On this week's episode of Industry Focus: Consumer Goods, Motley Fool analysts Jason Moser and Asit Sharma drive into Canadian Tire, a very successful -- you guessed it -- Canadian big-box retailer with a diverse collection of brands and businesses under its umbrella. Learn about the business model, the risks and challenges, the Monopoly money rewards program, the most important business metrics, and what to track going forward. Plus, the hosts check in on earnings from the big two in home improvement: Home Depot (NYSE:HD) and Lowe's (NYSE:LOW).
Also, Jason chats with new Fool analyst Thomas King about his investing history, living in a tent, a stock he really likes, and more.
To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.
This video was recorded on May 28, 2019.
Jason Moser: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market each day. It's Tuesday, May 28. I'm your host, Jason Moser, and on today's Consumer Goods show, we're going to dig into a business a bit better known north of the border, we'll take a look at the latest quarters for home improvement giants Lowe's and Home Depot. But we begin this week with another installment of Between Two Fools.
As you may remember, we've recently brought four new analysts onto our investing team here at The Motley Fool, and we wanted to take the opportunity here on Industry Focus and Between Two Fools to introduce you to them. This week, I had the opportunity to sit down and speak with Thomas King. I hope you enjoy our conversation.
Okay, Tom, first thing's first: Tell us who you are and tell us what got you here to The Motley Fool.
Thomas King: Hi, Jason, thanks for having me on the show. My name is Thomas King. You can probably hear from my accent that I'm not from around here.
King: [laughs] I'm originally a South African. I moved to the United States in July of last year. I wasn't always a financial analyst. I was actually an environmental scientist before this. But I got very interested in finance and particularly in analyzing companies and economics. So I got the education that I needed and came over to the States, and looked around at who would be wonderful to work for, and fortunately, I found The Motley Fool and The Motley Fool find me, and that's how I got to be here.
Moser: I remember talking with you right after you got here. So listeners know, I was part of the interview process, watching you go through that process and meeting you and learning about you. Shortly after we hired you, you said something to me that really struck me -- I felt the same way when I got hired, too. You said, "I think I found my tribe." And I thought, you know what, I know what you mean.
King: Yeah, that's exactly how I felt.
Moser: That was really good to hear. Very interesting educational background you have. That gives you a lot of good perspective when it comes to investing. I think one of the more enjoyable things about our job, especially when you're new like you are, is figuring out what kind of investor you are. I came here, and I wasn't exactly sure, either. What kind of investor are you? Do you consider yourself a value guy or a growth guy? Are you kind of in between, or something else entirely?
King: I would describe myself as a value guy in the value field. That's where I was kind of brought up. My first introductions to investing were in value investing. That is my pedigree. I think it's the style of investing, also, which makes the most sense. But I have learned since I've been here, you've got to be open-minded. It comes also down to your personality, as well. I'm a bit of a Doubting Thomas. I like to see something before I'll believe it, to some extent. There's got to be evidence, there's got to be a reasonable basis, you've got to weigh up your probabilities. I don't try to go into hopes and dreams too much, although it is good to be an optimist in this business, but you've also got to be a realist.
Moser: Yeah, yeah. I think that's a good mix there. The more you meet with David Gardner, for example, who is our resident growth expert -- I don't think he really likes that term, growth investor. But Rule Breaker. He goes in there and he looks for those companies with that special sauce, something different, and you can't quite put numbers around it, maybe, in the beginning. But you know there's something there. There is a leap of faith you're taking with virtually every investment we make. But I think that's one of the fun things there is, as you go on, you will find, you develop into a more well-rounded investor with a lot of different perspectives. It's very helpful, and I know we'll enjoy watching you develop here.
Since you have gotten here -- it hasn't been all that long, right? You've only been working here for a few months. But this is The Fool. Every day is an adventure. What is something you've learned in regard to investing since you got here that surprised you, something maybe you weren't expecting?
King: I think what I'd have to say that would be, would be just the wide variety of backgrounds and styles here. We're not expected to fit into any kind of box.
Moser: Well, we're motley.
