The Third Quarter Was Good To Lowe's

By Stephen D. Simpson, CFA | November 19, 2012 AAA

One quarter ago, I said I favored Lowe's (NYSE:LOW) over Home Depot (NYSE:HD), as I thought the difference in valuation outweighed the difference in quality between the two companies. So far, so good, with that call, as Lowe's basically doubled Home Depot's return for the past three months. While I do worry that both stocks are a little expensive on the basis of investor optimism for a housing recovery, I won't rule out the idea that an improved business plan coupled with improving sales trends will be a powerful boost to earnings and cash flow for Lowe's over the next few years.

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Solid Progress in Q3
Lowe's logged good performance in the third quarter, though admittedly not as strong as Home Depot's performance for the same period. Still, Wall Street is a realm of relative expectations and nobody expected Lowe's to top Home Depot.

Revenue rose about 2% for the quarter, with comps up 1.8%. Not only is that an improvement from last year's 0.7%, but it's also an improvement over the recent trends, and it represents pretty meaningful upside to analyst estimates that seemed to cluster around 1% (and some predicted a drop in comp sales).

Profits continue to improve as the company nears the end of its adjustments to merchandising and inventory management. Gross margin improved about 15 basis points, the first expansion in about a year and a half. Adjusted operating income rose about 3%, and Lowe's delivered a solid beat.

Sandy + Recovery + A New Plan
Lowe's should have plenty of tailwinds pushing it along for the next few quarters. The recovery/rebuilding efforts in the wake of Sandy should offer a triple-digit boost to comps, particularly given the agreement between Lowe's and the state of New Jersey.

Beyond the storm recovery, there are ample signs that there is a real (if still slow) recovery in the residential housing market. Companies like Louisiana-Pacific (NYSE:LPX) and Weyerhaeuser (NYSE:WY) are getting more optimistic (even if cautiously so), and new building and remodeling activity do appear to be picking up.

Last and not least, Lowe's new pricing and merchandising approaches should lead to better sustained traffic patterns. Couple a recovery in demand for home improvement products with better traffic and perhaps more store-brand merchandise on the shelves, and Lowe's could be looking at some solid years to come.

But There's Still Work to Be Done
I'm optimistic that Lowe's will fix what has been ailing the company and close some of the gap with Home Depot. However, it's worth remembering that the gap is not inconsequential.

Lowe's had 1.8% comp growth this quarter, while Home Depot had 4.2%. What's more, this was the first time in a little while that Lowe's was less than 300bp behind Home Depot in comps. While the gross margins are quite similar (34.3% for Lowe's this quarter and 34.6% for Home Depot), the adjusted operating margins, when analyzed, are quite different, as Home Depot has a roughly 350-basis-point advantage (up from about 275bp last year).

The point here is not to bash Lowe's for its shortcomings, nor to assume that the company will quickly close the gap, but just to offer a reminder that Lowe's has both opportunity and risk when it comes to its model and the relative performance it has been producing.

The Bottom Line
As I said in the intro, I thought Lowe's was the better relative value and had more upside potential if its own self-improvement and remodeling plans worked out well. I still believe that to be the case, but the performance of both stocks has been pretty solid over the past year. Consequently, I would be in no hurry to jump off the bandwagon, but I'm not sure I'd chase these stocks right now.

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

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