone. This opens the playing field to many smaller businesses. As the program ramps, this could allow Walmart to quickly add literally hundreds of thousands of sellers.
  2. It’s very competitive with Amazon. Shopify’s announcement noted that, “unlike other retailers” Walmart charges no setup or monthly fees, though it will charge a “referral fee”. It looks like Walmart will charge anywhere from 6-15% of the sale (except Jewelry is 20%). Amazon charges essentially the same rates, it appears. However, as discussed in my last post, Amazon charges $39.99 for “Fulfilled by Amazon” services as well as other fees.
      • FBA sellers don’t pay for shipping or packaging, but you do have to pay an “FBA fee” which covers these costs – detailed here
      • FBA also has monthly storage fees (which can be long-term or short-term)
      • Walmart uses a third-party to help you ship your products with 2-day shipping. The service even has a website for you to compare exactly how much it would cost to fulfill via Amazon vs. their service! Talk about targeting the competition…
  3. It is launching at a near perfect time. One challenge with any marketplace is getting sellers and buyers to sign up. Walmart.com already has the buyers and COVID19 has caused all retailers to move most of their business online. That’s why US e-commerce sales were up ~74% in Q1 Y/Y. At the same time, Amazon is under anti-trust scrutiny. Perhaps this is an opportunity to launch competition in the space (while a competitor is both slightly distracted but at the same time, welcoming a competitor).
  4. It is clear Walmart wants to be a platform, not just compete with them as a physical retailer with an online presence. Probably the most important item in the post and research I’ve done on Walmart’s recent actions is that it is clearly trying to pivot and use its already massive scale to its advantage. Clearly, if its going to compete in the future, it must take on Amazon.

Still though, if you are someone who wants to see a competitor to Amazon, this deal leaves something to be desired. With just 1,200 additional Shopfiy sellers (that also have to be pre-approved) it’s not really opening up the floodgates of competition.

I also wonder what products they will sell – is it items that just doesn’t make sense for Walmart to sell? Perhaps this is a way for Walmart to prune low margin sales in its portfolio and just collect a platform fee.

Either way, it’s a positive for Walmart and a clear shot across the bow at Amazon. Walmart wouldn’t be doing this if their 3P marketplace wasn’t a key part of its go forward strategy.

Walmart had just launched “Walmart Fulfillment Services” or “WFS” in February of 2020, so clearly teaming up with Shopify would help both of them to compete with Amazon’s FBA service.

It will be interesting to see if Walmart can market this well enough that consumers and sellers recognize the benefits. Consumers are paying Amazon $120/year for Prime whereas Walmart is free. Returns are free on most Amazon Prime and you can do it through any Whole Foods, but 90% of America lives within 15 minutes of a Walmart store, so returns will also be free and pretty easy for all of America (not just the 1%…). Is this a strategy that Walmart recognizes?

So far, Walmart doesn’t have a ton of sellers on its platform and it seems like its holding them to high standards (e.g. only allowing 1,200 at first in this launch, believe they only have ~300k in total vs. millions at Amazon). This may disappoint shareholders who would prefer Walmart “move fast and break things” but it also will reduce scrutiny and costs down the road like Amazon has received and it also means you’re not competing for space against a bunch of other sellers on Walmart.com.

It seems like Walmart’s stock will be one to watch in the retail space, though I do have caution given some of Walmart’s past attempts haven’t been that great (thinking Jet.com…it just ended up being folded into Walmart.com). 

This is also very interesting from Shopify. Shopify in 2020 announced the Shop app which seems to me like a clear desire to be a big platform like Amazon as this would allow Shopify sellers to access buyers in one place. Obviously, its stock has reacted and is now a $96BN (~54x LTM sales at the time of writing).  Maybe this is a sign they need a partner? Time will tell.

Why is Everyone Freaking Out about Hertz Issuing Equity in Bankruptcy? I Break It Down $HTZ #COVID19

Well, it happened. Hertz is cleared to issue equity in bankruptcy on Friday, June 12. This is a monumental day (which I live tweeted the hearing process on my twitter for those interested). Companies issue equity all the time – why does anyone care that Hertz is issuing equity in bankruptcy.

