rona initiating coverage
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Consumer Products,
Merchandising & Special
Situations
February 12, 2009
Jessy Hayem, CFA Shane Leech-Porter (Associate)
514 289 0385 514 985 4733
jessy.hayem@tdsecurities.com shane.leech-porter@tdsecurities
YOUR ATTENTIONIS DIRECTED TOTHE IMPORTANTDISCLOSURES INAPPENDIX A.
RONA Inc.(RON-T) C$11.78
INITIATING COVERAGE
Recommendation: BUYOverall Risk Rating: Medium12-Month Target Price: $15.5012-Month Projected Return: 31.6%
Challenge Breeds Opportunity
Market Data Financial Data Estimates
Current Price (C$) $11.85 Fiscal Y/E Dec 2006A 2007A 2008E 2009E 2010E
52-Week Range (C$) $10.0317.20 Shares O/S (mm) 115.8 Sales (mm) $4,552 $4,785 $4,844 $4,757 $4,963
Market Cap. (C$mm) $1,372 Float Shares (mm) 114.7 EBITDA (mm) $384 $400 $377 $354 $387
Float Cap. (C$mm) $1,359 Net Debt (C$mm) $510 EPS (f.d.) $1.64 $1.59 $1.36 $1.22 $1.38
Avg. Daily Trading Volume1 595 Net Debt / Total Capital 25% FCF / Share (f.d.) $0.50 $0.52 $1.13 $0.27 $0.43
Net Debt / EBITDA 1.3x
ROE 11.5% Valuation
P/E 12.8x 10.8x 8.7x 9.7x 8.6x
EV/EBITDA 7.5x 6.6x 5.1x 5.3x 4.9x1 over 3 months period Note: All figures in Canadian dollars unless otherwise specified.
Investment SummaryWe are initiating coverage of RONA Inc. (RONT) with a BUY rating and $15.50
target price. We believe that management has implemented a number of positive
initiatives that should benefit the company when the economic climate improves
and for the long term. RONA also continues to prudently preserve capital by
reducing store openings and related capex. In the near term, the macro-
environment is clearly challenging, masking the benefits of aforementioned
initiatives. As such, we expect continued deterioration in sales trends over the next
few quarters, with our EBITDA margin bottoming around Q3/09 and the lack of
earnings momentum in 2009 limiting multiple expansion. Therefore, the stock
could experience further weakness in the near term, as the market awaits visibilityon the timing of a rebound, which the macro conditions render difficult to predict.
However, we believe that investors should be gradually accumulating positions in
RONA at opportunistic prices (downward revisions to estimates post Q4 may
provide this opportunity), in anticipation of a bottoming in fundamentals toward
mid-end 2009. Home improvement and housing related stocks have typically been
among the first consumer related stocks to rebound.
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2 A Division of TD Securities Inc.
Table of Contents
Executive Summary ..................................................................................................... 3
Outlook ..................................................................................................................... 4
Valuation and Recommendation............................................................................... 4
Company Profile........................................................................................................... 6
Store Network and Distribution Infrastructure ......................................................... 6
Macro Picture to Weaken Further Before Recovery ........... ........... ........... ........... .... 9
Uninspiring Outlook for Home Improvement in 2009............................................ 12
Industry Overview ..................................................................................................... 14
Growth Strategy......................................................................................................... 17
Acquisition-Driven Growth in the Past................................................................... 17
Niche Penetration by Acquisition Opportunistic Tuck-Ins Likely...................... 18
No Large Scale Acquisition Expected in the Short to Medium Term .................... 19
Economic Climate Favours Affiliate Recruitment: A Priority for RONA.............. 20
No U.S. Foray on the Horizon ................................................................................ 21
Optimizing the Existing Business ........................................................................... 22
Financial Analysis ...................................................................................................... 31
Q3/08 review .......................................................................................................... 31Expected future performance.................................................................................. 32
Our Forecast SSS in the Context of the Current Downturn.................................... 34
Strong Balance Sheet, FCF Generation and No Financing Concerns..................... 38
How Has RONA Fared versus Others in the Industry? ......................................... 39
Valuation..................................................................................................................... 46
Looking at Previous Recessions ............................................................................. 46
Justification of Target Price ........... .......... ........... .......... ........... ........... .......... ........... . 51
Key Risks to Target Price.......................................................................................... 52
Overview of Key Players............................................................................................ 53
Home Depot Inc. (HD-N, not covered)................................................................... 54Lowes Companies Inc. (LOW-N, not covered) ..................................................... 56
Canadian Tire Inc. (CTR-T, not covered)............................................................... 57
Home Hardware Stores Ltd .................................................................................... 58
Appendix I. Share Structure and Ownership ........... ........... .......... ........... ........... .... 59
Appendix II. Management Compensation Aligned With Shareholder Interests.. 60
Appendix III. Key Executives ................................................................................... 61
Appendix IV. Board of Directors.............................................................................. 62
Appendix V. Canadas Housing Foundation Lacks U.S. Architect ........... ............ 63
Appendix VI. Long-Term Fundamental Drivers .................................................... 66
APPENDIX A. IMPORTANT DISCLOSURES ..................................................... 69
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Executive Summary
RONA Inc. holds the leading market position in the Canadian home
improvement landscape with a 15% market share. Its network of 693 stores is
spread across all provinces, with a solid position in Quebec. One of its main
competitive advantages lies in a one size does not fit all approach, consisting
of multi-format and banner stores. This gives it exceptional diversification and
flexibility to access growth areas that cannot be served by big box outlets, andwhere low population density rules this option out, in addition to areas that
favour consolidation.
In our opinion, the current state of the economy represents a significant
challenge for RONAs growth prospects in the short to medium term, as it does
for any company tied closely to consumer spending. And, unfortunately, we
believe that there are few options in the companys control to counter such a
downturn. About 80% of its revenues are directly related to the renovation industry,
and the balance is tied to new housing construction. Despite the negative near-term
outlook, over the longer term, we believe that the fundamental drivers for increased
home improvement spending remain intact people spending more leisure time athome, housing stock becoming older, homeownership rates on the rise, etc.
About half of RONAs growth over the past decade is attributable to
acquisitions, particularly since 2000. Past acquisitions and affiliate recruitment
have not only fuelled RONAs growth, but have also greatly diversified its
geographic presence, enhanced its buying power, and enabled it to reach different
types of customers. Relatively speaking, same store sales (SSS) and new store
growth have been lesser contributors to growth. Yet, store renovations, product
mix and merchandising revamping, as well as innovative marketing concepts, are
key to attracting customers. In 2009, RONA remains focused on improving
internal operations. Expansion priority, in our opinion, will center arounddealer recruitment, a profitable way to grow, requiring no capital outlay, and
limited incremental costs. This is favoured by the fact that the Canadian home
improvement industry remains highly fragmented, with the four largest players
commanding approximately 55% of the market and the rest being in the hands of
small independents. Acquisitions, if any, will likely be opportunistic tuck-ins, in
new niche areas. This also reflects our belief that, given the current economic
climate, RONA is tilting toward capital preservation.
Driven by, what we view as, a well thought out acquisition and affiliate
recruitment strategy, RONAs revenues grew at a CAGR of 20% and
EBITDA margins rose on average 70 bps per year, between 2001 and 2006.Over the same period, organic growth averaged 7.5% and EPS grew at a CAGR of
25%, as the home improvement industry benefited from a booming housing
market, and RONA implemented initiatives to increase store traffic, sales and
profits. Its SSS growth peaked in 2004, and has since decelerated, affected by
significant lumber price fluctuations in 2005-2006 and, more recently, a
deteriorating macro-economic climate. When the economy recovers, SSS should
follow suit; until then, we do not expect a material improvement. Yet, RONA
is not sitting by idly. Programs for continual upgrade of stores and merchandise
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4 A Division of TD Securities Inc.
have been in place to keep up with increasingly selective and sophisticated
consumers. In addition, in February 2008, RONA unveiled a four-year strategic
plan consisting of two overlapping phases: the PEP, which addresses Productivity,
Efficiency and Profitability, and an accelerated development plan.
Critics of the RONA story would point out that the slowing economy is uncovering
the need to fix a number of issues, including IT system upgrades, and redundant
store locations, which have resulted in the company initiating its PEP program.While there is some truth to such statements, we also believe that solid operators
typically seek to bring improvements to their operations when times are
tough, tweaking the metrics that would improve efficiency and get the
company ready for the eventual economic rebound.
A concern on investors minds has been Lowes Companies, Inc.s (LOW-N,
not covered) recent entry into Canada, adding a third, potentially national
player in the country. Lowes remains committed to opening big-box format
stores, prompting speculation about saturation of the format in Canada. This may
indeed be the case or close to it, per our analysis, suggesting that aside from
possibly stealing market share from RONA and Home Depot, Lowes may need torevisit its commitment to the big-box format, a task that its U.S. rival, Home
Depot, has struggled with. It is important to acknowledge the difficulty that typical
big-box retailers have in squeezing a large number of SKUs into a smaller store
format without a corresponding strong distribution and special order system that is
integral to servicing smaller formats. This is an advantage that RONA has, owing
to its multi-format stores and associated distribution capability.
