“We have turned the clock back. We’re actually now only in the fourth inning. We see a tremendous runway ahead of us there”
CEO Todd Vasos didn’t mince his words. I’ve never invested in Dollar General stock before (to my detriment) because I thought the growth and reinvestment story had come to a close. That was wrong.
Despite being brick-and-mortar focused, they continue to excel in basically any operating environment. Their unique real estate strategy, where they set up low-cost buildings in rural towns as the one-stop-shop at affordable prices, is key.
I’m filing this post under my competitive strategy series because clearly Dollar General is a stellar retailer with unique strategy – and the stock has delivered excess returns.
Since the beginning of 2015, I’ve watched store count grow from 11.8k to ending 2020 with over 17.1k stores. That is a 46% increase!
Dollar General stock benefitted from this growth despite being an “old school” business — no FANG here, but with FANG-like returns. Coming from brick-and-mortar retail, no less.
They don’t appear to be overloading the system either. Going back to 1993 – Dollar General hasn’t had a year when SSS comps have declined.
So if you invested in Dollar General, you’d have benefitted from
Growing stores
SSS Comp increases
Margin enhancement from this operating leverage
A high ROIC / highly cash generative model (even now, Dollar General mgmt estimates the stores are a 2-year payback)
Ok, again. I missed all of that growth. How could one possible invest in Dollar General stock now? Especially with the dawn of e-commerce, is it rational to expect the company can continue to perform?
There are still a bunchof reinvestment opportunities at very high rates of return. I will outline six different ones the company is targeting:
DG Fresh – Increasing stock of perishable & frozen items. Self-distributing these products as well to control costs
This really started in earnest back in 2013 as DG increased the amount of cooler doors in their stores.
At the end of 2012, DG stated they had about 11 cooler doors per store. By the end of 2018, they had 20 doors per store. They expect to install 60k in 2020!
Dollar General continues to view this as the #1 sales driver going forward (again driving that one-stop shop mentality).
DG Fresh also entails distributing these items themselves to help lower production costs and improve in-stock position, enhancing their competitive positon.
The Non-Consummable Initiative (NCI) – Selling such as home decor products, seasonal items, or party items just as some examples.
These are higher gross margin and increase transaction amounts, which helps operating leverage on stores.
Seasonal items that rotate also helps the “treasure hunting” aspect in retail shopping.
New Store Formats (Popshelf). DG has about 17k locations… but that doesn’t mean it can’t use its infrastructure set in place for a new concept. Popshelf is a new store concept targeting suburban women, with products priced under $5 in the seasonal, home decor and beauty products, as well as cleaning supplies and party goods.
This stemmed from the NCI work the company did.
Dollar General doesn’t take any decision lightly, so I think this could be a real opportunity and the US could easily support thousands of these stores.
As an aside, and call me crazy, but I could BIG as a DG acquisition target.
Popshelf reminds me of Big Lots, though I guess Popshelf doesn’t seem to be targeting furniture.
There would be immense synergies, with BIG benefitting from DG’s low cost distribution as well as scale on corporate costs.
Big Lots is still smallish with only 1,400 stores, but still has all the public company costs, back-office costs, HR, accounting, legal, etc. All of these could be scooped under the DG umbrella. It would give DG 1,400 more stores in a concept it wants to target.
BIG also trades at less than half the multiple DG does, so it would be highly accretive to DG.
Smaller format stores (<6,000 sq ft) for urban areas where Dollar General doesn’t currently target
Private label / Increased Foreign Sourcing.
Other “Core” continuous improvement items like lowering “shrink” (i.e. theft), zero-based budgeting, etc
These are six items outside of tech-enabled strategies like Buy Online, Pickup in Store (BOPIS) or the ability to scan items on your phone to expedite check-out (both of which DG has been talking about for years).
Let’s put some math behind the go-forward opportunity
DG clearly has been a COVID beneficiary. I mentioned before that DG has had tremendous SSS growth over its history, but with expected SSS of +16% in 2020, I fully expect 2021 SSS may decline for the first time.
However, DG currently has more cash than ever on its balance sheet ($2.2BN). The next highest the company has had pre-COVID was $600MM back in 2011. It’s basically been around $200MM since then.
