The home improvement business in Canada is heating up. On Tuesday, Canadian home improvement retailer Rona (TSE:C.RON) rejected the $14.50 a share, $1.8 billion offer from Lowe's (NYSE:LOW), saying it wanted to carry out its business plan independently. The Quebec government reacted immediately, suggesting the deal wasn't in the best interests of Quebec or Canada. I think that's for the shareholders to decide. Nonetheless, the move indicates Lowe's is taking the fight to Home Depot (NYSE:HD) north of the border. I'll explain why this deal is a win/win situation for both companies.

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Rona Failing
In fairness to Rona, I'm no fan of Lowe's, whose customer service in Canada leaves a lot to be desired. However, Rona's business is a hodgepodge of differently sized stores that don't make enough money. In the past decade, it's grown revenues 163% from $1.83 billion at the end of 2001 to $4.81 billion at the end of 2011. That's the good news; the bad news is that operating profits couldn't keep pace, growing just 73% over the same period. Shareholders on board since Rona's IPO on Oct. 29, 2002, have achieved a total return of 76%, compared to 101% for the Toronto Stock Exchange. Lowe's performance over the same period is surprisingly worse, up just 50%. Lowe's needs to make something happen and this offer is just the ticket.

SEE: The Wonderful World Of Mergers

Catching Up
Lowe's had 31 stores in Canada at the end of January, compared to 180 for Home Depot. Using figures from each of their 10-Ks, I estimate that Home Depot's 2011 Canadian revenues were $5.8 billion, approximately 6.3 times the $892 million for Lowe's. Furthermore, the average Home Depot store delivers $31.3 million in revenue, $2.5 million more than Lowe's. It's no wonder Home Depot's stock has outperformed Lowe's over the past decade; by almost every key productivity indicator, including average ticket and number of transactions, Big Orange is the winner. Buying Rona and converting many of its 80 big-box locations (60,000 to 165,000 square feet) to Lowe's would immediately double its size in Canada, making it a much bigger threat to Home Depot in Quebec and out west.

SEE: Effects Of The New Canada-U.S. Border Deal

Rona's move to shrink its bigger stores with 30-50% less selling space will make them cheaper to run, but not necessarily more relevant. Rona is essentially a Quebec business, with 45% of its sales in the province. There's no reason why Lowe's couldn't continue to operate the smaller stores as Rona's or sell them to someone who would. To reject the offer without exploring the deal further is nothing but stubborn pride on the part of the board, and an effort by the Quebec pension plan to extract the maximum profit on its investment in Rona combined with the best possible outcome from a political standpoint.

SEE: The United States Vs. Canada - Differences In Investing

The Bottom Line
In the past five years, Rona's operating margin has averaged 6.7% compared to 7.6% and 8.2% for Lowe's and Home Depot, respectively. Home Depot's current operating margin is just under 10%, with an improvement in profitability in each of the last three years, from 6.1% in fiscal 2008 to 9.5% in fiscal 2011. The markets give it an enterprise value that's 10.3 times EBITDA. At $14.50 a share, Rona's enterprise value is 8.5 times EBITDA, which is plenty for a company that's having a tough time making money. Lowe's will make this deal but it might take a little longer than expected. In the end, it's a good deal for both companies.

At the time of writing, Will Ashworth did not own shares in any of the companies mentioned in this article.

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