King: [laughs] Exactly. We have a lot of freedom to explore our interests, follow our noses, and see where that leads us. And I think that's a great thing. It gives people the chance to be innovative and to expand their intellect. I think it's great. It's a very interesting place to work and to be.
Moser: I've always called it -- I don't know if you're familiar with Montessori School?
King: I am.
Moser: I went to Montessori School growing up, and I've always likened this place to a Montessori School for adults. You can come in here and you just do. You have that opportunity to come in and just do something. And it can be different every day. But I think what it leads to is, you see this investing team we have here with a lot of different perspectives, a lot of value to offer in a lot of different ways. I'm sure that you'll see that as time goes on.
Tell me, what is the best piece of investing advice you've ever gotten? It doesn't have to be from here. It can be something when you were growing up, maybe something your father handed down to you. What is the best piece of investing advice you've ever gotten?
King: I would have to say, this has come through from Peter Lynch and from Warren Buffett, it is to see a share that you earn as a part ownership in a business. I realize that people might be like, "Duh, yeah, of course it is." [laughs] But it is quite easy to forget that fact when you see stock prices, you see blips on the screen. It's easy to forget that you own part of this business. You employ the CEO and the CFO to do a job for you because you can't be there yourself. If they fail at that job, it becomes your problem. They are your employees. I think that keeping that in mind is really important, to keep your perspective correct as you go about the investing process. So I would say that is the single most important piece of advice I've ever received.
Moser: I like that. My wife and I work with our girls, helping them learn about money and investing and whatnot, so they're investors, and that is how we started. They essentially started with that mentality -- they're an owner, they're a part owner of that business. And so now they've realized that anytime we go to Disney World or watch something on TV from Disney, they're like, yeah, you own a little bit of that company. If you get something from Starbucks, you're kind of paying yourself. And they appreciate that perspective. Because you're right, in the day to day, stock prices go up and go down. You can't really make sense of the madness sometimes. But focusing on that underlying business really is what it all boils down to.
Going away from investing, you've had, obviously, an interesting life that has led you to work with us here. Tell us something unique or special about you, something that's happened in your life that people out there should know.
King: My most interesting story is that I spent nearly a year living in a tent.
Moser: [laughs] Not as a Boy Scout or anything, I assume?
King: What I was doing was, after I left school, I worked for a company, we did minerals exploration. Our specialty was getting to remote locations, basically to be the first boots on the ground, getting samples as part of the mineral sampling programs. Basically that means, where we went, there were generally no roads and certainly no civilization, so we lived in tents. I did that for a year and I really enjoyed it and have a lot of memories. It was an interesting time.
Moser: I can imagine. I grew up a Boy Scout, and we did our fair share of camping, but I don't think I ever stayed in a tent for quite that long. I can imagine the challenges that you overcame. Wow, that is very interesting. Cool. Good deal.
All right. Well, we normally like to wrap these interviews up, and I get book recommendations from the people we're interviewing, but because you're in here as an analyst now, we're getting people to listen to your advice and your stock ideas, I want you to give our listeners out there a stock on your radar, a stock that you like today and why.
King: Okay. I'm very interested in a business called Texas Instruments. You may probably be most familiar with them as the maker of the calculators. There are a lot of attractive features to this business. I think the management team is very experienced. They set transparent targets for themselves and they measure themselves against these regularly. That is always good to see.
In terms of the economics of the business, it's a manufacturer of semiconductors, which are essentially the brains of our electronic devices. They do all the processing, process all the information. They've got a very strong wind in their sales as devices become more and more computerized. I mean, we're putting semiconductors into washing machines these days.
Moser: [laughs] It's scary.
King: So, they've got a good wind in their sales. They're also a very profitable company. It has amazing returns on equity. Over the last five years, its return on equity has varied between 26.6% and 57.7%.
Over the same period, their amount of debt as a proportion of total capital has varied between 25.6% and 36%. What that says is that TI is achieving these returns on equity without significant leverage.
Moser: That's always encouraging.
