Lowe's Earnings Preview: Valuation Gap Has Improved, But Comps Need To Improve Also

| About: Lowe's Companies, (LOW)

Lowe's (NYSE:LOW), the "other" do-it-yourself (DIY) home-improvement retailer, reports fiscal third-quarter earnings before the bell on Monday, Nov. 19. Analyst consensus is for flat earnings per share of $0.35 on slightly higher revenues of $11.9 billion. Third-quarter revenue and earnings per share consensus have changed very little since the August earnings update. Q3 comps are expected to be flat to +1%.

Since we last wrote about Lowe's pre-earnings, in August, the stock has rallied nicely, despite what was a difficult Q2 2012 with little fundamental news to get excited about. So the tailwind that now exists in housing has lifted all boats.

Lowe's and Home Depot (NYSE:HD) are remarkably similar in that neither DIY-er is generating much revenue growth or new-store growth given the housing depression we've experienced since 2006. Home Depot, however, seems to be executing far better on expense controls today. Thus, margins are better for Home Depot than Lowe's.

Gross Mgn Op mgn Net mgn Store Count
10/12 34.62% 10.47% 7.13% 2250
7/12 q2 33.93% 34.16% 9.07% 12.49% 5.2% 6.45% 1748 2255
4/12 q1 34.70% 34.72% 7.25% 9.62% 4.0% 5.57% 1747 2252
1/12 q4 34.22% 34.95% 5.05% 8.31% 2.8% 4.83% 1745 2246
10/11 q3 34.16% 34.40% 6.57% 9.32% 3.7% 5.39% 1744 2245
7/11 q2 34.49% 33.99% 9.76% 11.34% 5.7% 6.74% 1753 2245
4/11 q1 35.45% 34.64% 6.80% 8.45% 3.8% 4.83% 1751 2248
1/11 q4 35.55% 34.66% 5.17% 6.86% 2.7% 4.88% 1750 2248
10/10 q3 35.05% 34.25% 6.31% 8.72% 3.5% 5.02%
7/10 q2 34.86% 33.91% 9.88% 10.56% 5.8% 6.14%
4/10 q1 35.18% 34.36% 7.01% 7.74% 3.9% 3.40%
1/10 q4 34.95% 34.41% 3.72% 4.99% 2.0% 2.76%

Source: Internal spreadsheet, company earnings reports, and SEC filings.

Numbers always tell a story, and the reader can quickly discern from the above table that Home Depot has really improved its operating and net profit margins. While Lowe's has made a lot of progress in his area, it has not matched Home Depot's ability to leverage its mid-single-digit comps.

What is amazing is that since January 2010 (what we consider roughly the beginning of the bottom of the housing market), Lowe's has cut its sales, general and administrative (SG&A) expenses from 27% to 22% of revenues. Since that same time period, Home Depot has cut its SG&A as a percentage of revenues from 26.5% to 22%. Although we didn't put these metrics in the above table, Lowe's is still "comping" at a lower rate than Home Depot, which seems to be limiting its ability to expand margins.

Since the August 2012 report, Lowe's has significantly narrowed the valuation gap that existed between itself and Home Depot, as the stock has run from $26 to $31 per share. Our internal spreadsheet values Lowe's at $33, while Morningstar has an intrinsic value on Lowe's at $32 per share. Lowe's is currently trading at 11 times cash flow and 16 times free cash flow, with 1% earnings growth expected in fiscal 2013, but 20% and 22% expected in fiscal 2014 and 2015.

In our August 2012 article on Lowe's we identified the Lowe's discount to Home Depot. However, we then got spooked by the earnings report, sold the stock, and have now watched it run $6 this quarter. Lowe's is not greatly overvalued here; it's just that a lot of the valuation discount has come out of the stock given the latest increase in its price.

Housing is in a firm recovery, no question, and Lowe's should benefit from this tailwind. It is buying the stock at a sufficient discount to intrinsic value that makes sense for longer-term investors that is the difficulty. Right now, despite its run and its premium valuation, Home Depot is the DIY to buy, given its consistency. We now like Lowe's closer to $28 for the first shot and even better in the mid-$20s. We'll have additional comments Monday morning.

Disclosure: I am long HD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.