Specialty Retail: Ad Hoc Opportunity

On Dec. 19, I sat down with some of Morningstar’s specialty retail analysts— Liang Feng, R.J. Hottovy, Joscelyn MacKay, and Peter Wahlstrom—to discuss the state of that sector and the credit offerings therein.

Morningstar launched corporate credit ratings in 2009 and now offers ratings on more than 700 of the largest corporate debt issuers in the world. In addition to credit ratings, Morningstar analysts also publish company reports, lists of bond investment recommendations, industry reports, and their opinions of new bond issues. In 2012, Morningstar plans to launch municipal-bond research as well.

Philip Guziec: Obviously, you can’t really look at specialty retail in aggregate—every subindustry is completely distinct—but that’s what generates investment opportunities. It looks like you’re pretty excited about home-improvement retailers. Can you give us the lay of the land in that industry, given what’s happened over the past five years?

Peter Wahlstrom: Over the past decade, Home Depot HD and Lowe’s LOW have basically doubled their square footage. These companies are now looking to improve their productivity and profitability within existing store walls. This makes sense in that you also have, with the housing downturn, fewer people spending on residential construction. Commercial construction is still a driver of the business, but these companies now want to encourage general merchandise, day-to-day traffic, and smaller repair/remodel projects. In the meantime, Home Depot and Lowe’s generated $75 billion and $50 billion in annualized revenue, respectively, while not spending a lot on new store capital expenditures, which lends to solid free cash flow.

Guziec: Which is why we’re excited from a debt perspective.

Wahlstrom: That is exactly right. Both of these companies do have fairly large share-buyback programs, and they also pay dividends that yield between 2%–2.5% currently. But we do think that there’s ample free-cash generation beyond those. And that’s why Joscelyn likes both of these companies at this point.

Joscelyn MacKay: We’ve been pretty bullish on Home Depot, from a credit perspective, for some time. We felt that the market was underappreciating the firm given its moderate leverage and very strong, stable free cash flow despite the heavy dividend and share-repurchase activity, especially relative to its peer, Lowe’s. In the spring, we had rated Home Depot one notch lower than Lowe’s, but we recently downgraded Lowe’s. We believed that the market was giving too much of a premium to Lowe’s bonds relative to Home Depot; we thought that gap should narrow, and this has proved true. We continue to like Home Depot given its strong, widemoat characteristics.

Lowe’s is a company that we felt was getting a little too much credit; we ended up downgrading the firm to A from A+ in November 2011. Right after that, the company announced an even-larger share-buyback program and decided to take its leverage target to 2.25 times from 1.8 times, which are the factors we discussed when we downgraded them. As a result, the bond spreads widened— but a bit too much, in our view. We think the market’s reaction is exaggerated. We did downgrade them, and we feel that their credit quality is weaker, but now Lowe’s bonds are trading closer to a BBB+ credit instead of an A credit.