Outlook
While we expect RONA to continue benefiting from the PEP initiatives, webelieve these will be more than offset by challenging business conditions in 2009
and the ensuing negative leverage. As such, we expect continued deterioration in
sales trends over the next three to four quarters, and our forecasts reflect continued
margin compression through mid-2009. We forecast EPS of $1.22 for 2009, down
approximately 10% from $1.36 in 2008. A rebound is expected in 2010, with EPS
up 13% to $1.38, aided by a return to positive SSS territory and additional benefits
from its PEP program. We caution investors that our 2009 and 2010 EPS estimates
are approximately 10% below Street estimates. We would expect some downward
revisions to those estimates following the release of RONAs Q4 results on
February 19 and this, in our opinion, may create a better entry point in the stock.
Valuation and Recommendation
RONAs stock price performance is highly correlated with Home Depot and
Lowes. As such, following their stock downturn, RONAs stock performance had
started to deteriorate well ahead of the overall Canadian market downturn, when its
SSS turned negative in Q3/07. RONA has historically traded at an average
discount of 15% to both companies. Interestingly, both comparables appear to have
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Company Profile
RONA is Canadas largest retailer and distributor of hardware, home
improvement and gardening products. The company was founded in 1939 and
went public in 2002. It now has 21,000 employees (or 27,000, inclusive of
affiliates). It offers about 90,000 products through a multi-format, multi-banner
network that includes 235 corporate, 23 franchise, and 435 affiliate stores, and 9
distribution centers. Products sold are sourced from about 3,000 suppliers (with nosingle supplier representing more than 5% of sales), of which 90% are located in
Canada. As a member of A.R.E.N.A., a buying group that accounts for annual
purchases of US$28 billion, RONA has significant purchasing power.
RONA has two distinct business segments: retail sales through corporate and
franchised stores (Retail segment) and distribution to affiliated stores (Distribution
segment).
Exhibit 1. RONA Inc.: Retail Segment Represents Bulk of Revenues and Profits
Net Sales Breakdown by DivisionFY07
Retail
77%
Distribution
23%
RONA's EBITDA Breakdown by DivisionFY07
Retail
82%
Distribution
18%
Source: Company reports.
Store Network and Distribution Infrastructure
RONAs network of 693 stores across Canada with 15 million square feet (mmsf)
of retail space is composed of different store formats and banners located in both
metropolitan and small rural areas. The store network is supported by a strong
distribution infrastructure, inclusive of nine distribution centers (DCs)
across Canada.
Exhibit 2. RONA Inc.: Store and Distribution Centre Network
British Columbia Alberta Saskatchewan Manitoba Ontario Quebec Atlantic Total
Store Types
Big-box 4 7 1 3 20 41 1 77
Proximity 28 27 3 4 25 241 8 336
SpecializedConsumers 15 12 5 8 113 71 16 240
SpecializedICI 6 0 0 0 23 11 0 40
Total 53 46 9 15 181 364 25 693
Distribution Centres 1 4 1 3 9
Source: Company reports.
RONA is Canadas largest
retailer and distributor of
hardware, home
improvement and
gardening products.
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A Division of TD Securities Inc. 7
RONAs 235 corporate stores include those for which the companys ownership
is above 50%. The 435 affiliate stores are 100% dealer-owned but must adhere to
RONAs guidelines on marketing, advertising, presentation, and product
purchasing. The 23 franchise stores are majority-owned by dealers. These stores
follow the same guidelines as affiliates; however, RONA also manages their
product selection, supply and assortment, in addition to overseeing leasing and
subleasing agreements for the properties.
Exhibit 3. RONA Inc.: Ownership Structure
# of RONAs
Type Stores Ownership RONAs Interest
Corporate 235 >50% - Distribution and retail sales
Franchised 23 050% - Royalties of 3.55% on sales
Affiliated 435 0% - Distribution sales
Total 693
Source: Company reports.
RONAs network includes four primary store formats, each of which caters to
a targeted market. Big Box Stores offer over 40,000 hardware, renovation, and
gardening products. These stores range from 60,000 to 165,000 sf in size and cater
to all customer types. Proximity Stores, a new generation of stores launched in
2004, are much smaller and offer a reduced assortment of products meant to cater
to the basic hardware and seasonal needs of local communities. These stores also
typically offer an extended selection of interior decorating products. Specialized
Consumers Stores are similar in size to Proximity Stores, but are specialized to
meet the needs of specific targeted groups, including contractors, tradesmen andgardeners. Lastly, SpecializedICI Stores target Institutional, Commercial and
Industrial customers by focusing on specific product categories such as building
materials and plumbing.
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Exhibit 4. One Size Does Not Fit All
RONA STORES Banner Size (Sq ft) Products/Other
RONABig-Box Stores RONA Le Rgional
RONA Home & GardenRONA LentreptRno-Dpt
Proximity Stores RONA Le Quincaillier
RONA HardwareRONA Lexpress
RONA Le RnovateurRONA Home Centre
Totem 30,000 - Specialized in home renovation products / services- Exclusively in Alberta
Specialized Consumers RONA CashwayRONA LansingRONA Building CentreRONA Lexpress Matriaux
BOTANIX 2,00020,000 - Plants / gardening products / related services
Chester Dawe 30,000 - Building materials / hardware products- Large presence in Newfoundland and Labrador
Specialized ICI Matriaux Coupal - Market leader in sales of building materials in Montreal
Curtis Lumber - Market leader in sales of home improvement / hardware products in BC2,50060,000
Noble Trade - One of the largest plumbing / heating supply wholesalers in Ontario
Dicks Lumber - Leading lumber / building materials / hardware specialist in BC
- Wide variety with higher proportion in lumber / building materials
5,00060,000 - Specialized in lumber / building materials
5,00060,000
60,000165,000 - Extensive: 40,000 products
5,00025,000 - Complete range of hardware / painting / seasonal products
Source: Company reports.
RONAs distribution infrastructure consists of nine DCs utilizing a sophisticated
management information system for product processing, distribution, and
inventory management. Depending on the size and type of orders, agreements with
suppliers, and the geographical location of stores, RONA also utilizes direct
delivery services from suppliers. RONAs three primary DCs are located in
Boucherville and Terrebonne, Quebec and Calgary, Alberta.
Exhibit 5. RONA Inc.: Distribution Centres
Indoor Lumberyard
Distribution Centre 000 sq. ft 000 sq. ft Activity
Boucherville, QC 926 DC for hardware products
Terrebonne, QC 380 Flow-through for hardware products
Saint-Hyacinthe, QC 100 125 Hub for forest products / building materialsHalton Hills, ON 45 77 Hub for forest products / building materials
Calgary, AB 320 DC for hardware products
Calgary, AB 104 375 Hub for forest products / building materials
Hopewell, AB 171 DC for hardware products
Edmonton, AB - 185 Hub for forest products / building materials
Surrey, BC 85 378 DC for hardware products; Hub for forest
products / building materials
Total 2,131 1,140
Source: Company reports.
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Macro Picture to Weaken Further Before Recovery
In our opinion, the current state of the Canadian economy represents a significant
challenge for RONAs growth prospects in the short to medium term, as for any
company tied closely to consumer spending. And, unfortunately, we believe that
there are few options in the companys control, to counter such a downturn.
With the Canadian economy now in a recession, the outlook for homeimprovement spending remains challenging. Historically, home improvement
spending, which is positively correlated with GDP, has benefited from low interest
rates, rising employment and disposable income. While interest rates are at historic
lows, typically making it more affordable to renovate or purchase a house,
unemployment is on the rise and disposable income has been negatively affected
by reduced home equity values and household net worth. While we are certainly
seeing significant deceleration in the Canadian housing market, we believe it is
highly unlikely that it would experience a correction as significant as the one
witnessed in the U.S. We believe this is the result of many factors that shape our
housing sector environment, including: 1) a conservative banking sector culture
and government regulations, 2) a far less exotic and much smaller sub-primemortgage share (peak of 5% of the Canadian market in 2006 versus 2025% of the
U.S. market), 3) a mandatory insurance by the CMHC for mortgages with down
payments of less than 20%. These are just a few takeaways, and for a detailed
write-up on the subject by TD Economics, please refer to Appendix I.
