It seems like a fuzzy memory now, but Lowe's (NYSE:LOW) was once seen as the superior operator to Home Depot (NYSE:HD) on the big-box home improvement battleground. Times have definitely changed, though, as Home Depot has gained an edge not only with its store locations (more stores in or near urban centers), but also with its merchandising. Making matters worse, Home Depot has significantly closed the gap (if not leapfrogged) Lowe's in an area where Lowe's once dominated – back-office logistics and cost management.

Discount Brokers Comparison: Your one-stop shop for finding the perfect broker for your investments.

Even if Home Depot has been operationally de-pantsing Lowe's recently, it doesn't show up in the stocks over the last year – they both have nearly equal 60%-plus gains to their credit. Look at the two-year, five-year, or 10-year comparisons, though, and you see a wide gap between the performance of Home Depot and Lowe's (in favor of Home Depot). While there is a lot that Lowe's could do to close the gap and be a relative out-performer, the real question has to be “will they?”

A Disappointing Start To The Fiscal Year
If Lowe's is going to start doing markedly better, it's going to have to be next quarter, as this one was largely a waste.

Revenue fell less than 1% this quarter, as comps declined 0.7%. This was notably worse than both the average sell-side estimate (around a 2% improvement) and Home Depot's reported 4.3% comp growth for the same period. Keep in mind, too, that the company benefited from both Sandy (50bp to 75bp of comp growth) and lumber inflation (75bp to 90bp). While Home Depot also reaped those benefits, netting them out results in very different comp growth profiles.

Profit performance was slightly more encouraging. Gross margin improved about 10bp from last year, which was more or less in line with expectation and encouraging given the revenue miss. Likewise, operating income grew 3% with a 25bp improvement in margin, good for a slight beat relative to estimates.

SEE: Understanding The Income Statement

Did It Only Rain On Lowe's Stores?
Management turned to weather to excuse at least part of the poor performance this quarter. Given that Home Depot and Lowe's don't have completely overlapping store footprints, I suppose it's possible that weather played some role. Even so, I think Lowe's has bigger problems.

For starters, common suppliers to both companies (including Stanley Black & Decker (NYSE:SWK), Masco (NYSE:MAS), Electrolux (Nasdaq:ELUXY) and RPM (NYSE:RPM)), and ) reported growth in their relevant businesses of about 2% to 3.5%, suggesting Lowe's underperformed. What's more, Lowe's had been without a Chief Merchandising Officer for some time and may still be seeing some growing pains from its move to an everyday low price format.

I will offer one counterpoint in favor of Lowe's, though. Scotts Miracle-Gro (NYSE:SMG) did report tough first quarter results due to the weather, and I suppose it's possible that Lowe's suffered disproportionately – I don't have any data on relative market shares between Home Depot and Lowe's for outdoor product categories, but Lowe's did cite outdoor sales as a real weak spot.

Time To Do Better
The good and bad news for Lowe's is that there's still a lot that they can do better. Having a CMO in place (the company hired Michael Jones back in January of 2013) should lead to better merchandising decisions and higher customer satisfaction. Management is also looking to increase effective worker hours on the selling floor to improve the company's “close rates” in appliance sales – various analysts have estimated that Lowe's lags Home Depot and Sears (Nasdaq:SHLD) by meaningful percentages here and having more staff on hand could help.

I do wonder, though, if Lowe's needs to also go back to its own drawing board and see what it can do about driving better operational cost improvements. The company's recent line review apparently alienated a lot of vendors and working with them could be mutually beneficial. Elsewhere, maybe some fat and inefficiencies have crept back into the logistics and supply chain in recent years.

The Bottom Line
Lowe's has always lagged Home Depot in terms of converting revenue to free cash flow, and that hasn't really changed even as Lowe's has slowed its store growth. To that end, it is possible to argue that there is a lot of margin potential lurking under the surface at Lowe's. The trouble for investors is figuring out how much of that can be brought to light and how quickly. Luckily, it's not as though Lowe's has really missed the recovery in housing – there's still time to get its house in order before the recovery really picks up.

SEE: 5 Must-Have Metrics For Value Investors

I'm looking for Lowe's and Home Depot to post similar long-term revenue growth rates, but I'm giving Lowe's an extra point of free cash flow growth to account for the margin improvement potential. Even so, though, the resulting fair value of about $44 doesn't seem so impressive after the move in the stock and its current price of $43. While it's hard to argue that Lowe's deserves the benefit of the doubt today, I do believe there's a better chance of Lowe's outperforming expectations and Home Depot shares yielding a bit to high valuations.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

Related Articles
  1. Investing Basics

    5 Tips For Investing In IPOs

    Thinking of investing in IPOs? Here are five things to remember before jumping into these murky waters.
  2. Investing Basics

    Buy-And-Hold Investing Vs. Market Timing

    If volatility and emotion are removed, passive, long-term investing comes out on top.
  3. Options & Futures

    Demo Accounts A Good (But Imperfect) Indicator Of Investing Skills

    Scoring huge profits in a demo account doesn't mean you can expect this performance in real trading.
  4. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  5. Professionals

    The Best Financial Modeling Courses for Investment Bankers

    Obtain information, both general and comparative, about the best available financial modeling courses for individuals pursuing a career in investment banking.
  6. Investing

    Where the Price is Right for Dividends

    There are two broad schools of thought for equity income investing: The first pays the highest dividend yields and the second focuses on healthy yields.
  7. Economics

    Investing Opportunities as Central Banks Diverge

    After the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
  8. Stock Analysis

    The Biggest Risks of Investing in Pfizer Stock

    Learn the biggest potential risks that may affect the price of Pfizer's stock, complete with a fundamental analysis and review of other external factors.
  9. Stock Analysis

    Why did Wal-Mart's Stock Take a Fall in 2015?

    Wal-Mart is the largest company in the world, with a sterling track-record of profits and dividends. So why has its stock fallen sharply in 2015?
  10. Stock Analysis

    Allstate: How Being Boring Earns it Billions (ALL)

    A summary of what Allstate Insurance sells and whom it sells it to including recent mergers and acquisitions that have helped boost its bottom line.
  1. What does low working capital say about a company's financial prospects?

    When a company has low working capital, it can mean one of two things. In most cases, low working capital means the business ... Read Full Answer >>
  2. Do nonprofit organizations have working capital?

    Nonprofit organizations continuously face debate over how much money they bring in that is kept in reserve. These financial ... Read Full Answer >>
  3. Can a company's working capital turnover ratio be negative?

    A company's working capital turnover ratio can be negative when a company's current liabilities exceed its current assets. ... Read Full Answer >>
  4. Does working capital measure liquidity?

    Working capital is a commonly used metric, not only for a company’s liquidity but also for its operational efficiency and ... Read Full Answer >>
  5. How do I read and analyze an income statement?

    The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the ... Read Full Answer >>
  6. Can working capital be too high?

    A company's working capital ratio can be too high in the sense that an excessively high ratio is generally considered an ... Read Full Answer >>

You May Also Like

Trading Center