To put it simply: because the equity is likely still worthless.

Now, I can back up. Hertz was already highly leveraged coming into the COVID19 crisis, but the economy was good. Perhaps Hertz could manage its way through its debt problem.

When people stopped traveling due to COVID19, that crushed demand for transportation, especially rental cars which are typically picked up at airports. In addition, the pressure on the economy meant that the “residual value” it receives for cars coming off lease was also diminished (i.e. used car sale prices went down).

Here is how Hertz described it in their bankruptcy filing:

Typically, when a company goes bankrupt, its stock will still be listed for a little bit of time, but it will not be worth anything. It will trade, but its  typically much smaller amounts. It is just waiting to be delisted.

There are a few exceptions to this such as W.R. Grace. Grace filed for bankruptcy because of growing asbestos liabilities, but did not have solvency issues. The equity continued to trade and had value. It had value because the value of the business after all liabilities were paid was still greater than zero. There aren’t many other cases I know of like this except maybe General Growth Properties, which Bill Ackman was involved in.

Another example is American Airlines when it last filed for bankruptcy. The equity was initially deemed to be zero, because unsecured creditors were not going to be made whole, but valuations moved up and that created equity value in bankruptcy.

So why is Hertz issuing equity in bankruptcy different?

First, it still seems pretty clear that the market is saying the bonds are not going to be made whole. Let’s look at the trading prices and also discuss the “waterfall.”

Here is a Hertz unsecured bond. You can see that pre-covid, investors essentially deemed it likely that Hertz would pay the money back and they would be made whole. These bonds traded from par to a low of 12 cents on the dollar, but some others traded as low as 9 (before bankruptcy, bonds that mature earlier than others are said to have temporal seniority – i.e. the company will try to take those bonds out first, so you at least have some chance or option value to make out better than later-maturing classes).

Trading at 9-12 cents on the dollar means the bonds are saying that’s likely what their recovery in bankruptcy would be. Pretty simple – bond investors wouldn’t just sell a bond at 10 cents on the dollar for no reason. The coupon on these bonds was 6.25% too so the market with such a low price was implying in March and April already that they wouldn’t pay another coupon.

Here’s an example “waterfall” chart. It’s simplistic, but the point is to say, if there is no value after the secureds are paid off, senior unsecured creditors get nothing.

Here’s another way credit debt investors draw it out. I’m showing 3 scenarios that hopefully are self-explanatory enough:

This math is why it is so crazy to people that Hertz is issuing equity in bankruptcy.

Even with all the positive news (for creditors) that Hertz is issuing up to $1 BILLION in bankruptcy, the bonds are still at less than 50 cents on the dollar. That implies the bonds are still in the hole by 50%. So Hertz may raise a $1 billion of equity that may immediately be worthless.

The  thought that maybe issuing equity increases option value of the equity might be a little crazy too. At this point, it is still hard to argue that the unsecureds are going to be made whole here. Even if they rise to 65, 70 cents on the dollar that is still the case. The market started to improve for GGP from 2009 to 2010, but its bonds also snapped up to 100 cents on the dollar.

It also hard to say right now that the operating environment will improve in such a strong way that Hertz will increase in value. Valuations are conducted on a 5 year view anyway (i.e. no one is valuing Hertz solely on trough 2020 earnings – they essentially do a DCF) so it seems unlikely to me they aren’t already including some strong rebound next year.

What Differentiates McDonald’s from Other Restaurant Players? $MCD

Many know the history behind McDonald’s, but if you don’t I highly recommend the movie The Founder. It details how McDonald’s started as a simple restaurant business, but Ray Kroc took it over to expand the business and eventually takes it over. It also gets into the groundwork for McDonald’s strategy it would use for decades to come.

McDonald’s is not in the restaurant business, per se, it is in the real estate business.

As a reminder, this Competitive Strategy series I am doing is trying to unravel why some businesses do better than others, even in highly competitive industries. This post will be brief and mainly focus on this real estate point – to me, it is a truly differentiated strategic decision from McDonald’s.

Why Does McDonald’s Own or Lease the Real Estate?