Exhibit 6. Relevant Statistics
Canada
Home improvement spending vs GDP
-15%
-10%
-5%
0%
5%
10%
15%
20%
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008E
2009E
2010E
YoYChange(%)
-2.0%
0.0%
2.0%
4.0%
6.0%
YoYChange(%)
YoY GDP Growth (RHS)
YoY Change in Home Improvement SpendingLagged 1 Yr (LHS)
R2= 90%
Canada
Home improvement spending vs Existing home sales
-20%
-10%
0%
10%
20%
30%
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008E
2009E
2010E
YoYChange(%)
YoY Change in Existing Home SalesYoY Change in Home Improvement SpendingLagged 1 Yr
R2 = 89%
Canada vs. US
YoY Change in Existing Home Sales
-40.0%
-30.0%
-20.0%
-10.0%
0.0%
10.0%
20.0%
30.0%
40.0%
1980
1983
1986
1989
1992
1995
1998
2001
2004
2007
2010E
YoYChange(%)
Canada US
l-----------l
Mar'01Nov'01
l----------l
Jul'90Mar'01l----------l
Jul'81Nov'02
Canada
Existing home sales vs Unemployment rate
15
20
25
3035
40
45
50
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Q1-09E
Q1-10E
Existinghome
sales
(000)
5%6%7%8%9%10%
11%12%13%14%
Unemploym
ent(%)
Unemployment rate (RHS) Existing Home Sales (LHS)
Source: CREA, CMHC, Statistics Canada, NAR, TD Economics.
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Not surprisingly, existing home sales have tapered off and recent data released
indicates that the Canadian housing market is squarely on the path of correction. This
too does not bode well for home improvements, as new owners will typically
renovate within three years of purchasing a home. Since February 2008, home sales
have continued to exhibit large year over year declines. Existing homes sold in
Canada declined 1.8% in December month over month to 27,400, on the heels of two
consecutive monthly double-digit declines in November and October. Sales activity
is now at its lowest level since 2000, and on a year-ago basis, sales volume is down36%. For the year, sales dropped 17%, representing the worst drop since 1990, when
sales fell 22.4%. Looking ahead, TD Economics forecasts that existing home sales
will drop 12.6% in 2009, before rebounding with a 6.5% increase in 2010.
Housing starts have been on a downtrend since April 2008. As of December 2008,
housing starts were down 4% year over year, off of an easier comparable as
December 2007 starts were down 16% year over year suggesting the worst in
home improvement spending is not behind us yet. To date, the decline has been
concentrated in single-unit properties, RONAs primary business segment.
However, according to CMHC, multi-unit housing, to which RONA will be
increasingly exposed to (10% of sales) through its Commercial and ProfessionalDivision, is forecast to drop significantly in 2009.
Exhibit 7. A Look at Canadian Housing Stats
Canada Housing Starts
110
130
150
170
190
210
230
250
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
2008E
2009E
2010E
Units(000)
-30%
-20%
-10%
0%
10%
20%
30%
Starts (LHS) YoY Change (RHS)
Canada Existing Home Sales
100150200250300350400450500550
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008E
2009E
2010E
Units(000)
-30%
-20%
-10%
0%
10%
20%
30%
Existing Home Sales (LHS) YoY Change (RHS)
Source: CMHC, CREA, TD Economics.
Historically, homeowners could usually recoup part of their investment later
through the resale market. Housing prices have a large impact on discretionary
income, particularly for home improvements. Until recently, with increasing
home prices, consumers could borrow against the rising value of their homes to
finance projects.
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A Division of TD Securities Inc. 11
Exhibit 8. Home Prices Declining in the U.S. and Canada
YoY Change in Home Prices
2010E
Canada
US
-15%
-10%
-5%
0%
5%
10%
15%
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
2009E
Y
oYChange
Canada US
Source: CREA, NAR, TD Economics.
Over the past 10-years, home prices in Canada grew at a CAGR of 7%, fuelling
increased home improvement spending. However, in 2008, home prices dropped
by 1%, with December prices down approximately 13%, representing the worst
drop on record. The drop was particularly pronounced in British Columbia, Alberta
and Ontario, where prices were down 14%, 7% and 12%, respectively; however,
Quebec, which accounts for about half of RONAs business, was down only 1%.
TD Economics expects this drop to be more pronounced in 2009, with Quebec
existing home sales dropping over 13%.
Exhibit 9. Existing Home Sales in Canada Weakening in All Regions
RONA's Sales Breakdown by Region
FY07
Western Canada29%
Ontario24%
AtlanticProvinces
2%
Quebec45%
Canada
Existing Home Sales by Region
-30%
-20%
-10%
0%
10%
20%30%
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008E
2009E
2010E
YoYChange
Western Canada Ontario Quebec Atlantic Provinces
Source: Company reports, CREA, TD Economics.
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Uninspiring Outlook for Home Improvement in 2009
About 80% of RONAs revenues are directly related to the renovation
industry, with the balance tied to new housing construction.
Exhibit 10. Home Improvement Retailers SSS Move in Tandem with Housing Stats
RONA SSS
vs. YoY Chg in Canada Existing Home Sales
-14%-11%-8%-5%-2%1%4%7%
10%13%
1Q-03
3Q-03
1Q-04
3Q-04
1Q-05
3Q-05
1Q-06
3Q-06
1Q-07
3Q-07
1Q-08
3Q-08
YoYChg(%)
RONA SSS Growth YoY Chg in Existing Home Sales
Home Depot & Lowe's SSS
vs. YoY Chg in US Existing Home Sales
-14%
-10%
-6%
-2%
2%
6%10%
14%
18%
1Q-01
3Q-01
1Q-02
3Q-02
1Q-03
3Q-03
1Q-04
3Q-04
1Q-05
3Q-05
1Q-06
3Q-06
1Q-07
3Q-07
1Q-08
3Q-08
YoYChg(%)
HD SSS Growth LOW SSS Growth YoY Chg in Exis ting Home Sales
Source: Company reports, Bloomberg, CREA, NAR.
Current industry conditions do not bode well for the home improvement industry
over the near term, explaining our cautious outlook for 2009. In the U.S., the
market has seen steady declines since mid-2007, although the rate of decline
has recently flattened. The Canadian renovation market has held up well,
especially when compared to the U.S. However, it appears that like housing, the
renovation market is starting to cool in Canada. Renovation spending growth
slowed to 6% in 2Q/08, the slowest pace since mid-2002, before improving slightly
to 7.7% in Q3/08, which still represented the third lowest growth rate since the
beginning of 2003.
Exhibit 11. Remodelling Activity Slowing in Canada and Declining in the U.S.
Canada Remodelling Expenditures
$0$5
$10$15$20$25$30$35$40$45
1Q-00
3Q-00
1Q-01
3Q-01
1Q-02
3Q-02
1Q-03
3Q-03
1Q-04
3Q-04
1Q-05
3Q-05
1Q-06
3Q-06
1Q-07
3Q-07
1Q-08
3Q-08
C$bln
0%
5%
10%
15%
20%
YoYChange(%)
Four Quarter-Moving Expenditures YoY Change
U.S. Home Improvement Activity Indicator
$70$80$90
$100$110$120$130$140$150
1Q-00
4Q-00
3Q-01
2Q-02
1Q-03
4Q-03
3Q-04
2Q-05
1Q-06
4Q-06
3Q-07
2Q-08
1Q-09E
US$bln
-20%-15%-10%-5%0%5%10%15%20%
YoYChange(%)
4-Quarter-Moving-Total Expenditures YoY Change
Source: Statistics Canada, Harvard Universitys JCHS.
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A Division of TD Securities Inc. 13
Typically, remodelling cycles lag homebuilding activity by several quarters
and are less volatile. First-time homebuyers will generally spend less than trade-
up buyers, given their lower incomes and the fact that a substantial part of their
wealth is usually tied up in their new homes. Home improvement spending is
driven in part by housing turnover, given that new owners will typically renovate
within three years of purchasing a home. Despite the negative near term outlook,
over the longer term, we believe that the fundamental drivers for increased
home improvement spending remain intact. Homeowners take on remodelling projects to improve their living environment, especially given that people are
spending more leisure time in their homes. Among other factors, the housing
stock is becoming older and homeownership rates are on the rise (for details
see Appendix IV).
Despite the negative near-
term outlook, over the
longer term, fundamental
drivers for increased home
improvement spending
remain intact .
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Industry Overview
The Canadian Home Improvement Industry has grown at a 10-year CAGR of
approximately 8.5% to reach $41 billion in 2007. It remains highly fragmented,
with the four largest players (three of which are publicly traded),
commanding approximately 55% of the market. Remaining players are much
smaller, with most generating less than $100 million in annual sales.
Exhibit 12. Canadian Home Improvement Industry
Canadian Retail Home Improvement Industry
$15
$20
$25
$30
$35
$40
$45
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008E
2009E
C$b
0%
5%
10%
15%
20%
Market Size YoY Change
CAGR ('9707): 8.4%
Canadian Home Improvement Industry
C$41b (2007)
Other45.2%
Home DepotCanada
14.7%
HomeHardware
11.7%
RONA
15.3%
Canadian TireRetail
13.1%
Source: Company reports, Hardlines.
RONA has achieved impressive market penetration, increasing its market share
from approximately 6% in 2000 to 15% in 2007 perHardlines, an industry
publication, although the company claims to have a 17% share (based on its own
computed market size of C$36 billion). It has been the prominent consolidator in
Canada and we believe that RONA remains well positioned to continue leading
the consolidation of the Canadian home improvement market. Its goal of
reaching a 20% share of the market by 2011 seems realizable, seeing that a largeportion of the market remains in the hands of independents.