This tells DG has $1.6BN-$2.0BN of cash to invest. It means that they can pull forward many projects they have planned.
I estimate the unit economics for a new Dollar General branch based on what they’ve disclosed (the 2016 Investor Presentation was a big help) and what I know about other retailers. Clearly the returns are pretty good.
But what this really tells me is that each $1 that Dollar General invests is worth about $10 at maturity. This assumes no growth after year 10.
Said differently than above, $1.6BN to $2.0BN invested in the company’s growth will likely translate into >$16BN of value. The current market cap is $51BN.
Coincidentally, DG’s pre-tax ROIC on tangible capital averages >50% over time based on my numbers.
If they invest $1.6BN to $2.0BN at these kinds of returns (perhaps a big IF), that could mean a $800MM-$1.0BN uplift in operating income (estimated by assuming a 50% ROIC). For a company that did $2.3BN in operating income in 2019 – that is very meaningful!
Sure, they could also use that cash for share repurchases or dividends, but like my post on Big Lots, clearly the optionality for DG, and growth, has been enhanced.
While they do have 17k stores, their goal is 25,000 locations. So $1.6BN investments, when a new location just costs $250k to open, leads to 6,400 stores right there…
Remember, DG performed very well during the great recession due to a trade down effect as the consumer wanted to save costs. This led to them having more cash than competitors to expand and reinvest in the business.
As you can see in the chart below, this is when EPS really started to ratchet up.
DG doesn’t look optically cheap today. Currently it trades at roughly 16x 2021 EBITDA and 21x EPS. That’s what used to be called a “growth” multiple. However, they have several growth avenues and you’re backstopped by earnings that actually go up in recessions. So you have growth + stability in cash flow, which drives a premium valuation.
One thing I like to look for in a stock is a doubling of EPS over 5 years. It helps me gain comfort in the multiple I am buying in at (the multiple can be cut in half and I still wouldn’t lose money). This would be tough given where we are buying in at DG (coming off of a peak COVID earnings), but they will have so much capital to deploy with many avenues. I have EPS 70% higher from where it will end 2020 due to store growth, modest SSS growth, modest margin expansion over 2019 levels and share buybacks. Assuming shares trade at 20x FCF in 5 years, I think you can earn a 14.5% IRR.
I can’t talk about a retailer without addressing e-commerce. If you think about Dollar General’s footprint, it is immense and its generally where e-commerce is still underpenetrated (i.e. rural areas).
However, that also means DG is best positioned with their distribution capabilities to attack that market. Much like they segmented rural areas for brick-and-mortar retail, they could do the same thing in e-commerce. They are the anti-Whole Foods, if you will, which many believe Amazon acquired to enhance their platform.
I’ve been tardy in my Competitive Strategy posts – living in a global pandemic really disrupts a routine. The focus of this article is on AutoZone stock which would have been a tremendous winner to buy and hold over time.
AutoZone fits the exact mold for my Competitive Strategy Series: auto parts retailing isn’t a sexy business and it’s competitive, but I wanted to dive into any strategic choices the company has made and why that translated into such strong equity returns.
If I could sum up AutoZone stock in one phrase I would say it is: “perennially underestimated.”
Quick Background
AutoZone started as “Auto Shack” in 1979 and quickly expanded from 1 store in Arkansas, to 23 stores by 1980, to greater than 250 by 1985. The company also sold a majority stake to KKR around this time (which may be part of the firm’s culture of understanding of capital allocation priorities and its capital structure). By 1989 they exceeded $500 million in sales and opened the 500th store. The company went public in 1991.
Focus on the Customer
AutoZone’s core strategy was to offer low price automotive parts with high quality customer service. Similar to Amazon, it seems as though AutoZone figured out early on if the customer is happy, they’ll keep buying from you, and that will translate into good outcomes for shareholders. In other words, customer interests and shareholder interests are aligned.
AutoZone likely also took cues from Wal-Mart, which focuses on low everyday prices, given the company’s founder sat on the Wal-Mart board several years before starting “Auto Shack”. The Chairman & CEO of AutoZone, William Rhodes III is also a board member at Dollar General. Both tremendous retail equity stories… is it any wonder that AutoZone stock was destined for greatness?