King: Yeah. And in the last financial year, it had a free cash flow margin of 38%, with free cash flow calculated as cash from operations minus capital expenditures. So for every dollar this business earns, the shareholders could happily take out $0.38 without impairing the competitive position of the business. This is also not just a once-off blip in its performance. This free cash flow margin has grown from 28% five years ago to its present level. Another nice thing about it is, you can buy this business currently for about 15 times free cash flow.
Moser: A relative bargain in a market where everything looks pretty darn expensive today.
Moser: All right. Well, great stuff. Good deal, Tom. I appreciate that. I'm sure our listeners enjoyed getting to know you. I'm sure they'll be hearing a lot from you in the near future. Thanks for coming by!
King: Thank you very much!
Moser: Joining me in the studio now via the magic of technology, it's Mr. Asit Sharma. Asit, how's everything going?
Asit Sharma: Fantastic, Jason. I just got back from a trip to Canada last week. My wife's niece got married. I loved it because it was a big Indian wedding, so I got to eat a lot of delicious food, dance the Bhangra dance, see some old friends. I also got to look at lots of fascinating Canadian businesses on the ground while I was there.
Moser: I was wondering what the impetus was for this kicking the tires on Canadian Tire this week. Now I get it! I mean, hey, let's jump right in here, because it's not a business I was very familiar with before you had mentioned it. But I had a chance to give it a look over the weekend and there are some interesting points of this business here that I think are worth expanding on. I'm going to throw it over to you immediately here, just ask you, what is it about Canadian Tire that has your interest today?
Sharma: First off, the name is deceptive. It's not really a tire company. Canadian Tire started out as a tire business in 1922. They're coming up on their 100-year anniversary in 2022. But it is a widespread Canadian retailer which sells automotive tools and hardware, home essentials, sports and recreation, and outdoor living products all under one roof. Some locations also have grocery and apparel. If you think about big box stores here in the U.S., maybe a little bit of Walmart, a little bit of Sam's, a little bit of Home Depot, a little bit of Dick's Sporting Goods, and maybe a little bit of TJ Maxx, you'll start to get the flavor of a Canadian Tire store. It's a uniquely Canadian concept.
Why I'm interested in it is, we just don't spend enough time looking at those businesses north of the border. It's a smaller market. U.S. businesses tend to go into Canada and expand, so we hear about Canada all the time. Folks who read financial reports, you know that the consumer goods companies you're investing in are going into Canada. But what about these local companies?
I'm going to run down the makeup of this big retailer for you and maybe hit a couple of financial snapshots, and hand it back to you, Jason, for some comments. But listeners, picture this. The company has roughly 500 Canadian Tire flagship stores, that big behemoth store, big-box store I just described. They also own gas station chains. The biggest is called Petroleum. It's got [...] and convenience stores combined. They have an apparel and footwear company called Mark's, which has 400 stores nationwide in Canada. It's got SportChek, which is a sporting goods and activewear retailer, and Pro Hockey Life. Hockey is extremely important to the lifestyle in Canada. They have multiple hockey-based businesses. It's big business in Canada.
Also, the company acquired a Norwegian sportswear and workwear a company called Helly Hansen last year for about $985 million Canadian dollars, which is in the $800 million U.S. range. They also have a consumer-brand division, which expands multiple private-label brands. The one that listeners will be familiar with is MasterCraft, the tool company. We often see MasterCraft tools here south of the border. It finally has a finance segment to offer loyalty credit cards and also a REIT [real estate investment trust] segment, a real estate investment trust, which invests in properties, not just its own, but income-producing properties across Canada.
Just to give you an idea of how big this company is, last year, it had revenues of $14 billion Canadian. That's about $10.6 billion U.S., and it experienced 6% year over year revenue growth. And it also has pretty solid margins. Gross margins were 33.5% last year. Operating margin was 9.2%. And it booked net income of around $700 million Canadian -- that's about $520 million U.S. Lastly, it's got a fairly solid balance sheet. It's got a debt-to-equity ratio of about 0.38 times, so not very highly levered, and that's after taking on this big acquisition of Helly Hansen last year.