Typically, McDonald’s will own or lease a restaurant site and lease or sublease it to a franchisee. McDonald’s return on that real estate investment is derived from a fixed % of sales as rent payment from the franchisee. McDonald’s also earns a royalty fee, but the bulk of earnings is actually tied to this “rent” payment.

As you can imagine, this is a unique relationship between franchiser and franchisee.

Here is a comparison of gross PP&E on a group of restaurants balance sheets compared to the number of locations they have. The only names that come even close are Chipotle, which has no franchisees so isn’t really comparable, and Starbucks, which also is mostly company-operated stores.

Think about if you were a landlord and received rent plus a fixed percent of the tenant’s sales. You want the tenant to do well and may even kick in funds to help them (if you think the returns will be favorable to you).

This is the case with McDonald’s. When a restaurant unit needs to be remodeled or needs new capital investment, McDonald’s will typically share some of the expense, which helps relieve some of the burden on the franchisee, while also allowing the company to cycle through new looks and new menu items. This keeps McDonald’s menu relatively fresh and restaurants looking up-to-date.

McDonald’s also does not allow passive investors. This aligns incentives for the store owner to maximize sales and profits (because that is how they derive most of their income) which in turn boosts McDonald’s profits.

As a result, McDonald’s has posted a powerful financial track record over the past couple decades. As shown below, its same-store sales results are pretty impressive when you think about how mature McDonald’s is as a business.

But doesn’t this make McDonald’s more capital intensive?

Yes!

Here is a chart of capex as a % of sales for each of the players:

But that actually doesn’t hinder the company much. Look at its return on assets compared to peers. It actually stacks up quite well, which is surprising when you think about how much more in assets the company has.

What could be the driver of that? Profitability. McDonald’s is just much more profitable than most of its peers. Part of this is scale (can leverage corporate fixed costs well with the number of branches), but also part of it is the way the company has established its fees.

Assessing the Age Old Question: Home Depot vs. Lowe’s? $HD $LOW


In this post, I am going to compare Home Depot vs. Lowe’s. Note, I’m now including this in my Competitive Strategy series, as I think the decisions Home Depot has made to date compared to Lowe’s have clearly manifested themselves in their results. 

Pershing Square, now has a ~$1bn investment in Lowe’s stock and this is an age old question. We have two companies in a big industry. Everyone knows their names… how do you pick one over the other?

Ackman’s thesis seems to rest on Lowe’s “closing the gap” with Home Depot’s performance – and that will cause Lowe’s stock valuation to also close the gap with Home Depot’s stock. Ackman even says Marvin Ellison, the Lowe’s CEO who is an ex-Home Depot executive, was his top pick for the CEO job.

As such, I will be examining Home Depot stock vs. Lowe’s and also determining if there are any structural differences between the two companies.

In essence, I will see if Ackman’s thesis has merit. I hope to finally tie that into valuation. Because so much of this report will be comparing the two building product juggernauts, this might as well be viewed as a report on both Home Depot stock and Lowe’s stock.


I’ve been studying Bill Ackman’s portfolio and strong performance so far and it seems the hedge fund manager is getting back to his roots. Gone are the shorts in Herbalife and aggressive long in Valeant, and instead he has waved in a new era of “high-quality, simple, predictable, free-cash-flow-generative businesses with formidable barriers to entry.”

As shown in the slide below, it seems as if Ackman is positioning himself towards high-quality blue chip names. And not pictured, he added Berkshire Hathaway to the mix and existed UTX and ADP.

As a quick aside, this strategy is puzzling to me. For a hedge fund manager to be buying huge, blue chip stocks… it just seems odd. Perhaps it is due to his view on the business cycle and these investments, with good balance sheets, will perform fine in good or bad economic times. However, they also are now mostly consumer discretionary businesses.  Maybe he is bullish on the consumer 10 years into an expansion? Odd indeed.


Company Overview:

Brief History

Lowe’s history dates back to the early 1920’s when it opened its first hardware store in North Wilkesboro, North Carolina. In anticipation of dramatic increase in construction following WWII, Jim Lowe (the son of the original founder) and his partner Carl Buchan began focusing on hardware and building materials. Following some years’ operating together, the two disagreed on focus and Jim Lowe split with his partner to focus on grocery (and started Lows Foods grocery chain) while Buchan operated Lowe’s.

