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Two Strong Performing Home-Improvement Firms
Posted by: Patricio Kehoe (IP Logged)
Date: October 21, 2013 05:17PM

The U.S. housing market is on a steady path towards improvement, and along with it, the housing industry as a whole is gaining momentum. Home-improvement companies such as Lowe’s Companies Inc. (LOW) and Home Depot Inc. (HD) can benefit from the rise in home building material demand, associated with the growth of the housing industry. Although there seems to be ample room for both these firms to increase their share in this fragmented market, both are focusing on improving their supply chain in order to face future competition.

Highly Automated Supply Chain

With 1,750 stores distributed throughout the U.S., Canada and Mexico, Lowe’s is currently the second-largest home-improvement retailer in the world. With a wide product offering ranging from home decorating, to maintenance and repair, the firm mainly targets do-it-yourself enthusiasts. The firm recently reported sales amounting to $15.7, accumulating an annual growth rate of 10.3%. Investment guru Lee Ainslie of Maverick Capital was surely glad to hear the news, as he is a Lowe’s bull with a very large position in the firm.

This home-improvement retailer operates with a scale that allows it to command strong purchasing power. The low-cost position the firm achieves through its scale, gives Lowe’s a competitive advantage over rivals. In addition to purchasing power, Lowe’s logistics system allows for purchase orders to be made at a discount, which it translates to a low-cost edge. In order to gain this advantage, full truckload shipping must be ensured. Hence, the firm has put in place a highly automated supply chain wherein vendors, distribution centers, and stores are all part of a single IT platform.

That IT platform, which drives operational efficiency, is what sets the company apart from Home Depot, its largest rival. Since the firm’s strength resides in its regional distribution network, the IT platform is crucial to ensuring full truckload shipping and efficiency in the supply chain. The $300 million the company invests in IT maintenance and improvement is well justified, as it gives the home-improvement retailer a wide economic moat. Also, this is an advantage Lowe’s wants to keep over rival Home Depot, which is already following in its footsteps.

One of the downsides of Lowe’s is its price. Currently trading at 24.1 times its trailing earnings, the firm has a price premium of 23.3% relative to the industry average. As share value has been rising steadily over the past year, the time for entry seems to have passed. Also, while the domestic store base matures and new store growth ceases to be an option, increasing pressure from competitors is expected to put a strain on returns of invested capital. Despite this risk and the price premium at which the company is trading, I feel bullish regarding Lowe’s future.

Restructuring Underway

Despite being the world’s largest home-improvement retailer, with annual revenue surpassing the $78 billion mark, Home Depot has been facing challenges as of late. In order to counteract the unfavorable economic environment of the past years, the company has focused on updating its distribution network. Lowe’s already has a highly automated supply chain and placed a large emphasis on new store openings, but Home Depot seeks to improve its current stores' productivity.

Some of the upgrades the firm has introduced include self-service checkout machines and online shopping websites. Through these mechanisms, the company is looking to reduce customers waiting time and reduce staff, while increasing their product offerings. In addition, Home Depot has targeted one of Lowe’s competitive advantages by restructuring its supply chain and improving its information technology infrastructure. The firm has already reaped some early benefits from its reworked supply chain, especially in terms of additional merchandising capabilities. The introduction of new technology is expected to provide additional flexibility in inventory and sales at the store level, thus improving profitability. By switching to a regional distribution network, such as the one operated by Lowe’s, Home Depot seeks to take advantage of its tremendous economies of scale.

Despite the rosy outlook of the company’s restructuring, the IT and supply chain improvements are still underway and thus face risks. Poor implementation and setbacks could seriously harm the firm’s profitability. Also, Jean-Marie Eveillard of First Eagle Investment Management and John Burbank of Passport Capital have recently sold their entire stake in the firm. The bearish feeling of these two investment gurus towards Home Depot does not inspire confidence in the company’s future growth potential. Since the home-improvement retailer is currently trading at 22.1 times its trailing earnings, those seeking to invest must face a 19.5% price premium relative to the industry average. I think Home Depot will fare well in coming years, especially if the restructuring efforts are successful.

Trailing Behind

As the U.S. economy rebounds and home-improvement sales rise, Lowe’s and Home Depot are both set to see their revenue increase. However, Home Depot seems to be trailing behind Lowe’s in terms of supply chain automation and IT infrastructure. As new store growth slows down, this competitive advantage could be highly beneficial for Lowe’s. Although both firms have strong financial positions and good future outlooks, I tend to follow investment gurus’ transactions and thus feel more bullish towards Lowe’s. Nevertheless, I think there is yet enough room for both companies to grow and increase their market shares without suffering the effects of fierce and direct competition.

Disclosure: Patricio Kehoe holds no position in any of the mentioned stocks.

Guru Discussed: Jean-Marie Eveillard: Current Portfolio, Stock Picks
John Burbank: Current Portfolio, Stock Picks
Stocks Discussed: LOW, HD,
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