Home Depot Beats Lowe's

Nov.21.13 | About: Home Depot, (HD)

Over the past five years, both Lowe's (NYSE:LOW) and Home Depot (NYSE:HD) have outperformed the S&P 500's 104% gain with LOW up 160% while HD is up 288%. While holders of Home Depot have done better, shareholders in LOW have cannot be too upset about its performance. As both companies are levered to housing prices with consumers spending more to refurbish their home when its value is rising, some investors might be considering investing in Lowe's rather than Home Depot on the hope that it catches up to HD's performance. However, I believe that Home Depot remains the better buy because the company is simply performing much better as the most recent quarterly results show.

Home Depot reported a superb quarter (available here) with revenue increasing 7.4% year over year. Overall same store sales were up 7.4% while U.S. stores were up a blistering 8.2%. Thanks to stronger sales, earnings zoomed 28% to $0.95. Operating margins were 11.8% compared to 9.6% last year. Whenever same store sales are increasing by more than 5%, I expect to see a notable uptick in margins as there are significant fixed costs, like rent and components of SG&A that barely budge from increasing sales. As such, nearly all of the incremental gross margin flows straight to the bottom line. With continual growth, I am looking for continued margin expansion in 2014.

This quarter was simply fantastic as revenue came in $700 million ahead of management forecast while EPS was $0.10 better, allowing management to increase its 2013 guidance to a still conservative $3.72, which I think the company will probably best by $0.05-$0.08. Management is not yet offering official 2014 guidance. However, I think it is fair to expect continued strong sales growth with revenue growing about 6% to $83 billion. With this sales growth and a modest increase in margins, I would look for earnings on a share count neutral basis of $4.38. However, Home Depot has been buying back about $2-$2.25 billion in stock every quarter. I expect a similar pace in 2014, which would push EPS towards $4.55-$4.60. This means HD is trading at 17.4x 2014 earnings.

Lowe's reported a less robust quarter that mixed signs of strength with signs of weakness (report available here). Revenue grew 7.3% while overall same store sales were up 6.2%. In the U.S., same store sales were up 5.8%. These numbers are certainly not bad, but they do noticeably lag Home Depot, which has been the trend for four years. Lowe's, while benefitting from a strong underlying market, continues to lose market share. On these numbers, Lowe's did raise EPS guidance to $2.15 from $2.10, but that forecast is below the street's $2.19, suggesting a relatively weak holiday shopping season.

My big concern is that Lowe's is guiding to relatively weak operating margins of up 75bp year over year. Home Depot has ramped them 220bp, which suggests Lowe's is not getting nearly as much operating leverage from increased sales. On the conference call, management noted that appliance margins were under pressure, making me believe some of this sales growth is due to increased promotional activity in an effort to keep share against Home Depot. Moreover in the first nine months of their fiscal year, Lowe's improved operating margins by 91bp from 5.26% to 6.17%. Guidance suggests significant margin compression in the critical holiday quarter. To guide to weaker margins when sales are up noticeably indicates a significant lack of pricing power that is indicative of declining market share.

This quarter continues the trend of Home Depot outperforming and taking business from Lowe's. I expect this to continue in 2014 because Lowe's guidance suggests management expects continued share loss. I would look for 4% sales growth to about $55 billion. With an aggressive share buyback and margins that should stabilize given cost cut measures, I would look for $2.40-$2.45 in EPS. This means after the 6% earnings drop, Lowe's is still trading at 19.5x 2014 numbers.

While both companies are benefitting from long postponed home improvement projects, Home Depot continues to outperform Lowe's. It is growing sales more quickly, gaining share, and improving margins at a far better clip. Yet despite its far superior competitive position, shares of HD are trading at a notable discount to LOW as investors jumped into Lowe's hoping it could gain ceded share. This quarter makes that thesis very tenuous at best as HD continues to execute at the expense of Lowe's. With significant revenue and profit growth, I am a buyer of HD and believe it will pass $90 in 2014 while I would be a seller of Lowe's all the way to $40. Home Depot should not trade at a discount to Lowe's, and I would rotate into HD here.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.