As a quick aside, seeing these company associations made me think about my own experience of seeing AutoZones. When I drive through a small town I don’t know, there are two stores I typically see front and center… a Dollar General store (or something similar) and an AutoZone. Dollar General specifically targets these towns because a “dollar” store becomes the one-stop shop for many of its consumers. I went back to AutoZone’s original prospectus to see what they said about store strategy. It seems to me that they must also target areas where (i) there are plenty of older vehicles on the road that need maintenance and (ii) a high population of DIY-ers.
Back in the 1980s, the company began using an electronic catalog to help employees determine which parts were needed for specific vehicles quickly. This system helped pave the way for AutoZone to launch an e-retailing siterelatively early on – in 1996.
Second, it trained employees to have general knowledge of cars so that they could answer customers’ questions in an educated way. Then, it would even install some parts for the customer. Think of windshield wipers, or running a diagnostic on the car for free to see what’s wrong without visiting a dealer, or replacing a battery for the customer.
Resilient business driven by aging vehicles on the road
AutoZone is a surprisingly resilient business. If you think about it, this makes sense. There will always be a base group of customers that repair their own cars (either to save money or because of interest in cars).
In a recession, AutoZone probably gains a few more customers that would’ve taken it to a repair shop. People may not buy that new car either in a recession and instead opt for fixing the old one they own. This plays exactly to AutoZone’s benefit:
Here is a graph of the vehicle age over time:
I don’t know of many companies that kept same-store sales growth up during the financial crisis, but you can clearly see they started to quickly grow low-to-mid single digits after that as well (likely because it was a long, slog of a recovery).
Recall, 2009-2011 was a period of high unemployment. People weren’t buying new cars and were repairing existing ones. That could play out again.
Thinking about post-COVID for AutoZone: One thing I am thinking about is that new car sales, pre-COVID, were at record levels for the past few years. AutoZone will likely see a recession benefit post-COVID as well, but then those new cars sold the past few years will start needed repairs. In other words, cars sold in 2015 will start to be 7 years old in 2022, which could buoy results for some period of time.
How has AutoZone warded off competition – isn’t it ripe for Amazon to steal share?
Yes and no. First, AutoZone has been in the online retail business for a while now. As of writing, it doesn’t offer two day, free shipping like Amazon does, but that may not matter right now.
Why? Because when something isn’t functioning on your car (and you are part of AutoZone’s core customer base as a DIY-er) then you probably are going to go fix it soon.
Imagine driving in the rain and one windshield wiper stops working. You pass an AutoZone store and understand from their commercials that they’ll even put on the new one for you. Why wait 2 days and risk getting caught in the rain again, being unable to safely drive? Sure, Amazon is moving closer and closer to same day delivery, but so far that has been AutoZone’s capture. AutoZone has nearly 6,500 stores, so it’s hard to miss one!
Like I said though, AutoZone clearly tries to focus on the customer and this is called out almost upfront in its 10-k.
Another reason: comfort knowing the part will actually work with your car. I’m somewhat of a DIY-er myself and, while AutoZone isn’t perfect either, sometimes you buy a part for a car that ends up not working on your specific model. That’s frustrating. Imagine a similar example to the above but now you need to return the item and buy a new one.
Supply Chain is the key
You can already start to piece together that the thing that drives Autozone’s business, the reason why people shop there and the reason why they win your sale, actually comes down to having the part and having it for a fair price.
AutoZone has a very efficient supply chain and this is really what keeps other competitors out of the business. In reality, I would venture to say that the do-it-yourself (DIY) market has developed into an oligopoly now – AutoZone, O’Reilly, Advance Auto, NAPA dominating the market, with Amazon also in the works.
AutoZone has an interesting store concept that reminds me of what Fastenal did, which I described in a prior post. They have satellite stores, which carry around ~24k SKUs, as well as “hub stores” which carry 40-60k SKUs and deliver to the satellite stores 3x a day. This ensures if someone orders a “tail-end” SKU, AutoZone can have it available either that day or the next. Lastly, they’ve deloveped “MegaHub” stores, which have ~100k SKUs. These stores deliver to both satellite stores and hub stores.
At this point, AutoZone notes that all of its hubs and satellite stores get touched at least 1x a day so adding more hubs or MegaHubs doesn’t increase coverage…. However, adding more of these stores reduces the amount of time it takes for deliveries to make it to the end customer.
