Lowe's Had Better Start Improving

By Stephen D. Simpson, CFA | May 22, 2013 AAA

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.

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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.

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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.

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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.

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