The company expanded in the Southeast. After Buchan died in the early 60’s, his executive team took the company public with 21 stores.

In the 1980s, the company suffered against Home Depot and the big-box retail concept. Home Depot was formed in just the late 1970s and early 80s with the home-improvement superstore concept. Their first stores were built in spaces leased from JC Penney in Atlanta and began branching out in the southeast US. By 1989, Home Depot surpassed Lowe’s in annual sales.

Lowe’s resisted this big-box format, mainly arguing that Lowe’s served smaller, rural communities where a big box chain doesn’t make much sense. However, it eventually did succumb to pressures. Today, Lowe’s has ~2,000 stores and ~209 million square feet of store space and does ~$72BN in sales. Home Depot, in contrast, has 2,289 stores, ~240 million square feet, and ~$110BN in sales. More on these comparisons later.

Market Overview

Lowe’s and Home Depot operate in what is estimated to be a $900BN market. With $72BN in sales, this means Lowe’s has less than 8% market share while Home Depot has ~12%.

However, I will say it is unclear to me what this market size estimate includes. Obviously, the housing market is huge and the market that Home Depot and Lowe’s serve must be big given the size of their respective sales ($180BN combined). But if they’re including everything within home improvement, the addressable market is likely much smaller for the duo. They will never truly displace the lumber yard. Nor should they. That is a low margin, commodity business. Home Depot in the past as alluded the market is more like $600BN, which makes more sense to me.

The customer base is split in DIY (do it yourself) and DIFM (do it for me) customers as well as professional contractor customers. I think we can all understand the DIY / DIFM customers well. These people are doing repairs on their home and come into Home Depot or Lowe’s for a certain tool, toilet, door, window, flooring, etc. Lowe’s and Home Depot serve as a one-stop shop for them.

Contractors on the other hand are a bit different. This is the segment Lowe’s is now aggressively targeting. As noted at Lowe’s investor day in 2018,

“[Our] final focus area will be intensifying customer engagement. At the core of this objective is winning the Pro. We have a tremendous opportunity to grow this portion of our business. This is a customer that is very important because the typical Pro spends 5x as much as the average DIY customer.”

We will discuss this in more detail later on, but I can see the challenge of this sector of the market. Time is money for a Pro and when they need something, they need to go to one place. That is why specific building supply stores and distributors exist. Not necessarily for one stop shop of everything (cabinets and windows in the same purchase), but more like, “You need plumbing products for that job? Head to Ferguson. Need HVAC products? Head to Watsco.”  There are also showrooms around the country to sell tile, flooring and cabinets specifically for the pro channel. For example, Fastenal, Grainger, Ferguson, HD Supply, Watsco each have a niche they are targeting in the Pro segment. 

It makes sense why Home Depot and Lowe’s would target this customer. If a pro stops in to buy one product and then decides to throw a hammer, some fasteners, adhesives, and paper towels in the cart as well, that is all upside to Lowe’s.

Comparison – How do Lowe’s and Home Depot Stack up?

Now that we’re starting to get into their differences, I’d like to provide a simple breakdown first of Lowe’s and Home Depot’s stats. I think this is where it becomes clear that their performance differential is stark, despite seemingly similar store count.

Clearly, Home Depot has similar store count, but is much more productive. Home Depot has 14% more stores, but 50% higher sales, 140% higher EBITDA, and incredible return metrics on invested capital, despite spending about 2x as much per store.

What about like-for-like sales comparisons?

As shown below, Lowe’s was performing well against Home Depot up until the financial crisis. Since that time, Home Depot has been eating Lowe’s lunch. This should give a clue as to why Home Depot’s stock then has been crushing Lowe’s. 

This is more clearly seen by looking at the two-year stack (that is, comparing the last two years sales growth rate together). Coming out of the crisis, Home Depot took a strong lead and has since maintained it.

If we look at the drivers of Lowe’s sales since 2010, we can see in the chart below that in the past few years, most of the growth has come from larger average ticket sizes, while transaction growth (or volume) stalled.