Most participants in the Canadian home improvement industry are members of
buying groups. As of 2007, 10 buying groups represented approximately $13.6
billion in purchases, or approximately 33% of the Canadian industry. However,
faced with increased competition and defections to RONA and Home Depot, as
well as the impact of softening commodity lumber prices, the buying groups
collectively reported a 3% drop in purchases in 2007, the first drop since 2001.
Buying groups continue to face significant challenges, including limited
succession planning underscored by the aging owner demographic, continuedintense competition from the likes of RONA and Home Depot, not to mention
the impact of the weakening economy. In an attempt to remain competitive they
are becoming more proactive. As confirmed by Hardlines, current trends among
buying groups include:
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Exhibit 13. Top 50 Dealers and Retail Chains in Canada
Retail # of Y/Y Chg
% Market Sales (C$M) Y/Y Stores in # of
Company Location Share 2007 Change 2007 Stores % DIY % Pro Affiliation
1 RONA QC 15.3% 6,300 10% 679 37 85% 15% A.R.E.N.A.
2 Home Depot Canada1
ON 14.7% 6,040 1% 165 10 85% 15%
3 Canadian Tire Retail2
ON 13.1% 5,382 4% 473 5 85% 15%
4 Home Hardware ON 11.7% 4,800 4% 1,031 6 55% 45%
5 Pro Retail Services ON 2.9% 1,200 0% 800 0 70% 30%
6 TruServ Canada SK 1.6% 670 2% 766 0 80% 20% Mutual7 Alpa Lumber Group
1ON 1.6% 650 2% 19 0 10% 90%
8 Kent Building Supplies1
NB 1.0% 417 6% 32 2 50% 50% ILDC
9 United Farmers of Alberta1
AB 0.9% 360 13% 35 0 na na Sexton
10 Canac-Marquis Grenier Lte1
QC 0.7% 296 8% 16 2 72% 28% Mutual (May/07)
11 Windsor Plywood BC 0.6% 235 6% 61 2 50% 50% Delroc
12 Nelson Lumber AB 0.4% 160 3% 5 0 20% 80% Tim-BR-Marts
13 Pacific West Systems1
BC 0.4% 155 5% 8 0 5% 95% Tim-BR-Marts
14 McDiarmid Lumber Ltd. MB 0.4% 151 13% 14 1 40% 60% Tim-BR-Marts
15 Dicks Lumber1,3
BC 0.4% 147 7% 3 0 15% 85% Sexton
16 The Rockett Group1
ON 0.3% 140 4% 5 0 5% 95%
17 Peavey Industries AB 0.3% 133 8% 29 1 95% 5% Mutual/Mid-States
18 Patrick Morin1
QC 0.3% 127 3% 13 0 50% 50% ILDC
19 TSC Stores1
ON 0.3% 124 10% 39 8 92% 8% Mutual
20 Igloo Building Supplies1
AB 0.3% 119 13% 4 1 0% 100% ILDC
21 Patene Bldg. Supp. Ltd.1
ON 0.3% 115 8% 12 0 3% 97% Tim-BR-Marts/TSG
22 Central Home Improv. Warehouse1
NS 0.2% 92 3% 8 0 60% 40% ILDC
23 Franois LEsprance Inc.1,4
QC 0.2% 81 4% 5 0 50% 50% RONA
24 Pierceys Building Supplies1
NS 0.2% 80 4% 5 0 25% 75% PAL
25 Turkstra Lumber ON 0.2% 79 1% 12 2 20% 80% ILDC
26 Star Building Materials1
MB 0.2% 75 4% 5 2 95% 5% ILDC
27 Jaques Lafert Lte. QC 0.2% 68 5% 4 0 65% 35% ILDC
28 Copp Building Materials Ltd. ON 0.2% 62 5% 4 0 60% 40% ILDC
29 Potvin & Bouchard Inc.1
QC 0.1% 57 4% 5 0 70% 30% ILDC
30 Builders Warehouse1
ON 0.1% 55 4% 1 0 33% 67% BMR
31 Millwork Home Centres ON 0.1% 55 4% 3 0 50% 50% ILDC
32 Davidson Enman Lumber1
AB 0.1% 54 8% 3 0 5% 95% Tim-BR-Marts
33 Groupe Dynaco1
QC 0.1% 54 4% 12 0 n/a n/a BMR
34 Gibson Bldg. Supplies1
ON 0.1% 53 4% 2 0 20% 80%
35 McMunn & Yates MB 0.1% 52 6% 11 0 40% 60% ILDC
36 Notre Dame Agencies NFLD 0.1% 51 9% 9 0 70% 30% Castle
37 House of Tools AB 0.1% 51 6% 13 0 20% 80% Western Tool38 J&H Builders Warehouse SK 0.1% 47 7% 2 0 35% 65% ILDC
39 United Lumber ON 0.1% 46 0% 4 0 45% 55% Home Hardware
40 Moffat & Powell ON 0.1% 43 8% 5 0 35% 65% ILDC
41 Groupe Gaston Ct1
QC 0.1% 43 5% 7 0 35% 65% ILDC
42 Logic Lumber AB 0.1% 41 21% 2 0 10% 90%
43 Bolt Supply House AB 0.1% 38 9% 14 0 0% 100%
44 J.O. Lvsque1
QC 0.1% 36 6% 5 0 100% 0%
45 Executive Home Bldg. AB 0.1% 35 9% 1 0 10% 90% Home Hardware
46 Ferlac Inc.4
QC 0.1% 34 6% 4 0 70% 30% RONA
47 Payzant Building Products1
NS 0.1% 34 3% 3 0 45% 55% Home Hardware
48 Quincaillerie R. Durand1,4
QC 0.1% 33 3% 1 0 70% 30% RONA
49 Harrons RONA Building Centre4
ON 0.1% 30 11% 2 1 3% 97% RONA
50 Lake Scugog Lumber ON 0.1% 27 4% 1 0 30% 70% Castle
Total market Size5
71.2% 41,062 4,362 80
1Hardware Merchandising sales estimates
2Home and Leisure sales only
3Acquired by RONA in December 2007
4Included in RONA's sales figures
5Hardlines estimate of market size
Source: Hardware Merchandising, TD Newcrest.
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Growth Strategy
RONAs stated four areas of growth can essentially be grouped into two:
1. Acquisitions: Acquiring complementary businesses and recruitment of
independent dealers
2. Organic growth: New store openings and initiatives to drive SSS growth such
as renovations/upgrades as well as a number of programs grouped under itsrecently launched strategic plan, including optimizing the supply chain, IT
upgrades, loyalty programs, new store concepts, product rationalization and
increased sales of private label brands.
Acquisition-Driven Growth in the Past
About half of RONAs growth over the past decade is attributable to acquisitions,
particularly since 2000. Over the past eight years, RONA has successfully
completed 11 acquisitions, adding over 200 stores and approximately $2.8 billion
to sales. Past acquisitions have not only fuelled RONAs growth, but have alsogreatly diversified its geographic presence, enhanced its buying power, and
enabled it to reach different types of customers. The company has recorded
about $80 million in synergies from past acquisitions, and has yet to fully reap the
benefits from its latest acquisitions.
Exhibit 14. About Half of RONAs Growth Stems from Acquisitions
Approximate Sources of Growth
20022007
Acquisitions50%
Organic growth
30%
Affiliate
recruitment20%
Source: Company reports, TD Newcrest.
RONA has a strong track record of sticking to its acquisition criteria, which
include: 1) profitable target that is immediately accretive to earnings; 2) operations
in a segment with good growth potential; 2) operations in a complementary
business for recurring synergies to be attainable; and 3) strong management. The
company typically pays 57x EBITDA and looks for a minimum ROI of 15%.
About half of RONAs
growth over the past
decade is attributable to
acquisitions, particularly
since 2000.
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RONA has typically achieved synergies of 34% of sales, once acquisitions are
essentially fully integrated, usually by the end of the second year. The average
EBITDA multiple paid, post-synergies, was therefore closer to 3.54.0x.
Primary synergistic drivers include improved purchasing terms, the elimination of
overlapping corporate functions, as well as improvements in distribution and
merchandising. The integration of different information technology systems is
usually lengthier and can take up to a couple of years. Wherever possible, RONA
applies best-practices from acquired companies across the rest of its network. Thisis especially true for those with experience in ICI, a relatively new area for RONA.
Niche Penetration by Acquisition Opportunistic Tuck-Ins Likely
In the first several years after its IPO, RONA focused on expanding its geographic
footprint coast-to-coast. However, in 2005, the company established a Pro Services
division to address the ICI market (Institutional, Commercial and Industrial market).
Since then, four of the seven acquisitions undertaken have been in this segment.
At the end of 2007, RONA grouped the operations of Materiaux Coupal, CurtisLumber, Noble Trade, and Dick's Lumber under a newly created Commercial and
Professional Division. The new division includes 40 of the companys corporate
stores and accounts for 10% of consolidated revenues. Below, we detail the two
most significant acquisitions in the segment.
