While neither Home Depot (NYSE:HD) nor Lowe's (NYSE:LOW) were exactly what I thought of as “cheap” a quarter ago, I did think Lowe's looked like the better buy as I believed the Street would start factoring in improving operations and more HD-like performance. That call seems to have worked out, as Lowe's shares outperformed Home Depot by nearly 15% over the last quarter. As Lowe's still looks cheaper than Home Depot and has more upside to operational improvements/outperformance, I would probably stick with Lowe's over Home Depot, but almost anything house-related in retailing seems strong these days.
 
Very Good Results Should Boost Confidence
Lowe's has been taking a number of steps to improve its operating performance and close some of the gap that was created by Home Depot's strong marketing and price positioning. It looks like those moves are starting to pay off in real results.
 
Revenue rose more than 10% this quarter, with comp growth of 9.6%. Not only is this close to Home Depot's 10.7% reported just the other day, but it's also the best result in almost ten years (Q1'2004). This 9.6% comp is also quite a bit stronger than the Street was looking for, as I've seen “consensus” estimates of 3% and 5.3% (the latter of which seems more credible to me).
 
Margins also improved, as gross margin expanded by almost half a point (42bp). Operating expenses were kept under good control despite adding staff and hours, and operating income rose almost 25%, with operating margin expanding more than a point. Like Home Depot, Lowe's also saw good inventory control, as inventory growth (up 4.7%) was less than half of sales growth.
 
Appliances And Tools Leading The Way
It would seem that renovation and remodeling has come back in a big way. While Lowe's reported that all product categories (12) had comp growth of better than 5%, appliances and tools were among the categories highlighted as above-average growers. Given the comments from Home Depot and the appliance comp growth at Best Buy (NYSE: BBY) this quarter, it does look like this is a strong market again for appliances (likely good for Whirlpool (NYSE: WHR)).
 
Improvements Bearing Fruit, But More Work To Do
Lowe's has invested time and money into increasing store hours and staffing levels and improving its in-stock positions. Coupled with a new(ish) everyday low-price merchandising approach, Lowe's does appear to be regaining some of the traffic it lost to Home Depot. One quarter doesn't prove anything (and the comps at Lowe's are still lagging those at Home Depot), but it's a step in the right direction.
 
Still, there's room for improvement. The two companies have virtually identical gross margins, but Home Depot still manages to squeeze out about three extra points of operating margin relative to Lowe's. That's a huge difference and goes a long way toward explaining the differences in free cash flow margin, returns on capital, and valuation. It also tells me that there's still room for Lowe's to improve.

SEE: Home Improvements That Boost Resale Value
 
The Deal For Orchard Seems A Little Strange
Prior to this quarter, Lowe's also announced that it reached an agreement to acquire Orchard Supply out of bankruptcy. Lowe's will be paying $205 million in cash and assuming close to $90 million in payables for a company with a little more than $650 million in FY2012 sales.
 
This is a somewhat curious move. Adding Orchard's stores in California certainly improves the company's presence in a huge state (and where Home Depot is much larger), but I don't understand management's stated intention to maintain the Orchard banner and run it is a separate entity. Ultimately, I expect management to re-think this and eventually re-brand/fold in the stores into the Lowe's brand.
 
The Bottom Line
In many cases, the renovation/remodel/happier homeowner trade has gone past the point of value-driven recovery and is now about momentum. There are still some undervalued stocks out there, but not many and they're not undervalued by all that much. Count Lowe's among them.
 
If Lowe's can basically match the revenue growth I expect from Home Depot (around 4.5%) and do slightly better on free cash flow, then the shares are right around fair value and slightly cheaper than Home Depot. Were Lowe's to close the free cash flow generation gap a bit more, and sport a long-term free cash flow margin in the high single digits, the target goes above $50 and matching Home Depot would take the fair value to nearly $60. I'm not expecting that, but it does make me feel a little better about slightly preferring these shares over Home Depot today.
 
Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.

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