So that's an overview of this really sprawling Canadian company, which considers a lot of our well-known big-box retailers its primary competition. What do you think about this company, Jason? I know you've had a chance to look at it over the last few days.
Moser: Yeah, I took a look at it. The first thing that struck me was, it does seem like they've hit a little bit of a wall on top-line growth there. But that could be for a number of reasons. I guess when it comes to retailers, though, generally, you have to at least ask yourself the question, how much can they grow from where they are today? I think the one hang-up I have, generally speaking, when it comes to retail plays that are branded to the market in which they serve -- in this case, Canadian Tire, obviously, hitching its brand to its Canadian identity. Not that there's anything wrong with that. But I do wonder how much that brand resonates outside of its home-market opportunity. I think that would be the big question for me. In a world where we've got a lot of choices as consumers, if we're looking at Canadian Tire and trying to figure out where the growth might be coming from, other than acquisitions, how much is this company going to be able to grow beyond its home market? How much growth do you think is left there in its home market? Do you have any thoughts where that's concerned?
Sharma: Sure. I think those are really good points. In fact, historically, the company has had two forays into the U.S. which weren't very successful. The tool segment is a great example. It just could not make it, and turned its focus back to Canada. I think that Canadian Tire's answer to that question is this expansion into alternate business lines, very lucrative consumer-finance segment and also this REIT, which invests in properties.
One of the strategies the company is employing is growth through acquisition, which still begs your question, Jason. If not through acquisition, how will the company keep expanding? The primary vehicle that it's used to do this, really since the 1960s -- 1958 is the core year -- they have developed a loyalty program which is really popular in their market. It's called CTM or Canadian Tire Money. And this, funnily enough, is actual paper money. It looks like Monopoly money, but actually close to Canadian bank notes, which you get every time you make a purchase. I think it's 0.4% of your total purchase, you get paper money that you can then use at a subsequent visit to the stores. And it's so popular in Canada that a lot of mom-and-pop stores will accept Canadian Tire Money because mom-and-pop are shoppers at Canadian Tire. They have really updated this whole system in the last two years. Now it's a card-based system very similar to what we see in the U.S. It's basically credit cards, loyalty cards, and they've upped the rewards. They still have that paper money, which is so popular in Canada. But now, this program, which many big-box retailers in the States have had for 10 to 15 years based on consumer-finance models, they're still touching the surface of that. I see some growth in this segment, the more profitable segment.
We usually look at one side of the equation, which is, how will a company grow. An advantage of this company is that it's very hard to compete against. The company, because it sells so many different products under one roof and owns a lot of smaller brands, it considers a wide range of U.S. retailers as its competition. There's no one direct competitor. In fact, their annual report named Walmart, Costco, Home Depot, Cabela's, Bass Pro Shops, Lowe's, and Nordstrom as primary competition. Why I think this is important is, about five years ago, Target tried to enter the Canadian market in a big way. And they bumped up against this company. This was one of the reasons that Target actually exited Canada in 2015. In fact, Canadian Tire took over about 12 Target locations. So one thing I like about it is its insulation against encroaching competition.
But as far as growth is concerned, they have this two-prong strategy. They are going to acquire and they are going to try to grow the loyalty of the customers.
One last interesting stat on the loyalty program, they count 12 million customers in their loyalty program spread across all their brands. The population of Canada is only 37 million. So essentially, almost a quarter of Canadians are enrolled in this program under one brand or another. Another very interesting competitive advantage the company has.
Moser: Yeah, I mean, it's a small market, but it sounds like they maintain a very dominant presence in it. Having your own currency, there's some puts and takes with that. It reminds me a little bit of Gymboree back in the day, when Gymboree was still a publicly traded company. They had those things called GymBucks. Gymboree I was always a big fan of because it made it easy for idiots like me to buy clothes for their daughters. Unfortunately, Gymboree was taken private and then private equity pretty much ruined the company. But I will say, GymBucks were smart in that they encouraged that repeat business. Certainly, I can see where Canadian Tire's currency would do the same. Asit, great look at the Canadian Tire. Definitely a company worth getting on one's watch list.
