Home improvement retailing is an approximately $400 billion, highly fragmented industry that is comprised of two major players, Home Depot (NYSE:HD) and Lowe's (NYSE:LOW), and a large number of smaller local and regional businesses. Home Depot and Lowes account for about 16% and 11% of sales, respectively, in the United States and each enjoys economies of scale over the other local and regional players. While the size and fragmented nature of the industry will allow both Home Depot and Lowe's to create value by capturing market share, expanding market penetration, and streamlining operations, the companies have different paths to value creation.
Although Home Depot is by far the larger of the two companies with a market capitalization of about $72 billion and 2,250 stores compared to Lowe's market capitalization of about $34 billion and 1,700 stores, Home Depot has been playing catch up as it seeks to match Lowe's much more efficient automated regional distribution network. This disparity in distribution capability has led to superior profitability and cash flow generation for Lowe's and has prompted Home Depot to change course and initiate a massive restructuring of its supply-chain and information technology infrastructure.
Lowe's gross margin has been about 34.7% and operating margin has been about 8.5% over the past 5 years compared to about 33.6% and 8.4% for Home Depot over the same period. And although the supply chain is relatively new and lack's the automation of Lowe's network, Home Depot is making strides toward closing the efficiency gap as demonstrated by the trailing twelve months operating margin which was up to 9.2% while Lowe's was only 6.5%.
If Home Depot is able to duplicate the distribution efficiency of Lowe's, the greater pricing power it has over suppliers due to its greater scale will be fully realized and value will be created by better margins and cash flow generation. Another factor that may propel Home Depot's results going forward is that it has entered the Chinese market. However, enthusiasm about this opportunity should be tempered by risks associated with entering an unfamiliar market with unique consumer preferences.
At a recent price of about $47 per share, Home Depot has a higher price to earnings multiple of about 16.8x compared to Lowe's price to earnings multiple of about 15.6x at a recent price of about $28 per share. Investors are paying a higher price for Home Depot's shares because earnings are expected to grow faster for the industry giant. Analysts' consensus estimates for Home Depot are for earnings per share growth of about 13.0% which bests Lowe's earnings per share growth which is expected to be about 10.5%. As a result, investors buying Home Depot are paying a price to earnings to growth multiple of only about 1.3x compared to about 1.5x for Lowe's shares. I believe that this 15% premium is worth paying to own Lowe's shares for a few reasons.
First, the competitive positions of the companies are such that Home Depot has shifted its strategic focus away from domestic growth and is now chasing Lowe's in terms of operational efficiency. I think that Lowe's advantage over Home Depot in its distribution network may erode over time but will do so only slowly, leaving Lowe's ample time to develop other ways to pursue value creation.
Second, I think that Lowe's is more likely to realize its forward earnings per share growth rate of 10.5% because revenue is expected to grow by only about 0.6% to achieve this earnings growth. Conversely, analysts expect Home Depot's revenue to grow by about 3.5% to achieve the 13.0% earnings growth. While both companies' revenue growth rates are likely, the growth rate for Lowe's is the more probable.
Finally, I prefer to pay up for Lowe's shares because its cash flow has grown faster than Home' Depot's annually since 2002, indicating greater long term value creation. Cash flow from operations has grown by about 10% annually since 2002 for Lowe's while Home Depot has actually seen its operating cash flow decline by about 2.9% annually during the same time span. Similarly, Lowe's has increased its free cash flow by about 29% annually compared to Home Depot which has grown its free cash flow by only about 3.5%.
Using a discounted cash flow model, Lowe's and Home Depot are both undervalued as their current share prices assume no growth in free cash flow going forward. I believe strongly that for Lowe's this assumption is misguided and that once the economy fully recovers, free cash flow will resume a higher growth trajectory after suffering declines in both 2008 and over the past twelve months. I am much less confident in Home Depot's prospects for growing its free cash flow that has declined by about 4% since 2007. The company has been reducing its investment in capital spending which will need to be reversed going forward if it hopes to attain a high level of operational efficiency through infrastructure and technology upgrades to its distribution network. This will crimp free cash flow unless it can boost operating cash flow by a higher rate than it increases capital spending which I believe will be difficult.
In the past twelve months, shares of Lowe's have increased by only about 3.8% compared to about 27% for Home Depot. I would be a buyer of Lowe's shares at the current price of about $28 or less if shares decline in tandem with a broad market slump. Home Depot shares are not attractive at the current price of about $47 due to the recent run up in share price and because I anticipate a difficult road to value creation through sustained free cash flow growth. However, Home Depot is a story that bears watching because if the company is able to reach parity or close to it with Lowe's in distribution network efficiency, Home Depot will be able to leverage its pricing power to regain its superior competitive position. Because I believe this outcome will take years (if it is achieved at all) I would not hold Home Depot shares over an extended time, even though the dividend will pay me about 2.5% to wait. Investors will be much better off taking Lowe's lower 2.0% dividend yield to own the industry's value creation leader.
About the author:
I fundamentally analyze every business from the top down.
In my personal life, I have a strong Jewish faith and enjoy playing Scrabble and entrepreneurship.