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Lowe's Undeserved Discount to Home Depot


Why Lowe's needs to close the gap in operating performance compared to its main rival.

MINYANVILLE ORIGINAL Home Depot (HD) and Lowe's (LOW) share almost a duopoly in home supply at this point, and are at the same place on their store maturity, which is to say fully built out. Their stores are similar. And their respective sizes are close enough that neither can out muscle the other, so their business risk is about equal. But they sell at different valuations. Home Depot, at $52 per share, using consensus sell side EPS estimates of $2.92 and $3.32 for 2012 and 2013, respectively, and a 6% risk premium, discounts a 7.5% five-year growth rate in EPS. Lowe's, at $27 per share, using consensus EPS estimates of $1.82 and $2.23 for 2012 and 2013, respectively, and the identical 6% risk premium, discounts a 3% five-year growth rate (a PE multiple difference of three times earnings). I think that if you explained this difference to the average customer of both stores, they would be scratching their heads, even if you told them that the there some operational differences in favor of Home Depot.

Home Depot's same store sales have been running ahead of those at Lowe's in 2011 and 2012 by two to three percentage points. Much of the reason for this is that Lowe's management could not read the economy (especially the building related economy) and the company was still focused on growth for a few years after Home Depot management had decided that there was no store growth to be had. (From 2007 until 2011, Lowe's saw 3% square footage growth vs. 0% for Home Depot). This was reflected in a 3% SG&A growth CAGR (compound annual growth rate) for Lowe's over the 2007 to 2011 period, while HD declined 1%. Better IT and ordering, along with the building of many regional distribution centers, helped inventory turnover and supported gross margin, and allowed for a big increase in the percentage of store personnel to be out on the sales floor. A bigger skew toward the professional market (about 10% of sales) helps Home Depot's relative same store sales growth as the economy slowly recovers. Further helping HD's relative same store sales trend, I believe, is that Lowe's has a greater percentage of its stores in Sunbelt markets that have had problems with the housing price bust, causing less demand for its products as well higher unemployment in affected areas. However, those Lowe's states should retain their faster growth status over time.

So Lowe's is playing catch-up in some areas, but surveys show that it still has a better customer image, which allows it the time do this without any major negative consequences. Lowe's has been moving slowly toward an EDLP (everyday low pricing) strategy, which has created some margin pressure (and this is not a JC Penney situation), in the past few quarters, which will help same store sales and SG&A when it is done. The company has been doing major product line reviews -- by the second quarter, the reviews should be 50% done -- but have had only 15% of the new product sets in place. (Old inventory sale has a depressing affect on gross margin as well.) That will help sales, gross margin, and inventory turnover over time. SG&A as a percentage of sales is 27% at Lowe's vs. 24.5% at Home Depot. Cutting that percentage is a longer term upside for Lowe's via capital expenditure reduction, store technology/IT, and less advertising.

While Lowe's and Home Depot have similar dividend yields and dividend growth, Lowe's has plans to increase its leverage around 30% to free more funds for share buybacks. Lowe's should have more of a tailwind from cash flow for buybacks going forward.

Anything housing related is difficult to estimate, but if Lowe's can grow its EPS at just 7.5%, which is the market's implicit expectation for Home Depot, the stock is a buy at a 20% undervaluation. If GDP under a new administration can get back up to a still modest 3.5%-4% growth rate out of a recessionary level, home center expenditures could grow in the 3% range. A meaningful SG&A leverage for Lowe's could come, as well as a small gross margin hike from its store inventory resets. Share buybacks might take EPS growth easily into the 7%-9% area for a five-year growth rate.

As for a catalyst, I believe that Lowe's just has to show some trend of starting to close the gap in operating performance with Home Depot. It does not have to show better numbers than Home Depot now.

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