At the same time, Home Depot has had a good mix of volume and pricing gains. To me, it looks as if share shift is clearly demonstrated in the last two years, where Home Depot is reporting stronger transaction growth to Lowe’s negative comps.


Rationale for the Underperformance?

Lowe’s called out some of the reasons for under performance here (my emphasis added): 

“We took a hard look at the current state of our stores. We saw that customers were very excited to come to Lowe’s. And therefore, our traffic growth was quite strong. However, frequent out of stocks led to poor conversion, lower transaction growth and a frustrated, disappointed customer. We have terrific associates who know this business well and give their all each and every day to find solutions for our customers. But we also saw that we made it difficult for those associates to do their job. Lack of process, procedures and clear direction made their work inefficient. Complex, outdated point-of-sale systems require too much time and training to navigate, leaving our dedicated associates scrambling and long lines of customers waiting. In effect, the staffing models placed too many hours in associate and tasking activities and not enough in selling activities.

In addition, the company called out the lack of focus on the Pro.

“We had also fallen out of step with the Pro. They had been a lack of focus on the depth of inventory, the right pricing and the products that they expect. In fact, we lost some critical brands years ago because there was a focus on margin rate rather than the understanding and responding to the comprehensive needs of that important customer. We also found that our online assortment was lacking with a significant SKU deficit versus the competition.”

Home Depot has had much more success with Pros recently vs. Lowe’s. On Home Depot’s Q2’18 call, they stated that Pro penetration is ~45%, while Lowe’s stated it is ~20-25%.

Why does the Pro matter? Home Depot stated in 2019 that they were going to dispel a myth: the Pro is not higher margin than DIY. The margin mix of products is similar.  However, they spend much more when in the store. Home Depot also stated that “the Pro represents nearly 40% of sales but only 4% of customers.” Therefore, you have more inventory turns in the big box store and you are much more productive. 


I think another reason why Lowe’s stores lag Home Depot’s and lag in serving Pros is geography. Lowe’s stores lag in the high density population areas, which are Pro heavy. Instead, I think they have more locations in more “rural” areas which is heavy DIY. Household incomes of these denser population areas are also higher on average, which means they have more to reinvest in their homes and renovate.

Why did Lowe’s outperform pre-crisis? I think Lowe’s stores where in areas which were likely impacted by the real estate bubble. As the bubble grew, the city sprawl grew as well and the values of homes on the outskirts of town also witnessed strong growth (at the time). This translated into higher sales for Lowe’s at the time. When the bubble popped, these areas were more heavily impacted. 

This is speculation on my part, but let’s compare some stores in areas. Note: this is completely anecdotal, but what I am trying to gauge is Home Depot’s density in city centers (where population is theoretically higher) compared to Lowe’s. I also pulled up some smaller cities to compare store count. It’s one thing if you have the same store count, but it is another if one competitor has 10 locations in Houston and another has none there, but does 10 in Des Moines. With a big box store you want to be serving as many people as possible in a day. 

Below is Boston. You can see some Lowe’s stores are peppered outside of the city, but no real ones serving the actual city. Contrast that with Home Depot on the right – more stores dead inside the population zone.

The next is Houston. This time, Home Depot has many more stores serving the 4th largest city in the US, both inside and outside.

Next is Oklahoma City. Home Depot and Lowe’s looked roughly well matched. However, Lowe’s has 11 locations there, including one outside of town. Home Depot has 9. Does it make sense for Lowe’s to have the same number of locations in Oklahoma City as it does in Houston, when Houston has 4x the population?

Next is Indianapolis. To me, it is the same story as Oklahoma City. You can argue now that Lowe’s will be better positioned as these other, smaller regions grow, but it is questionable how they’ve allocated capital in the past at least (we can open a store in Houston, or one in Indianapolis – which do you pick?).

Ok last one to test the bubble thesis. South Florida was blasted by the housing bubble due to very high speculation activity in these areas. Let’s check out the store count:

     

Are the differences structural?