Noble Trade Acquisition
In April 2007, RONA acquired Noble Trade, a leader in the Ontario plumbing and
heating, ventilating and air conditioning (HVAC) markets, with 19 stores and 1
DC. At the time of the acquisition, the company had annual revenues of over $150million, had been growing at an average annual rate of 27% since 1998, and had
EBITDA margins above RONAs legacy operations. We estimate that RONA paid
about 7x EBITDA and that the acquisition was immediately accretive to earnings.
With this acquisition, RONA significantly improved its purchasing power for
plumbing products and is also benefiting from Noble Trades management
experience in addressing the plumbing industry and more specifically commercial
and professional customers. In fact, at the end of 2007, it appointed Michael
Storfer, Noble Trades president, to head up its new ICI division.
In January 2008, RONA increased its penetration of the Ontario plumbing market
through the acquisition of Best-MAR Plumbing and Heating Supplies. RONAsubsequently rolled this company into Noble Trade.
The Noble Trade acquisition
represents a full push into
the Ontario plumbing and
HVAC markets
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Dicks Lumber = Where the Builders Buy!
In December 2007, RONA acquired Dicks Lumber, a lumber, building materials
and hardware specialist with three specialized stores in the Vancouver, British
Columbia area. At the time of the acquisition, the companys annual revenues were
about $100 million. Given its focus on lumber and building materials, which
typically carry lower margins, its profit margins were slightly below RONAs
legacy operations. However, RONA argues that owing to the limited investmentrequired by these businesses, returns on invested capital are equivalent to or higher
than retail operations. We estimate that RONA paid about 6x EBITDA and that the
acquisition was immediately accretive to earnings. This acquisition is RONAs
third in this segment in British Columbia, giving it the leading position in
western Canadas contractor building supply market.
Exhibit 15. RONA Inc.: Acquisition History
Transaction Est. Annual Sales /
Total Price Sales Price / Price / Store
Date Company Acquired Location Stores (C$m) (C$m) Sales(1)
EBITDA(1) Acquired
Mar-00 Cashway ON 66 $85 $342 0.25x 5.0x $5
Jun-01 Revy Home Centres Inc. ON, MB, SK, AB, BC 51 $220 $805 0.27x 5.2x $16
Sep-03 Rno-Dpt 2 QC 20 $250 $847 0.30x 5.1x $42
Apr-05 Totem AB 16 $96 $260 0.37x 5.8x $16
Mar-06 Chester Dawe 3 NL 8 $37 $80 0.46x 5.8x $10
Apr-06 51% interest in operating businesses of Matriaux Coupal Inc. 3,4 QC 9 $22 $64 0.35x 5.8x $7
Jul-06 Curtis Lumber3 BC 6 $28 $80 0.35x 5.8x $13
Aug-06 Mountain Building Centres Ltd. 3 BC 3 $7 $20 0.35x 5.8x $7
Apr-07 Noble Trade Inc. 3 ON 19 $152 $150 1.02x 7.0x $8
Dec-07 Dicks Lumber3 BC 3 $48 $100 0.48x 6.0x $33
Dec-07 Centre de Rnovation Andr Lessard 3,5 QC 1 $5 $15 0.36x 6.0x $15
Jan-08 Best-MAR Plumbing and Heating Supplies 3 ON 3 $7 $20 0.36x 6.0x $7
Total 205 $958 $2,782
Average - 0.41x 5.8x $15
1
Shown pre-synergies2 C$350m purchase price included ~C$100m in real estate; subsequent to the transaction, RONA entered a sale-and-leaseback transaction; PF EV/EBITDA adjusted
for sale-and-lease-back and assumed rent expense3
TD Newcrest Estimated Transaction Price4
Matriaux Coupal Inc.recorded 2005 annual sales of $125m5
TD Newcrest Estimated Sales Figure
Source: Company reports, TD Newcrest.
No Large Scale Acquisition Expected in the Short to Medium Term;
Focus on the Pro
We expect RONA to continue targeting acquisitions that further increase its
presence primarily in western Canada and Ontario. Significant opportunities
remain in traditional retail, but we believe the company remains more focused on
the ICI industry, a market estimated at $70 billion and largely in the hands of
independents. In particular, in the near term, we expect RONA to target
companies focused on plumbing and HVAC, similar to the recent Best-MAR
acquisition. These two industries alone are estimated at $13 billion nationally, with
plumbing accounting for $1 billion in Ontario alone.
Dicks Lumber doubled
RONAs presence in ICI
segment and significantly
increased its presence in
western Canada.
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In addition to the primary synergistic drivers previously discussed, acquisitions in
the ICI industry would offer some cross-selling opportunities with RONAs retail
operations and also reduce the overall seasonality of RONAs business, given that
it is typically less cyclical than retail. Management has indicated it would like to
have a national presence for its ICI operations by the end of 2010. We
estimate that a $50 million acquisition (or about $100 million in annual sales)
would add $0.020.03 to EPS on an annualized basis. RONA is not alone in
recognizing the potential for increased sales in the underdeveloped ICI market. Asdiscussed in the section entitled Overview of Key Players, both Home Depot and
Lowes have programs in place catering to the Pro.
In 2009, as RONA remains focused on integrating recent acquisitions and
improving internal operations (i.e., the PEP, or Productivity, Efficiency and
Profitability program), we expect the company to target opportunistic tuck-ins,
but will prioritize dealer recruitment. This also reflects our belief that, given
the current economic climate, RONA is tilting toward a capital preservation
mode. Once economic conditions begin to improve, and as the PEP program nears
completion, we believe that the company could look to make a larger acquisition.
We suspect that both Kent and Home Hardware are on its radar, although RONAhas also successfully been using dealer recruitment as a means to grow its market
share and buying power, while avoiding any potential competition bureau issues,
particularly in the case of Home Hardware.
Economic Climate Favours Affiliate Recruitment: A Priority for RONA
We believe that dealer recruitment represents a priority for RONA and a
profitable way to grow, requiring no capital outlay and limited incremental
costs. In fact, in mid-November, RONA announced that these activities would be
spearheaded by a separate department and would fall under the directresponsibility of President and CEO, Robert Dutton, attesting to the importance of
this growth vector for the company.
Exhibit 16. RONA Inc.: Affiliate Recruitment 2003-2008 (year to date)
Home Tim-BR Pro Retail Sexton
Year Hardware MARTS Castle Services Group Other Total
2003 0 1 2 5 0 3 11
2004 1 6 2 4 2 10 25
2005 7 4 2 8 1 9 31
2006 1 6 6 12 2 10 37
2007 2 5 6 6 3 5 27
2008 YTD 7 2 0 8 3 6 26
Total 18 24 18 43 11 43 157
Represents (C$m) 128 118 116 191 28 162 743
Source: Company reports.
In 2009, while RONA
remains focused on
improving internal
operations
its priority for expansion
will be through dealer
recruitment, a profitable
way to grow, requiring no
capital outlay and limited
incremental costs.
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Since 2003, RONA has recruited nearly 160 affiliates, representing over $700
million in annual retail sales. A new affiliate recruited by RONA typically signs
a 10-year agreement and agrees to purchase a minimum of 90% of its merchandise
through RONA although the company boasts that on average, this percentage is
often closer to 95%. In addition to lower price guarantees, the RONA banner and
private label programs, as well as marketing assistance, affiliates have the
opportunity to share the success through RONA share ownership (typically held as
collateral for the affiliates obligations). This is an advantage that buying groupssuch as Home Hardware cannot offer. Historically, new affiliates recruited have
recorded on average, a 1015% increase in sales within the first two to three
years of joining RONAs network. The company seeks to enlist affiliates with
entrepreneurial owners looking to grow their business; it will also assist them in
drafting their business and growth plans, the success of which ultimately benefits
RONA as well. In fact, as shown in Exhibit 17, RONA affiliates have initiated a
number of projects, ranging from new concepts to store expansions, and, in some
cases, even acquisitions.
Exhibit 17. RONA Inc.: Projects Initiated by Affiliates
2003 2004 2005 2006 2007 2008E Total
# of Projects 90 105 144 166 180 164 849
Value (C$m) 21.0 23.1 48.0 68.8 53.1 33.5 247.5
Source: Company reports.
In the tough economic context, independent dealers may increasingly look to
align themselves with a larger network, such as RONAs, in search of lower costs
obtained when joining a larger buying group, among other benefits such as improved
merchandising approaches and tested store concepts, wider product assortment, a
national distribution network, and exposure to a recognized banner. This also holds
true when taking into account Lowes entry into Canada, and the fear of dealers
being further squeezed out. It is also worth noting that a number of these
independents do not have formal succession plans in place. In fact, even
uncertainty over succession plans at Home Hardware, with its founder (said to be 87
years old) set to step down in April, are leading a number of its members to consider
alternative options. Note that RONA has recruited the most affiliates from Home
Hardware and Pro Retail Services (which consists of Pro and Ace dealers and has
had a large turnover of executives trying to run the brand in Canada).
No U.S. Foray on the Horizon
In our conversations with management, it was clear that RONA has no intention to
enter the U.S. market, at least over the next three years. Mr. Dutton firmly believes
that the company has enough growth opportunities in Canada, as evidenced by the
fact that the market remains highly fragmented even after several years of
consolidation, in addition to numerous niche opportunities described above; and
we tend to agree.