New Growth Focus – Commercial
AutoZone has historically sold mainly to folks like you and me, not garages and professional networks. Now, its new growth strategy is focused on supply garages and local shops with parts using its sophisticated supply chain. The shift is Do it Yourself to Do it for Me.
Think about this from a garage’s perspective: AutoZone will now house the inventory I need to get more jobs done quickly. This solves 2 issues for me: 1) lowers my need to hold inventory and 2) helps me turn customers which should increase my sales.
So far, the company has seen some success. In its earnings call in early March (pre-COVID impacts), it noted:
We also grew our commercial sales per store at mid-single-digit rate versus last year’s second quarter [which was up 12.9% so a tough comp]… We averaged $9,400 in weekly commercial sales per program this past quarter, up 5% over last year. We have grown our sales with mature customers and mature programs at substantially improved growth rate the last 2 years versus previous years, indicating our offerings. Products, coverage, customer service and ability to enhance the customers’ overall shopping experience are improved and have been recognized and rewarded by our customers.
I can’t prove this trend, per se, but it seems to me that the older generations felt more comfortable working on their cars whereas the younger generation would like to “outsource” that work. “Do It For Me” must be what AutoZone is seeing too and I think that is why they are targeting this market.
AutoZone generates a surprisingly high ROIC
We’ve talked through some of the pieces of the business so far, but it is astonishing to me how high of a ROIC AutoZone generates.
Yet despite this high ROIC, resilient business model, I think one reason the stock has performed so well is that it is perennially undervalued and underappreciated.
This will be hard to read (maybe click to expand), but it’s a trailing FCF yield over a long period of time. Consistently in the high single digit range as a % of market cap. The interesting thing is they plowed in excess of 100% of that FCF back into repurchasing stock.
So clearly, that increased debt of the company slightly over time if they’re spending more than 100% of FCF.
But the way I think about it is: high-single return from FCF yield (which was all plowed back into AutoZone stock) + using capex for high-return projects (new stores). That’s the formula for solid returns. Here is a chart of share count over time – they were early in the share buyback game, in my view, buying massive amounts in the 2000s.
What about the competitors in the space? What have their returns been like?
So Pep Boys is no longer public (no owned by Icahn Enterprises), NAPA is owned by Genuine Parts, so we can really only compare O’Reilly, Advance Auto and AutoZone stock now.
What’s interesting is O’Reilly underperformed AutoZone stock up until about the early 2010s (depending on your starting point). Why did they start closing the gap? They started doing massive share-buybacks. Unlike IBM, where buybacks failed, the automotive parts retailing industry clearly has benefitted from doing this.
Advance Auto actually paused share buybacks and you can see the divergence in equity performance there as well.
Now the real question: who has the best jingle? AutoZone or O’Reilly?
But seriously, I like AutoZone’s business model. It’s a segment of retail that I think will continue to perform well over the next 5 years. I also like AutoZone stock because, compared to peers, management’s decisions have been very consistent over long periods of time. As of writing, its actually a lower multiple as well.
The question from there is obviously electric vehicles. What happens when these auto retailers lose sales related to the internal combustion engine? It’s a million dollar question. I will say, however, that penetration could be overestimated.
Overall, there are 263.6 million registered vehicles in the US. The number of battery electric vehicles sold in the US was 245,000 in 2019 and the total number of cars sold was 16.9 million, which was around cyclical peak.
Let’s say tomorrow, every new car is electric vehicle and each new car replaces an existing vehicle. So 16.9 million is 6.4% of the existing base… that would take ~15.5 years to replace the entire existing fleet.
Sure, we’d have to factor in autonomous cars next, which would drive down car ownership, but I also think that is far off.
If that gets overly priced in to AutoZone stock, I would view it as a buying opportunity.
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.
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.
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 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.
Reading Time: 8minutesFastenal is a company that sells nuts, bolts, and other industrial and construction supplies. Pretty simple business – and definitely not sexy. How then has Fastenal stock created so much value? In keeping with comparisons to other high-flying stocks on sexier businesses (like my post on NVR) Fastenal stock has beaten both Microsoft and Apple since the 1990s!
