Buy Lowe's For Tomorrow, Not Today

By Stephen D. Simpson, CFA | August 22, 2012 AAA

Investors have a very clear choice in the home improvement/big-box home retailer sector. Home Depot (NYSE:HD) is posting solid growth, gaining share and raising guidance, while rival Lowe's (NYSE:LOW) is struggling amidst a meaningful change in its merchandising and inventory management. While Home Depot is definitely hard to beat for near-term momentum, investors with more of a value inclination ought to take a closer look into what's going on at Lowe's.

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Q2 Rings up Another Disappointment
Lowe's continued to lose ground on Home Depot this quarter. Revenue fell 2% as reported, with total comps down 0.4%. If there was a bright side (and I believe there was), it was that U.S. comps were slightly better (down 0.2%) and improved throughout the quarter, coming in at positive 0.7% in July.

Profits, though, are struggling as the company tries to implement its new strategies. Gross margin slid about a half-point from last year, while adjusted operating income fell more than 13%. In the wake of these disappointing numbers, management trimmed the full-year outlook by about 10%.

Transitions Are Often Painful, but This One Ought to Work
Right now, Lowe's is in the midst of an inventory and merchandising initiative designed to improve long-term profits and store traffic. Part of this is a transition to an "everyday low price" (EDLP) strategy that will see Lowe's move away from less predictable high/low pricing and heavy promotion. The idea here is that, over the long-term, customers will no longer be conditioned to wait for big sales or promotions, but will instead turn more to Lowe's on a day-to-day basis.

I think this is a wise move for the long run, but it's going to be painful. While it's a very different retailer, J.C. Penney (NYSE:JCP) is a case in point of just how difficult and disruptive a change in operating philosophy can be. That said, what Lowe's needs more than anything is the courage of its convictions - there is going to be a period of transition where traffic suffers, but management needs to fight the temptation (and perhaps investor pressure) to give in and launch sales to polish near-term numbers.

SEE: The 4 R's Of Investing In Retail

Have Investors Bid up the Recovery Too Much?
I suspect that at least some investors have gotten a little too excited about the prospects of a real rebound in housing activity. Yes, housing activity has improved off a very low base and remodeling activity is all but certain to pick up at some point. However, it's still not a universally robust environment.

The prices of various types of lumber are up about 30% from last year, and lumber is about 7% or 8% of sales at Home Depot and Lowe's, but this has to be viewed in the context of lower harvests and inventories. Likewise, companies like Armstrong Worldwide (NYSE:AWI), Mohawk (NYSE:MHK) and Stanley Black & Decker (NYSE:SWK) aren't exactly struggling to keep up with newfound demand.

If there's good news here, it's probably that Lowe's is less vulnerable to an expectations reset than Home Depot. Along those lines, then, Lowe's should be through most of the pain of this merchandising reset in time to really benefit from the recovery.

SEE: 5 Factors To Watch In a Housing Recovery

The Bottom Line
There are investors who are going to think I'm absolutely nuts for preferring Lowe's to Home Depot, as the latter is gaining share and executing a lot better than Lowe's. In my view, though, the key to solid long-term results is thinking about where businesses are going to be tomorrow and not focusing so much on where they are today.

To that end, I think Home Depot is priced for continued high-end performance, while very little is expected from Lowe's by comparison. If Lowe's can grow its free cash flow around 4 to 5% a year for the next decade, the shares ought to carry a price in the high $20s. Consequently, I think value investors who are comfortable with the company's strategic shift can still find worthwhile value in this company.

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

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