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Investing Specialists

Two Retailers in the Bargain Bin

Despite the environment, we see value in these two home improvement firms.

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There is no doubt that the housing market is in recession now, and  Home Depot (HD) as well as  Lowe's  (LOW) are among those getting hurt. However, it appears the market is over-reacting with these stocks, and both are currently holdings of the real-money Tortoise portfolio. Here to talk about these stocks is Brady Lemos, who has been with Morningstar since 2004 and has covered these two companies for about a year.

Q: To start, can you quickly compare and contrast Home Depot and Lowe's?

A: Most of us have spent the better part of a Saturday afternoon shopping for home improvement goods in one--or both--of these retailers' cavernous warehouses. So we're familiar with Home Depot's and Lowe's fairly simple business model: provide do-it-yourself and professional customers with a local, one-stop shopping destination for all of their home improvement needs.

Home Depot was first to roll out its "big box" store model on a national scale. Today, its giant orange stores can be found in virtually every major market in the U.S. (about 2,000 stores), as well as some areas of Canada, Mexico, and China (over 200 stores combined). Lowe's has quickly gained ground on Home Depot, and now operates about 1,500 stores in the U.S. and a handful of stores in Canada. I think Lowe's has been able to compete with (and outperform on many measures) its larger rival by providing a superior customer experience, a critical point of differentiation, in my opinion. While Home Depot was busy cutting costs and building out its (now divested) contractor supply business, Lowe's focused on developing its sales associates and updating its store layout. Today, Home Depot is trying to reclaim lost market share by improving customer service at its stores.

Q: Does it make sense to have both firms rated with an economic moat rating of "wide"? What are the competitive advantages?

A: Yes, I think both firms will earn outsized returns over the long haul as they capitalize on their competitive advantages. While this expectation is rare for any pair of fiercely competitive rivals, it's particularly uncommon in retail. In fact, Home Depot and Lowe's join  Wal-Mart (WMT),  Walgreen (WAG), and  Amazon (AMZN) as the only retailers in our coverage universe that we award wide economic moats.

Home Depot and Lowe's benefit a great deal from their scale; Home Depot and Lowe's rank third and 13th, respectively, in worldwide sales among all retailers. This merchandising muscle ensures that the companies enjoy the most favorable terms from supply-chain partners who crave national distribution and topnotch marketing support.

Home Depot and Lowe's have also secured some of the most valuable real estate in the communities they serve. And since nearly 90% of these stores are owned (not leased), the firms are free to renovate or relocate whenever they please. Simply put, Home Depot and Lowe's have scale and operate proven business models in a relatively stable industry that's still largely fragmented. I think their advantages over one another are comparatively minor, but remain meaningful over the large number of smaller competitors still around.

Q: What sorts of margins and returns on capital does each firm have, and how do they compare with other retailers?

A: Home Depot and Lowe's consistently generate strong profit margins. Over the past five years, both retailers posted an average operating margin of about 10.5%, which compares quite favorably with other big box retailers. Over the same period, Wal-Mart and Target posted average operating margins of 6% and 8%, respectively. Home Depot and Lowe's also generate great returns on capital, routinely reaching high-teen levels and easily outpacing our estimates of the firms' costs of capital, as well as returns of the average retailer. I expect Home Depot's returns to improve now that HD Supply has been divested.

Q: How has the housing slowdown affected their businesses?

A: Demand for home improvement goods and services is closely tied to residential construction trends and real estate market conditions. So it's not surprising that Home Depot and Lowe's have seen their sales slide as the housing market has crumbled in certain regions of the country. I expect same-store sales at Home Depot to decline in fiscal 2007 for the second consecutive year, and for just the second time in the past 10 years. Lowe's, meanwhile, is on pace this year to post its first decrease in same-store sales in a decade.

Declines in same-store sales have hurt profitability over the past several quarters. In fiscal 2007, I estimate that Home Depot and Lowe's will each post their lowest operating margin in five years, due primarily to deleveraging of fixed costs. Even in tough times, however, Home Depot and Lowe's are highly profitable businesses. The retailers have earned returns on capital well in excess of their costs of capital every year for the past decade.

Q: Given the current economic backdrop, what are your operating projections for each?

A: Fiscal 2007 and 2008 should be challenging years for Home Depot and Lowe's. We see little evidence that suggests the domestic housing market will improve materially within the next few quarters. Consequently, I estimate that Home Depot and Lowe's will each post same-store sales declines in the low-single-digit range in 2007 and 2008. Over the following few years, I expect same-store sales to grow in the low-single-digit range, on average. This assumes a slow recovery in the domestic housing market.

Still, I expect both retailers to continue to open new stores at an aggressive pace. Assuming Lowe's opens approximately 150 new stores per year, total revenue growth should average almost 10% annually over the next five years. I think Home Depot will open nearly 100 stores per year, which implies 5% average annual revenue growth.

On the margin side, I anticipate lackluster sales will lead to depressed profit margins in 2007 and 2008, due to the negative effects of sales deleveraging and discounting. I estimate that Home Depot and Lowe's will each generate operating margins of about 10% in 2007 and 2008. Over the following five years, our model assumes that profitability returns to more normalized levels as sales trends improve. Now that HD Supply has been divested, I believe Home Depot's operating margin will approach 11% over the long term. My estimates are slightly less optimistic for Lowe's because its scale advantages are slightly smaller than Home Depot's.

Q: Would you mind reverse-engineering your cash flow models to tell us what sort of expectations the stocks are currently pricing in?

A: We'd need to project some pretty awful scenarios to reach Home Depot's market price of about $29 per share. First, we'd have to assume that the retailer slashes new store openings to just under 20 per year going forward. This seems extremely pessimistic for a company that has plenty of room to expand in countries like Canada, Mexico, and China. Secondly, we'd have to assume that Home Depot's same-store sales don't improve from this year's depressed level or benefit from any kind of price inflation over the next five years. Finally, we'd have to assume that operating margins average just below 10% going forward. For comparison, operating margins averaged nearly 11% over the past five years when the company owned HD Supply, a less profitable business.

Trying to reach Lowe's market price of about $24 per share is not any easier. We'd have to assume that same-store sales remain flat from today's depressed level and that Lowe's opens just under 50 new stores per year over the next five years. In reality, I think Lowe's can open about 150 stores per year now that it's beginning to expand into Canada and Mexico. We'd also have to assume that operating margins average just over 9% going forward. Lowe's hasn't had margins that low in over five years.

Q: I think I'll take the "over" on those expectations. Thanks, Brady.

A version of this article appeared in the November issue of StockInvestor.

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Paul Larson has a position in the following securities mentioned above: HD, LOW, WMT. Find out about Morningstar’s editorial policies.