It all came down to a certain way they decided to operate – its Competitive Strategy.
There probably have been hundreds of fastener businesses that have come and gone over the past 30 years, and many probably never created much value. So what gave Fastenal their competitive advantage? What drove their staying power? And how did they compound earnings so effectively? Clearly, something must be going right to translate into Fastenal stock being such a long-term winner.
One thing I’d like the reader to do is think actually how similar Fastenal’s strategy is to Amazon’s (I think the latter borrowed some things from the former’s playbook).
If you like this post and how it highlights why some companies succeed where others do not, consider checking out my other posts on Amazon, McDonald’s, Autozone, Home Depot + Lowe’s, NVR, and hopefully more to come!
First, some history to shed a light on the Fastenal business.
Fastenal was actually dreamt up by its founder, Bob Kierlin when he was just 11 years old. His father ran an auto supply shop in Wisconsin and Kierlin noticed customers typically drove from store to store looking for fasteners they needed for particular jobs. If a hardware store didn’t have the right nut or bolt, the store would send the customer to Kierlin’s store, and vice-versa. Bob noticed a lot of customers had to resort to buying the part, one-off, via a special order and wait.
Kierlin and four other friends started Fastenal in with $30,000 and rented a store in Winona, Minnesota. They opened a store as a one-stop shop with thousands of fasteners for retail customer needs.
But the idea was a flopand the company almost went bust.
Instead of focusing on the retail customer, Fastenal decided to pivot and focus on the commercial customer. It turned out that price was much less of a factor than timeliness for that market segment — contractors and companies often lost money searching or waiting for a particular part. Kierlin and his partners discovered that there was a great need for a service that could quickly provide the fastener or part that a buyer needed.
In short, Fastenal segmented out its buyer base and identified what their key purchasing criteria was. They focused on industrial and commercial buyers and they realized they didn’t need to be the lowest price, they just needed to have the item in stock.
At the end of the day, you can see why this makes sense.
Fasteners make up a small portion of project costs (e.g. building a home, building a car), but are crucial pieces in the process that can hold up work.
If Fastenal increased price of a particular fastener by 3%, their customer probably wouldn’t even notice in their project and could likely pass it on to the end customer if needed
Fastenal’s customers are many in size but also small in size, so they have limited bargaining power.
Fastenal further segmented based on geographic locations.
Fastenal opened its first branch in Minnesota and continued to target very small towns. Why? By targeting small towns that had healthy construction and manufacturing industries, but were also small towns that were underserved by big distributors, Fastenal could be the only game in town.
Finding New Segments
One thing a business can do to improve its competitive advantage is find new product segments. Think about Arm & Hammer expanding baking soda into a refrigerator deodorant – that was a creative decision to target a market and improved the overall market size.
In some cases, you can find new segments by broadening and you can find new segments by narrowing focus.
Fastenal actually did both.
Narrowing Focus (and Not Being Afraid to Try Something New)
This is from Fastenal’s 1996 10-K. Satellite stores weren’t a major success, but the company did expand to 71 satellite stores opened by 2001. The key was that Fastenal was focused on improving the customer relationship. Fastenal already was getting some business from these customers in smaller areas, but they wanted to make it even easier on the customer to get their Fasteners – and it preemptively did so. Sure, it would cost resources and no one else really saw the returns from doing it, but the customer sure would be loyal. Sound familiar to Amazon?
In 2014, Fastenal identified a new growth driver: Onsite locations. These are sites that are not open to the public, or a wide variety of customers, but instead serve one customer at their location.
In essence, the customer (typically a very large one) might consume enough fasteners that it could source them themselves, but they’d rather benefit from Fastenal’s scale and expertise so they hire them to serve all their needs.
Fastenal had locations like these since the 1990s, but they expanded following 2014 – growing from 214 locations to over 1,100 by 2019 and represents roughly 30% of the company now.
The company really started to build a vendingsolution in 2011, choosing to do so while industrial activity was still weak from the Financial Crisis.
They would give a customer a vending machine, essentially for free (estimated to be a $10,000 value), but in return it would essentially become a “mini-branch” at the customer’s site. The machines were also available to the customer 24/7 – not just when a supply room is staffed. It also helped the customer track consumption data, in some cases improving their ability to see which of their plants were consuming more or less of certain parts.