Let's take a quick look here at the quarter in home improvement. Two companies you and I follow pretty closely here, Home Depot and Lowe's. Seems like it was a bit of a tale of two cities, so to speak. Home Depot with a good quarter, rather tepid market reaction. Lowe's, not a bad quarter, but it wasn't good enough, and the guidance was a little concerning, and the market's really been selling the stock since then. What stood out to you between the two as far as the disparity here?
Sharma: You know, Jason, these two companies were some of the first companies that I covered with you several podcasts ago. I remember us talking about Home Depot just being in a great position to optimize good business and Lowe's being in a turnaround phase. And yes, the guidance was weak from Lowe's. The stock is down about 16% since reporting last week.
What stood out to me is that the market investors were expecting higher earnings. Lowe's had sales of $17.7 billion. That was a growth rate of 2.2%. And comparable sales looked great. They were up 3.5%. But the company's diluted earnings per share of $1.31, plus that outlook that you talked about, really unnerved investors. Investors feel like, with this top-line growth, the company by now should be turning out more bottom-line profit. But it's not easy to turn around a business which has subpar systems. This is something that CEO Marvin Ellison, since he came on board, has preached, that the company has outmoded processes for tracking inventory, for pricing, for keeping up with cost escalations -- even sales associates don't have great technology in terms of mobile devices they can use, which they're currently upgrading. So what you're seeing is, it's not so easy to turn spaghetti into higher margins. I think that many people are perhaps missing that this is going to be a several-quarter exercise for Lowe's still.
I'll give you one example in merchandising. The company has had a huge turnover. I think they have replaced 2 out of 3 top executives in the last several quarters. And their merchandising systems, the ones that they keep track of in order to be able to, in real time, move pricing when their cost escalates, those still aren't up to par. This quarter, CEO Ellison said: "Look. We had costs go up on us from raw materials increasing, but our system could not communicate quickly enough for us to adjust pricing. It's part of the reason why our margins went down." This is not a great situation, but it's a good problem to have. I'd like to point out that being cognizant of the core issue in an organization is the first step toward getting better.
I personally think Home Depot is probably still the better buy, but don't ignore Lowe's. It's not necessarily on a long downhill slope. This is just the tough work of getting your ship back in order. What are your thoughts on the two quarters?
Moser: There's no question that Marvin Ellison has a multiyear project on his hands. It's not going to be an easy turnaround. And I think he's doing the things that need to be done. It's never easy when you're having to do that in the face of a competitor that continues to perform well. I think with Home Depot, clearly, they're separating themselves when you look at things like big-ticket comp sales, sales that are over $1,000, that was up 4% for the quarter. But I think when you look at where Home Depot is really shining, it's with the pro customer. That pro customer now represents close to half of overall revenue. They're building a very robust rentals business from that, as well. Just to show you some of the math behind that, several years ago, they may have rented tools to 1 out of 10 or so of their professional customers. Now that number's closer to 1 in 4. Building a robust rentals business, and that certainly results in those professional contractors buying more stuff from your stores as they come and rent those tools that they need to use on an ongoing basis.
I mean, you can see where Home Depot's really executing. You can see where Lowe's really needs to get some work done. But to your point, it's not like Lowe's has been a bad investment. Over the last five years, the stocks have essentially tracked one another. You stretch that out to 10 years, Home Depot separates itself a little bit. But again, it's not like Lowe's has been a bad investment. Assuming that Marvin Ellison is on the right path here, I think there are reasons at least to be hopeful. But if you're looking for the no-brainer in the space, yeah, my money goes to Home Depot 10 times out of 10.
Listen, Asit, I hate to cut it short here, but we do have to go this week. I appreciate you calling in and talking as always. You take it easy there in North Carolina. I want to talk a little bit more about that trip you had up there, that Indian wedding, because man, I love some good Indian food and I'm trying to learn how to cook some more of it myself.
Sharma: We'll have to grab a meal together pretty soon.
Moser: All right, look forward to it. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. Today's show was produced by Austin Morgan. For Asit Sharma, I'm Jason Moser, thanks for listening and we'll see you next week.