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The Downside Risks for Home Depot and Lowe's

Morningstar's Erik Kobayashi-Solomon and Peter Wahlstrom discuss downside concerns for Lowe's, including fewer new-store openings and the possibility for a continued lackluster housing market.

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Erik Kobayashi-Solomon: Hi, I'm Erik Kobayashi-Solomon, co-editor of Morningstar OptionInvestor, and today it's my great pleasure to welcome back Peter Wahlstrom, who is associate director of research for the consumer cyclical sector here at Morningstar.

Pete, thanks for coming.

Peter Wahlstrom: Thanks for having me, Erik.

Kobayashi-Solomon: Now we talked in another video about the differences between Home Depot and Lowe's. Now I want to kind of shift focus to Lowe's. I wrote a covered call strategy on the shares of Lowe's and just want to understand more about the downside there.

So one of the things that we referenced in the previous conversation is that Lowe's, a couple years ago, was starting a 150 new stores a year; now they are going down to about 25 new stores a year, something like that.

Wahlstrom: That's correct.

Kobayashi-Solomon: I think that one of the reasons that the investment community liked Lowe's was because it was a very growthy name, right? They could see a lot of new stores being opened, etc. How does this slowdown in store growth affect Lowe's in terms of both business and kind of appeal to investors?

Wahlstrom: You know, when we take a step back and we think about the home improvement retail market, we think about two things; number one is that commercial construction has over the last four decades grown at about a 3%-3.5% clip, and if we're looking ahead the next three to five years what is the U.S. GDP going to grow at? And if you combine those two, that gives you a sense of how we're thinking about Lowe's growing its top line.

Kobayashi-Solomon: So basically, you're looking at it growing like GDP, maybe a little bit more?

Wahlstrom: That's correct. And the second thing to think about is, late November 2010, Lowe's held an analyst day where they talked about their five year projections, and we came away very encouraged because even in a lackluster economic environment, the company still thinks that it can lever expenses at a 1% comparable store sales growth figure, and that's pretty impressive to us.

Kobayashi-Solomon: So what that means basically for somebody who is not a consumer expert or a consumer cyclical expert, that means that even with kind of a flat top line, they can keep wringing costs out of their organization and keep growing profits?

Wahlstrom: That's correct, and if the company does realize 3% or 5% growth annually over the next three to five years, that's something that could translate into 50 basis points of operating margin expansion, and the company thinks that they can get to a 10% operating margin by 2015, and more importantly to us, considering that they are not spending money growing their store base, is that they are going to be generating a lot more free cash, and the return on invested capital is expected to be north of 15%.

Kobayashi-Solomon: Right, sure. So, they've spent so much money on store openings that their free cash flow is actually a little lower than their competitor's, Home Depot. So, you see this really boosted over the next couple of years then?

Wahlstrom: That's correct. We also see Home Depot benefiting as well. We think that the largest, Home Depot, and Lowe's, the second largest, are very well-positioned as the U.S. economy comes back, and likewise Home Depot has also set their own five-year growth target and operating margins at 10%, and return on invested capital at 15%. So, as we take a step back again, we think these two companies are not going to be participating in more of a very competitive environment. It's going to be more rational competition.

Kobayashi-Solomon: So, they're basically operating in a very fragmented market anyway, so what you are saying is they're not going to step on each other's toes.

Wahlstrom: That's exactly right.

Kobayashi-Solomon: I see. So you've made a couple references while we were talking today: "as the economy improves." Someone that I respect a lot, Robert Shiller, just came out the other day and said he is wondering--of course, Robert Shiller is the founder of the Case-Shiller home price survey that's publicized widely now. He says he's worried that maybe cultural attitudes towards home ownership, cultural attitudes in the U.S. have changed and that actually we may face something like kind of a Japanese lost decade, where people are spending less on their homes. Is this is a downside risk for Lowe's or Home Depot, what do you think?

Wahlstrom: It's a very good point, and it's a question that we think about an awful lot. When we look back a couple of years, the pro-consumer or the contractor was 3% of traffic and 30% of sales. Today that mix shift has gone much more to the consumer, and Home Depot and Lowe's are stocking more in the seasonal, the consumable section, and they're also looking at smaller do-it-yourself projects instead of the $10,000 bath or kitchen remodel. So, ... Lowe's as well as Home Depot are doing a better job of allocating their product, driving customer traffic, and thinking about overall basket or customer transaction profitability.

Kobayashi-Solomon: I see. So, maybe shifting away from these large projects, but trying to appeal more to the weekend warrior?

Wahlstrom: That's exactly right. Now, when you look at Lowe's and Home Depot, the transactions above $900 for Home Depot and above $500 for Lowe's, they've started to stabilize a little bit, which is number one encouraging from a macro standpoint.

Kobayashi-Solomon: Yeah. That is encouraging.

Wahlstrom: But the average basket or the average transaction is still under $55. So, people are going in on a daily basis to buy very small targeted…

Kobayashi-Solomon: ...The necessities of life.

Wahlstrom: That's exactly right.

Kobayashi-Solomon: Rather than going in to buy the new granite countertops.

Wahlstrom: That's exactly right, and if we think that the U.S. consumer is no longer going to be doing that sort of just general maintenance and upkeep, I think we've got bigger issues than just the home improvement retailers.

Kobayashi-Solomon: It's certainly true. Pete, thanks a lot for coming in and talking to us about this.

Wahlstrom: Thanks for having me, Erik.

Kobayashi-Solomon: And thank you for joining us. Please stop by the Morningstar OptionInvestor website, where you can learn how to control risk in your investment portfolio and leverage Morningstar's fundamental research to profit in the options market.

Erik Kobayashi-Solomon does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.