Early on, Fastenal learned that it actually cut customer consumption (2011 conference call):
As we talked about on the Amazon review, if I were to distill differentiation with a buyer into two factors it would be: cut their cost and/or improve performance.
In this case, Fastenal cut the costs for its customers buy reducing spend, but it also differentiated Fastenal as a solutions provider. It also resulted in a share shift as customers looked favorably at the vending machines (quid pro quo) and Fastenal “locked” the customer into purchasing from them.
The company now has 105,000 vending devices in the field and generate $1.1BN of revenue.
Expanding Breadth
Fastenal decided in the mid-90s to test out new products. If a customer came into the store for fasteners, they might want to pick up something else why they are in the store. Convenience outweighs price.
In 1995, threaded fasteners were ~70% of sales. By 2000, it was just 51% of sales. Now, Fastenal has 9 different product categories it sells and targeting further product diversity:
The company also decided that in some cases, it made sense to manufacture tools for a customer. This would be rare, but in some cases it would pay off royally (and gain customer loyalty).
In one instance, a Ford plant’s assembly line was shut down by a breakdown that required a few dozen special bolts. Ford’s regular supplier told the company it would have to wait until Monday—three days later. “Meanwhile, it’s costing them something like $50,000 an hour to have this line not operating,” Slaggie [one of Fastenal’s founders] said in the March 11, 1992, Successful Business. “They called us and the part is an oddball, something we don’t have in stock. We had them fax us the blueprint for the machine and we determined we could make it…. We had them finished Sunday afternoon.”
Doing some simple math, $50,000 a day is $1.2MM in cost… for 3 days that would cost the company $3.6MM. Fastenal could make a part and charge $50,000 for it, and I’m sure Ford would pay for that all day… I have no idea what Fastenal charged in this case, but you can see why Fastenal created differentiation here as a service provider.
Decentralized. By the time Fastenal stock became public, they put out some interesting color on how they decided to manage new branch openings:
By reading the company’s filings, you can tell they first want to train their employees to understand the business and industry and then give them the power to make decisions on their own.
I’m a relatively cynical person, so I wonder to myself how the employees could possibly know more about what to stock than people who have been operating the business for 20+ years. Two words: Smile & Dial.
Putting it together
I could go on about Fastenal — there is a lot I didn’t touch on about how frugal the company chooses to be — but its performance as “just a fastener distributor” has been truly amazing.
I opened this series saying that I was tired of the terms “asset light” or “high margins” being used to say why a business is “good”… instead, you need to understand what the company has done to make its business sustainable and why they will create above average shareholder value in the long run.
Here are some summary financial metrics for Fastenal compared to other distributor peers.
What jumps off the page to me is (i) its gross margins for a distributor, (ii) its EBITDA margins and (iii) EBITA / Assets (a proxy for ROIC).
High Gross Margins: Its high gross margins relay to me that they truly have targeted their customer in a way that isn’t just based on price – otherwise I think the margins would be much lower.
EBITDA margins: Its EBITDA margins are high, which makes sense given the gross margins. But the delta between gross margins and EBITDA margins is nearly 23% of sales — meaning they spend 23% of sales on selling costs and general and administrative expenses. That’s definitely in the upper half of the group and tells me that they are spending a lot on service for the customer.
EBITA / Assets: One might look at this comp set and say, “hmmm, Fastenal’s metrics are good, but its FCF conversion (rough proxy using EBITDA – Capex over EBITDA) isn’t great because capex is so high.” That’s ok for me – when I look at EBITA / Assets, what Fastenal earns on every dollar of capex it spends is much higher than what I could go out and earn! It also will likely lead to above-average sales growth.
I hope you’ve seen from what I’ve outlined above that Fastenal is very similar to Amazon – relentless focus on the customer. But Kierlen also appreciated hiring the right people and giving autonomy, as shown in this interview I found with some hard-hitting reporters.
“I admit things I never knew how to do well – I admit I was never a good sales person, so I hired a good salesperson.” In some ways it reminds me of Steve Jobs (though it was later learned he had a tendency to micromanage), he did have a great quote:
“It doesn’t make sense to hire smart people and tell them what to do; we hire smart people so they can tell us what to do.”
