Housing market demand is back to its pre-recessionary levels, and two retail companies that are largely benefiting are Home Depot (HD) and Lowe’s (LOW). Value stock investors tend to favor LOW over HD due to its lower valuation, but could LOW be a value trap?
Value Stock Tale of the Tape: Lowe’s (LOW) vs. Home Depot (HD)
Home Depot and Lowe’s have a combined market share of 80% in the $182 billion home improvement stores industry. Apart from slight differences in customer types and retail outlay, Lowe’s and Home Depot have similar value propositions, so it’s hard to differentiate one from the other regarding service quality and product assortments. However, I see two significant differences in the companies’ performance: growth and profitability.
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Historically, the gross profit margins of both Home Depot and Lowe’s tend to be around 34%. Their ability to successfully negotiate with suppliers and price appropriate markups indicates that this gross margin trend is stable. However, the operating margin of Home Depot is considerably higher than Lowe’s, which could be attributed to Home Depot’s significantly lower selling, general and administrative (SG&A) expenses as a percentage of revenue compared to Lowe’s (as seen in the charts below).
It’s astonishing to see how Home Depot has managed to lower its SG&A costs since 2009 without sacrificing same-store growth. In fact, Home Depot has had higher same-store growth than Lowe’s since 2011!
The incredible success of Home Depot over Lowe’s has been well rewarded by the stock market, which gives HD a premium valuation.
Lowe’s has been adding stores to catch up with Home Depot. As of fiscal 2016, Lowe’s had 1,820 stores in the U.S., just 157 stores short of Home Depot. Home Depot, on the other hand, has been more focused on same-store sales growth, and as a result, Home Depot’s sales per square foot are higher than Lowe’s (see the chart below).
Home Depot’s sales per store had grown to an average of $38 million/store in FY 2016 from $30 million/store in FY 2011, whereas Lowe’s sales per store was around $30 million/store during the same period, largely because of lower revenue from its expanding new stores.
As both companies’ U.S. market penetration is about to become saturated, it’s Lowe’s turn to focus on productivity. Would it be possible for Lowe’s to increase its revenue per square foot? Could Lowe’s successfully improve its operating margin? Can Lowe’s withstand competition from private players such as Menard? Affirmative answers to these questions would lead us to conclude that LOW is a considerable bargain over HD.
Lowe’s acquired RONA, based in Canada (adding 245 stores in Canada), and Maintenance Supply Headquarters, which added further pressure on its internal operating matrices. Home Depot, on the other hand, purchased Interline Brands and Compact Power Equipment to strengthen its maintenance and rental division.
While Lowe’s is focused on store expansion (apart from minor investments in tech startups like Porch.com and Desktop Metal, a 3D metal printing company), Home Depot is strategically strengthening its penetration in the professional area (construction and maintenance). Home Depot management was well positioned for these strategic initiatives because it was not required to focus on store expansion.
Today, Lowe’s has almost achieved as much market penetration as Home Depot. But in the future, Lowe’s management will be judged on productivity. It would be imprudent for management to continue its aggressive store expansion strategy without focusing on improving sales per square foot. And brand awareness, in which Home Depot scores much higher than Lowes’ among millennials, should be a strategic imperative for Lowe’s.
LOW is the Better Value Stock
From a value standpoint, LOW is cheaper than HD today. It would be even a better bargain if Lowe’s switched its focus from aggressive store expansion to improvements in productivity. It’s too early to judge that today, but Wall Street will naturally appraise LOW stock as it sees the effect in the bottom line.
My task is to identify such strategic changes before they’re reflected in the earnings and share price. By the time Wall Street rewards LOW with HD’s valuation, LOW won’t be a value stock anymore. Stay tuned by subscribing to Cabot Benjamin Graham Value Investor.
Timothy Lutts heads one of America’s most respected independent investment advisory services. Each week, Tim personally picks the single best stock in his exclusive Cabot Stock of the Week advisory. Build your wealth and reduce your risk with the top stock each week for current market conditionsLearn More