In the tough economic
context, independents mayincreasingly look to align
themselves with a larger
network, such as RONAs,
in search of lower costs.
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RONAs growth target is realizable, especially given the trend among baby
boomers for more DIFM (do-it-for-me) projects (Appendix IV).
Increase Customer Awareness and Loyalty: RONA claims to have achieved
significant brand awareness in Canada, and that approximately 78% of Canadians
across the country are now familiar with the company. This should continue to be
achieved through several advertising and marketing campaigns, including the
companys sponsorship of the 2010 Winter Olympics in Whistler, BritishColumbia. The exclusive association (relative to competitors) with the Air Miles
rewards program in Canada has also proved fruitful, with 54% of RONA revenues
being derived from Air Miles collectors, who, according to management, spend
35% more on average than other customers. RONAs goal is to raise the level of
revenues from collectors to 60%.
Profit Enhancement Initiatives Prioritized under the PEP
The first phase of RONAs 2008-2011 plan aims to focus on lowering costs and
improving efficiencies.
Product Management: Since 2005, RONA has reduced its product offerings from
over 200,000 SKUs to 90,000, reducing store clutter, removing obsolete items, and
focusing on best selling, profitable product categories. A similar process now aims at
reducing the SKU count to 65,000 by 2011. The company will focus on in-stock
guarantees for its best performing SKUs. With improvements in demand planning
and the POS system, RONA should be able to pull products as needed direct-to-
store. This should result in lower inventory levels and a reduced need to use satellite
DCs.
Aiming for 100 Bps Improvement in Gross Margins: RONAs goal is toincrease its direct global sourcing to 810% of revenues sourced from Asia, 5%
currently. Increasing its private label offering from 15% of sales to 20% by 2011
should improve gross margins; these products are typically priced 510% below
national branded products, but carry 10 percentage points more in margins. In
Q3/08, these already represented 17% of total.
Expand Information Technology Systems: RONA will be investing $40 million
to standardize its IT infrastructure, which involves upgrading human resources,
financial and demand planning platforms. As for the POS system, an IT provider
has been selected and tests are to be conducted in 2009 in several stores. It aims to
eventually upgrade it to allow for greater data-mining flexibility for promotionsand price increase implementation across the network.
Improve Inventory Management and Optimize use of existing DCs: Enhanced
supply logistics, better demand planning and the harmonization of product offers
should reduce overall inventory levels. 2008 to date, the company has realized
significant inventory reductions, with same-store and DC inventory levels down
nearly $80 million or 10% year over year. RONA is also analyzing delivery
methods used by 200 of its major suppliers to fine tune its direct-to-store, DC
RONA aims to improve
gross margins by
increasing global sourcing
and private label offer,
among other initiatives.
Year to date, significant
inventory reductions were
achieved through improved
inventory management and
optimized use of DCs.
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or cross-dock deliveries. By having suppliers deliver high-volume products to
RONAs cross-dock DC rather than direct to store, on-hand inventory levels should
drop. We believe that the companys existing distribution centers are sufficient to
support organic growth over the forecast period and, in maximizing its cross-dock
use, the Terrebone DCs volume should double (now operating at 50% capacity).
Calgary DC expansion plans (set to cost about $25 million), as well as the eventual
consolidation of three DCs in Alberta, were recently put on hold until market
conditions improve. RONA also recently appointed Paul Jovian as the new SeniorVice-President, Supply Chain Management to oversee the optimization if its entire
supply chain, an initiative that stems from its strategic plan. Mr. Jovian has 25
years experience, having previously been employed at Canadian Tire, most
recently in the role of Vice-President, Supply Chain, major projects.
Disposal of non-core assets: To improve profitability, RONA closed four non-
profitable stores in 2008 (none were closed in 2007). We do not expect further
closures in the near term.
Modest New Store Construction Plans. But, Will They Be CurtailedFurther?
In 2007 RONA opened 10 new stores (compared to 15 originally targeted, and
versus 8 in 2006) in Alberta, Ontario and Quebec, for a total investment of $186
million. Six are located in Ontario, where RONA is focused on growing its market
share and strengthening its competitive position, particularly against Lowes; in
2007, Lowes opened its first six stores in Canada, all of which were located in
Ontario (see the section entitled Overview of Key Players for additional details).
Exhibit 19. RONA Inc.: New Store Openings
F09E
F04 F05 F06 F07 F08E TD Mgmt Target1
F10E
Big Box 1 2 5 7 2 1 2 2
Proximity 3 4 3 3 4 3 5 5
Total 4 6 8 10 6 4 7 7
11 big box and 2 proximity stores are relocations
Source: Company reports, TD Newcrest.
One of RONAs main competitive advantages lies in its one size does not fit all
approach. It allows the company flexibility to penetrate smaller markets quicklyin communities of all sizes. RONA has been scaling back the size of its typical big-
box store, which now averages 80,000100,000 sf, down from 120,000 sf a few
years ago. This is a result of scarcity of large development areas and escalating
land costs in some parts of the country and mainly the belief that the younger
more-informed generation is in search of convenience and expertise. This has also
led to the development of RONAs Proximity and Specialized stores, in addition to
its goal of providing consumers personalized service typical of small regional
hardware stores. It costs RONA $2430 million for a new big-box store and $14-
One of RONAs main
competitive advantages liesin its one size does not fit
all approach.
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18 million for a Proximity (land, building, inventory and pre-opening expenses
included). Once fully ramped up over 2436 months, we understand that these
stores typically add sales of $2040 million and $1220 million, respectively.
Fiscal 2008 to date, RONA has opened six stores two big-box and four
Proximity. Another Proximity store originally scheduled to open this year, is now
expected to open in early 2009. Management had indicated that it expects to
open two big-box (one relocation) and five Proximity stores (two relocations)in 2009. However, we question whether the company will maintain its new
store opening goals for next year given the deteriorating economic climate, and
suspect that RONA will likely postpone some of these projects to early 2010 (we
address this further in the Financial Section of the report).
Proximity Store expansion in Western Canada and Ontario is the focus. RONA
currently has land bank and site commitments for over 30 new stores, with the
majority located in Ontario and western Canada. We expect the majority of new
store openings to be Proximity stores averaging 52,000 sf, given 1) the limited sites
available for big-box formats, as we discuss below, and 2) RONAs ability to
leverage its distribution structure in addressing local customer needs with smallerstore formats.
Big Box Format Is Near Saturation, Especially In Ontario. So, Where IsLowes Going Next?
The big-box is a large format retail footprint of 85,000140,000 sf. Since their
appearance in 1992, big-boxes enjoyed significant growth and through the mid-
1990s, sales grew as much as 30%, perHardlines. The rate of sales growth peaked
in 2005, when market share topped 21.8%, and dropped slightly to 21.5% in 2007.
Canada counted 255 big-box stores, and will likely end 2008 with 264. Home
Depot is the largest in this category, with 172 stores; RONA comes in second with
77. Kent, the third player with seven stores, operates only in Atlantic Canada. The
announcement of Lowes entry into Canada, and the subsequent opening of eight
stores, adding yet a third (potentially) national player in the country, have
prompted queries over the ultimate penetration level of this store format.
RONA management believes that the Canadian market for big-box stores is
close to saturation, and our analysis below seems to concur. As described in the
section above, this is part of the reason why RONA has been scaling back the
opening of this store format (having pioneered the mini big-box as far back as
1997, with its RONA Regional banner in Quebec). Home Depot, which had 165
big-box stores in Canada (65% of total) at the end of 2007, is also testing smaller
store formats with a 45,000 sf prototype opened in Ontario in October 2008.
A recent article in Hardlines pointed out that unless Lowes can increase the big-
box market share without taking it solely from competitors, the total size of
Canadas big-box market is not likely to increase dramatically. We agree with this
and believe that over the next couple of years, if Lowe is successful in pursuing its
aggressive market penetration (with a target of 100 stores), both Home Depot and
The majority of new store
openings will likely focus
on Ontario and Western
Canada.
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Exhibit 21. Big Box Saturation Analysis in Canada
Canada Big Box Penetration by Company 2007 Canada Big Box Penetration by Company 2008E
Square # of people Square # of people
Population Population # of Footage/ / big-box Population Population # of Footage/ / big-box
(mm) Density big-box Population (000) (mm) Density big-box Population (000)
Home Depot 165 0.55 200 Home Depot 172 0.57 194
RONA 77 0.26 428 RONA 77 0.25 433
Kent 7 0.02 4,704 Kent2
7 0.02 4,759
Lowe's 6 0.02 5,488 Lowe's2
8 0.03 4,164
Total 32.9 3.5 255 0.85 129 Total 33.3 3.5 264 0.87 126
New Additions Possible 3,4 44 New Additions Possible 3,4 39
U.S. 301.1 31 3,917 1.43
1Store count as of Q3/08
2Store count as of Q4/08
3Assumes saturation point of 1 sf per person
4Assumes average big-box = 110,000 sf in size.