I think the differences in margin are not structural. However, I do think that turning a ship with nearly $80BN in sales is not easy and will not happen quickly. There may be taste changes that Lowe’s will have to overcome (didn’t have the product before, why should the Pro trust you now) and the investments may take some years to play out.

So what is Lowe’s doing to close the gap?

Clearly, it seems Lowe’s knows it needs to target the Pro. After an internal review, they discovered that there was inadequate coverage of Pro by their staff. The staff was busy with documentation work during peak hours and missed serving Pro staff. Time is money.

It does seem simple on paper: if they can be price competitive, have the right brands and quantities, and be consistent with service, I think that will help close the gap.

Again, however, I think this can only improve so much due to geographic differences.

On the profitability side, the company said that its payroll systems are antiquated and not prepped for changes in demand by department. Outside of COGS, store payroll is the company’s largest expense and they definitely spend more than Home Depot does on a per store basis (see EBITDA margin difference in table at beginning of this post). At the same time, they will be adding sales staff to support the Pro segment. The company’s goal is for the savings from one to fund the other.

They also noted they will focus more on “high velocity” SKUs in stock. Historically, they focused more on inventory dollar position versus inventory turns. If you are turning your inventory quickly – you are making more money. This seems like retailing 101 so hopefully is a quick fix.

As shown below, Lowe’s thinks it can improve sales per sq ft by ~10% over 2018 levels (and 8% over LTM Q1’19). By having better SG&A leverage, they think this will translate into 12% operating margins, or ~300bps higher than today and ROIC will improve dramatically.

In addition, Lowe’s is expanding its leverage target from 2.25x to 2.75x EBITDAR in order to free up cash flow for the equity.

This all seems to be a tough and a bit of a stretch. While $370 / sq ft is still behind HD, I try to detail my view on earnings if this were all to happen. I can see how you would get 110bps of margin expansion all being equal, but the company is also talking about investing in additional supplies, new technology, additional sales staff… all to support the Pro and help close the gap. That will cost something and doesn’t appear reflected in their goals.

However, as I look at consensus estimates, this isn’t totally priced in either. Street estimates show EBITDA margins expanding to 12.2% from 10.6% by 2021, so still high but not giving full credit. There is some doubt in the numbers which is good. It still seems rather optimistic to me, however.

Is it reflected in the valuation?

If I pull a list of comps for Lowe’s stock, I of course need to look at Home Depot, but I also need to show other defensible retail. I view the Home Depot and Lowe’s duopoly as similar to the auto repair stores. The customer service and experience drives customers back to their stores and there is some moat that Amazon will have trouble crossing. That said, if you don’t have the part in auto retailing, you lose the sale. Seems rather analogous to our discussion here.

Dollar Tree and Dollar General also remind me of Home Depot and Lowe’s. Two formidable competitors that serve a niche part of the market. Finally, I also think Walmart, TJX, Ross Stores and Target need to be included as they are retailers known for their powerhouse supply chains and ability to survive in a tough retail environment.

In each case, Lowe’s stock screens as pretty cheap. But given what we know, what would you do with Home Depot stock vs. Lowe’s stock?

Unfortunately, it is too simplistic to just compare multiple of earnings or EBITDA.

We have to also take into account ROIC.

Lowe’s is currently around a 12% ROIC while Home Depot is ~25%. If we were to run a DCF on these two companies and assumed they grew at the same rate and had similar WACCs, the one with the higher ROIC would clearly receive the higher multiple. Here is a brief summary with made up numbers:

Now compare to company 2…

If you then factor in that Home Depot has been crushing Lowe’s in growth, you have the formula for a much higher multiple that is warranted on Home Depot stock.

Lowe’s is just trying to close the gap, but during this time, Home Depot won’t be standing still. It could reinvest more in new projects that extend its runway.

In sum, I think that Lowe’s has a formidable competitor. While I like that they realize they were asleep at the wheel and have a former HD exec running the ship now, I am a bit afraid that HD will still be pulling away while Lowe’s is trying to catch up. I want to root for the underdog, but I’d probably put my money on HD outperforming Lowe’s.

Home Depot’s stock vs. Lowe’s stock? I have to go with Home Depot’s stock.