Source: Company reports, Hardlines, TD Newcrest.
Since Lowes first foray into Canada was in Ontario, we have taken a closer look
at the saturation of the Ontario market. Using the same assumptions as above, the
Ontario market seems to have little room for new big-box stores, or four net newadditions possible. Ontarios denser population, relative to other regions, would
justify a higher saturation level (as is the case in the U.S.). A slight tweak to the
saturation level to 1.05 sf of space per person and a store size of 100,000-110,000
sf, raises the number of possible additions to 1021 stores.
Exhibit 22. Big Box Saturation Analysis in Ontario
Ontario Big Box Penetration by Company 2008E
Square # of people Saturation Point (# of Sq. Ft. per Person)
Population Population # of Footage/ / big-box 1.00 1.05 1.10 1.15
(mm) Density big-box Population (000) 100 15 21 26 32
Home Depot 1 85 0.73 151
RONA 19 0.16 673 105 9 15 21 27Kent 0 - -
Lowe's 8 0.07 1,599 110 4 10 16 22
Total 12.9 13.4 112 0.96 114 115 -1 5 11 17
New Additions Possible2,3
4 120 -6 0 6 12Avg.
SquareFoo
tageof
New
Stores(000)
Sensitivity Analysis # of Big Box Additions Possible in Ontario
1Opened four stores in Ontario year to date as of Q3/08
2Assumes saturation point of 1 sf per person
3Assumes average big-box = 110,000 sf in size.
Source: Company reports, Hardlines, TD Newcrest.
Why We Do Not Believe Lowes is Interested in RONA, at Least For Now
Lowes announced entry into the Canadian market in June 2005 prompted
speculation surrounding its potential interest in acquiring RONA. This appears to
have subsided of late, but remains in the back of investors minds as a possibility;
we chose to address it as we believe that there are a number of reasons why an
acquisition of RONA might not make sense, for now.
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Lowes has not grown by acquisition in the past. Almost all its growth has
been organic, with the exception of one acquisition, of a 32-store hardware
chain in nine western U.S. states in 1998. At that time, it had 465 stores.
Both RONA and Home Depot are scaling their store sizes back as discussed in
the previous section. The exception to the rule remains Lowes Canada, which
has maintained its intention to build full sized big-box stores and a disciplined
approach to its store format. Industry observers seem to attribute this to Lowesdesire to provide Canadian consumers the full product assortment in order to
make biggest impact on the market, which it seems to have achieved.
So what is to stop Lowes from developing smaller store formats in Canada?
Nothing, in our view. But, it has yet to do so in its own backyard, where
independents make up over 45% of the market. The latest developments in the
U.S. indicate that Lowes is reconsidering its super-size strategy, with about
30% of its store openings in 2009 expected to use a 103,000 sf format rather
than the 117,000 sf format; No indications of going smaller have been
provided. It is also important to acknowledge the difficulty that typical big-
box retailers like Lowes and Home Depot have in squeezing a largenumber of SKUs into a smaller store format without a corresponding
strong distribution and special order system that is integral to servicing
smaller formats. RONAs system is constantly fine-tuned and still involves
over 20,000 items being hand-picked per day.
A few corporate differences arise when looking at the two companies as well:
Lowes entire store network is corporately owned, whereas RONAs includes
23 franchised stores (or 3.3% of its network). Admittedly, this is not a big
factor as these franchised stores could be converted or sold if need be. Also,
Lowes typically owns 90% of its real estate, versus RONAs 25%. And, most
importantly, particularly given that Lowes has such a disciplinedapproach to its store formats, we would be hard-pressed to see the
company become interested in RONAs affiliated dealer network of 435
stores (or 63% of its store network, which tends to be small in size).
Also, RONAs distribution network fully integrates both its corporate stores and
affiliates and would be nearly impossible to separate. About 25% of RONAs
workforce is unionized, whereas Lowes (and Home Depots) is not. And
finally, theres the Quebec factor. Owing to cultural differences and additional
costs involved in following laws governing the use of two official languages in
the province, it is typically developed last (or not at all). A few examples that
come to mind include retailers such as Pottery Barn, Williams Sonoma, andRestoration Hardware that have yet to open stores in the province.
It is also worth mentioning that RONA has a flip-in poison pill to
discourage unsolicited takeover bids (adopted in early 2005). Under the plan,
in the event of an unwelcome bid, existing shareholders (except the would-be
acquirer) may acquire additional shares at a 50% discount to the market price
and, in so doing, would significantly dilute the acquirers existing position.
Lowes maintains its
intention to open full sized
big-box stores in Canada.
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We acknowledge that Lowes growth could, to large extent, be achieved by
stealing market share away from Home Depot and RONA; but it seems
unlikely to expect the totality of its growth to stem from that, especially given
the scarcity of prime real estate locations. It is important to recall that when
Lowes began to encroach on Home Depots big-box market share in the U.S. by
offering a new fresher big-box look, the latters existing store network was more
mature and in need of revamping. This does not hold true in the Canadian market,
where the big-box store network is relatively younger. As shown in our big-boxsaturation analysis, Lowes would likely need to change its approach to new store
development and consider smaller store formats, in which case, the RONA
proposition becomes appealing. The one main issue remains RONAs extensive
dealer network, which is fully integrated within its retail distribution structure and
is tough to separate.
Lowes may steal some big-
box market share away
from Home Depot and
RONA. But then what?
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A Division of TD Securities Inc. 31
Financial Analysis
Driven by a well thought out acquisition and affiliate recruitment strategy and
mid-single digit SSS growth, RONAs net sales grew at a CAGR of 20%, and
EBITDA margins rose on average 70 bps per year, between 2001 and 2006.
Over the same period, organic growth averaged 7.5% and EPS (f.d.) grew at a
CAGR of 25%, as the home improvement industry benefitted from a booming
housing market and RONA implemented initiatives to increase store traffic, salesand profits. In fiscal 2007, RONA faced significant headwinds, with worsening
economic conditions and unfavourable weather conditions. For the year, the
company recorded a meager 0.9% organic growth, saw SSS drop for the first time
in its history as a public company and EBITDA margins retreat 10 bps.
Exhibit 23. RONA Inc.: Select Historical and Forecast Income Statement Statistics
Consolidated sales vs. EBITDA margins
0.0
1.0
2.0
3.0
4.0
5.0
6.0
2002 2003 2004 2005 2006 2007 2008E 2009E 2010E
C
$b
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
Net Sales EBITDA Margin
Net Income
020406080
100120140160180
2002 2003 2004 2005 2006 2007 2008E 2009E 2010E
C$
mm
Retail Sales & EBITDA margins
0.0
0.51.01.52.02.53.03.54.04.55.0
2002 2003 2004 2005 2006 2007 2008E 2009E 2010E
C$b
6.0%
6.5%
7.0%
7.5%
8.0%
8.5%
9.0%
9.5%
Sales EBITDA Margin
Distribution Sales & EBITDA margins
0.5
0.7
0.9
1.1
1.3
1.5
2002 2003 2004 2005 2006 2007 2008E 2009E 2010E
C$b
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
Sales EBITDA Margin
Source: Company reports, TD Newcrest estimates.
Q3/08 review
In Q3, RONAs results were weighed down by the deteriorating economic
conditions, despite the progress made on its PEP initiatives. At $0.46, Q3/08
EPS (f.d.) was down 10% from $0.51. Retail segment revenues were essentiallyflat, as the positive impact from recent acquisitions and new store openings was
offset by a 3% drop in SSS. Sales declined in most product categories, but average
basket size was up in the quarter. Distribution segment sales were up 9%, owing to
the recruitment of new affiliates, an accelerated conversion process and increased
purchases by existing affiliates due to the introduction of new sales programs.
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32 A Division of TD Securities Inc.
Consolidated adjusted gross margins improved 40 bps year over year in Q3/08
driven by 1) a 6% year-over-year increase in private label product sales, which
now account for approximately 17% of overall sales; 2) product management
improvements logistics costs were reduced by approximately $1 million due to
the continued optimization of RONAs distribution channels; and 3) improved
product purchasing terms. Retail segment EBITDA margins dropped 90 bps
year over year to 8.9%. However, excluding one-time charges related to store-
closures, margins would have been down only 10 bps as benefits from RONAsPEP initiatives partially offset the impact of lower SSS. Management indicated that
the integration of its two most recent acquisitions, Dicks Lumber and Best-MAR
were going well and that both posted improved EBITDA margins in the quarter. As
for the Distribution segment, EBITDA margins improved 41 bps, driven by
higher sales and supply chain improvements.
Expected future performance
In Q4/08,we foresee organic growth and margin momentum continuing to slide, as
economic conditions worsen. Retail segment revenues are forecast to drop 2.5%,driven by a decline of 5.5% in SSS, partially offset by the contribution of the past
couple of acquisitions (Best-MAR and Dicks Lumber). Distribution segment
revenues should fare better, aided by the addition of 25 dealers recruited to date. In
Q3/08, management noted that its affiliate dealers, which typically operate smaller
stores, have been less affected by the economic slowdown than the corporate store
network. We expectconsolidatedEBITDA margins to drop by 40 bps, which takes
into account previously announced store closure costs of about $3.7 million.
Excluding these costs, EBITDA margins would only drop approximately 10 bps.
Our EPS forecast stands at $0.20, down 22% year over year remember that Q4 is
seasonally the companys second weakest quarter after Q1.
In 2009, we are forecasting consolidated revenues to decline by approximately
1.8%, before turning 4% higher in 2010.Within the Retail Segment, we expect
the mid-single-digit SSS decline seen in 2008 year-to-date to continue into 2009,
with forecast SSS growth of -5%, more than offsetting the positive impact from
four new planned store openings. Management had guided for seven new stores in
2009, although we believe that a few of these projects may be postponed in view of
prudently allocating capex in the current economic backdrop.
In its 2009 Budget, the Federal Government proposed a new Home Renovation
Tax Credit (HRTC). Effective through January 31, 2010, homeowners can claim a
tax credit for 15% of renovation expenses up to $1,350, for projects between$1,000 and $10,000. The government estimated the total value of the tax credit at
approximately $3 billion, and expects about 4.6 million families to take advantage
of the benefit. The government of Quebec, the province where RONA generates
about half its business, also announced in January, that it would provide
homeowners with a refundable tax credit of up to $2,500 for home improvement
and renovation expenses in excess of $7,500.
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A Division of TD Securities Inc. 33
Piggybacking on this move, RONA offered a 10% cash-back to be redeemed in
gift cards applied to the cost of materials purchased at RONA or Rno-Dpt
anywhere in Quebec, for use in a project that is eligible for the governments tax
credit program. The company will also most likely extend this incentive outside of
Quebec. While this is a step in the right direction, in that it might stimulate some
consumer spending, we do not believe it will materially affect our expectations.
We expect 2010 retail revenues to improve modestly by 2.8%, given our
expectations for a similar new store opening pace in 2009 and 1% SSS growth.
In the Distribution Segment, revenues are expected to rise 5% and 9% in 2009
and 2010, respectively, mainly driven by the continued recruitment of new
affiliates, and despite weak organic sales growth of -1.1% and +1.3%. While we
believe that the current economic environment is supportive of recruitment, we are
conservatively forecasting $150 million in additional retail sales from affiliate
recruitment in 2009, below managements goal of $200 million.
Consolidated EBITDA margins are expected to drop about 30 bps in 2009 at
7.5% and increase by about 35 bps in 2010. This year, the negative leverage
from weak top line growth should largely offset benefits from profit improvementinitiatives launched, including improved product purchasing terms, increased
private label product sales and inventory management improvements. We expect
new store opening costs to remain a drag on profitability longer than is typical as
revenue growth will also take longer to materialize. Also recall that about 50% of
RONAs cost base is fixed, in addition to the fact that it is attempting to strike
a balance between reducing its payroll costs, which represent approximately
60% of SG&A, and continuing to provide good customer service a key
element in the battle with other home improvement retailers, and, along with
price, one of the two top reasons for shopping at a given retailer, after
proximity.Retail Segment 2009 EBITDA margins should drop approximately
40 bps, off of an easy comp in 2008, when RONA recorded close to $15 million instore closure charges (excluding these charges, margins actually drop 70 bps).
Distribution Segment margins are expected to remain essentially flat.
Exhibit 24. RONA Inc.: LTM EBITDA Margins and EPS to Trough in Mid-2009
LTM EBITDA Margins
6.0%
6.5%
7.0%
7.5%
8.0%
8.5%
9.0%
4Q03
1Q04
2Q04
3Q04
4Q04
1Q05
2Q05
3Q05
4Q05
1Q06
2Q06
3Q06
4Q06
1Q07
2Q07
3Q07
4Q07
1Q08
2Q08
3Q08
4Q08E
1Q09E
2Q09E
3Q09E
4Q09E
1Q10E
2Q10E
3Q10E
4Q10E
LTME
BITDAMargin(%)
LTM EPS (f.d.)
$0.70$0.80
$0.90$1.00$1.10$1.20$1.30$1.40$1.50$1.60$1.70$1.80
4Q03
1Q04
2Q04
3Q04
4Q04
1Q05
2Q05
3Q05
4Q05
1Q06
2Q06
3Q06
4Q06
1Q07
2Q07
3Q07
4Q07
1Q08
2Q08
3Q08
4Q08E
1Q09E
2Q09E
3Q09E
4Q09E
1Q10E
2Q10E
3Q10E
4Q10E
C$
Source: Company reports, TD Newcrest.
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While we expect RONA to continue to benefit from the PEP initiatives being
undertaken, we believe this will be more than offset by the challenging
business conditions in 2009 and the resulting negative leverage. Our forecasts
reflect continued margin compression through mid-2009, before rebounding. We
agree with managements recent statement that it may not achieve its original
objective of low single digit EPS growth over the first half of its 20082011 plan.
We forecast EPS of $1.22 for 2009, down approximately 10% from $1.36 in 2008.
Note that 2008 to date, RONA has incurred $15 million in pre-tax store closurecosts segments, which we do not exclude as one-time items, and therefore shave
about C$0.09 per share off our 2008 EPS estimate. We chose not to adjust our EPS
for these costs, given that this is the first year that RONA discloses them and the
fact that business was likely re-routed to other RONA stores nearby. We expect a
rebound in earnings in 2010, with EPS up 13% to $1.39, aided by a return to
positive SSS territory and additional benefits from its PEP program.
RONA is not exposed to material foreign exchange fluctuation. About 10%
purchases are denominated in U.S. dollars (the rest in Canadian dollars). These
purchases consist mostly of seasonal products acquired in Asia and some U.S.
sourcing. Its annual procurement in U.S. dollars is about US$200 million andmanagement typically hedges 80% of U.S. dollar purchases. Since RONA
conducts it business entirely in Canada, there is no other source of direct foreign
exchange risk.
Our sensitivity analysis indicates that each 1% change in SSS yields a 1520
bps change in EBITDA margin for RONA on an annual basis (or
$0.030.04/share). The sensitivity is more pronounced in Q1 and Q4, given
revenue seasonality and taking into account the lower fixed cost absorption during
these slower quarters.
Our Forecast SSS in the Context of the Current Downturn
Looking back at the past few recessions, the cyclical peak to trough decline in U.S.
existing home sales has averaged 30%. In the current cycle, the U.S. housing
bubble began to burst in 2005-2006, due to high default rates on subprime and
adjustable rate mortgages (ARMs). Since the peak of September 2005, U.S.
existing home sales are down 37%, nearing the level reached in the recession of
the 1980s (-39%). In Canada, since the peak of November 2007, existing home
sales have also dropped 37%. Although Canada is not subject to the same
difficulties tied to the U.S. subprime mortgage, existing homes sales activity
appears to have caught up rather quickly with U.S. housing declines. This isdespite the stark differences in the two housing markets, such as the lack of
aggressive lending practices in Canada and the consequent lower foreclosure rates.
Each 1% change in SSS
yields a 1520 bps change
in EBITDA margin for RONA
on an annual basis.
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Exhibit 26. Components of Year-Over-Year Change in U.S. Residential
Investments
-12
63.3
-115.4
8.8
13.8
5.4
-9.9
-16.8
16.5
-150.0
-100.0
-50.0
0.0
50.0
100.0
2005 2006 2007
YoYChange(U
S$bln)
New Construction Spending Improvements Other Investments
14% YoY Chg in ResidentialInvestment
(2%) YoY Chg inResidential Investment
(17%) YoY Chg inResidential Investment
Source: BEA.
As for Canada, residential investment as a percentage of GDP has held up
relatively well compared to the U.S. The ratio currently stands at 5.6%, above its
historical average of 4.7%. While we do expect this metric to soften, here again,
we do not believe the downturn should be as pronounced as it has been in the U.S.
Still, using TD Economics forecast GDP for Canada and a trough of 4.7% for the
residential investment-to-GDP ratio would yield an expected drop of about 16.0%
for residential investments in Canada in 2009. Taking into account the fact that,
historically, renovation has accounted for approximately 45% of the growth in
residential investments in Canada, home improvement spending could drop about
7% in 2009. Remember that it took 12 quarters for this ratio in the U.S. to movefrom its peak to the current trough, whereas our trough estimate for Canada is
reached in only five quarters.
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Exhibit 27. How Far Can Residential and Home Improvement Spending Drop?
Q1/07 Q2/07 Q3/07 Q4/07 Q1/08 Q2/08 Q3/08 Q4/08 Q1/09E Q2/09E Q3/09E Q4/09E 2008 2009E
US Residential Investment (US$b; SAAR) 677 654 618 571 528 505 479 439 427 413 401 433 488 418
GDP (US$b; SAAR) 13,511 13,738 13,951 14,031 14,151 14,295 14,413 14,265 14,237 14,229 14,297 14,408 14,281 14,293
GDP y/y chg 4.2% 6.7% 6.2% 2.3% 3.4% 4.1% 3.3% -4.1% -0.8% -0.2%
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