Positive recent housing and economic data have helped push both Home Depot (NYSE:HD) and Lowe’s (NYSE:LOW) shares about 10% higher in the past week. Accounting for most of their YTD gains, these advances reflect the DIY industry’s sensitivity to even small changes in housing and retail spending cycles.
I think the broadly anticipated, modest economic tailwind through next year will help each stock outperform the overall market. However, if you can own just one of the two names, I recommend HD, since it’s the better run company, and is poised to build on its existing advantages.
At its investor meeting on Wednesday (December 8), HD will share its 2011 views. Besides more detail, that outlook will likely see little change from the basic game plan provided after Q3 results in mid November. At that time, the company highlighted its every day value proposition, efficiency, and maximizing the profits/cash flows of its existing store base, cornerstones of its operating strategy.
A highly efficient business model
The average Home Depot store sells about 8% more product than LOW, despite operating from a box that’s 7% smaller (about 8,000 sq. feet) than its rival’s. With an average ticket of $52 at HD compared to $62 at LOW, the former offers more competitive prices, skewed toward mundane items like paint and hardware, than Lowe’s, which emphasizes big ticket items, like appliances.
What HD lacks in prices, though, is more than made up for in volumes, generating $646 (NYSE:LTM) in sales per square foot, almost 50% higher than LOW, at $433. The benefits from HD’s volume-oriented model are evident by comparing balance sheets, where over the last twelve months, HD has stretched its edge to 15% and 27% faster inventory and payable turns, respectively, than its competition. (Please see the table below.)
2007 – 2009 (avg) | LTM | ||||
HD | LOW | HD | LOW | ||
Inventory turnover | 4.1x | 3.9x | 4.1x | 3.6x | |
Days inventory | 89.4x | 93.1x | 89.3x | 102.3x | |
Payables turnover | 7.5x | 7.3x | 7.5x | 5.9x | |
Days in payables | 48.9x | 49.9x | 48.4x | 61.4x |
Over the past few years, HD has spent more than $250 million to upgrade its supply chain. Today, over 40% of its cost of sales is sourced from these smaller, more streamlined regional distribution centers. Moreover, 80% of HD’s product goes from delivery truck to shelf, rather than sitting in overhead.
The margin advantage that has accrued to HD from this operating leverage justifies its unique approach. The company’s heavy supply chain investments, begun in 2007, have helped HD turn what were 30 - 40 bp operating and net margin shortfalls versus LOW (from 2007-09), to what are likely to be about a 130 bp and 60 bp advantages, based on my FY 10 estimates. These higher margins and faster asset turnover rates lead to better returns on investment, as seen in the table below.
2007 – 2009 (avg) | FY 2010 E | ||||
HD | LOW | HD | LOW | ||
Operating profit margin | 8.5% | 8.8% | 8.5% | 7.2% | |
Net profit margin | 4.8% | 5.2% | 4.7% | 4.1% | |
Return on Invested Capital | 12.1% | 11.0% | 13.7% | 9.6% | |
Return on equity | 8.0% | 6.7% | 8.7% | 5.5% |
Lots of disposable cash, prudently allocated
Although both HD and LOW were slow to respond to the housing crisis, the former has more aggressively curtailed its capital program. Reduced spending has helped HD generate comparatively attractive free cash flows, in all environments. Indeed, the company generated more than 2X as much free cash in the trough years 2008-9, than in the peak years 2005-6. (Please see the table below.)
2006 - 2009 (Avg) | FY 2010 E | FY 2011 E | ||||||
HD | LOW | HD | LOW | HD | LOW | |||
EBITDA | 8,010 | 5,714 | 7,349 | 5,226 | 7,966 | 5,762 | ||
Capital expenditures | (2,660) | (3,204) | (1,089) | (1,562) | (1,300) | (1,874) | ||
Free cash flow | 3,476 | 1,023 | 3,925 | 2,174 | 4,217 | 2,420 | ||
Free cash flow margin | 4.8% | 2.2% | 5.8% | 4.4% | 6.1% | 4.7% | ||
Free cash flow yield | 5.8% | 2.7% | 6.1% | 5.5% | 6.5% | 6.1% |
After HD spends an estimated $1.1 billion and $1.3 billion this year and in 2011, it will be left with $3.9 and $4.2 billion in free cash, and a free cash flow yield at 6.5%. The company will probably have minimal square footage growth in 2011. By contrast, LOW whose nearly 2% increase in square footage next year, similar to this year’s new stores, will be at units challenged to meet their cost of capital in the current environment.
Organic sales growth now an advantage too
One advantage for LOW over the past 10 years has been sales growth, both in total and on a same-store basis. However, with FY 2010 mostly complete, Home Depot, with comp sales growing around 2.5%, versus Lowe’s at around 1.5%, is starting to overtake its rival in this key measure of organic growth. The incremental sales from a 1% comp advantage is about $650 million, equivalent to revenues from about 25 Lowe’s units - equivalent to the lower end of LOW's expected annual additions through 2015.
Imitiation is flattery
Recent comments by LOW, at its investor meeting this past week, suggest it is shifting toward the HD business model. Short term, it cut Q4 (ends Jan) operating margin guidance (to +50-60 bp’s, from +80 bp’s). Compared to the guidance given just two weeks prior, this reduction suggests a more promotional, value-oriented sales environment. Longer term (through 2015), LOW outlined much slower store growth (as mentioned above), and returning more cash to shareholders through dividends and buybacks. If properly executed, these changes will make LOW a tougher competitor, albeit in a race that HD has several years' head-start.
HD’s valuation premium should widen
HD has historically traded at a 45% and 19% premium to LOW on EBITDA and P/E. Based on my 2010 forecasts, that premium has fallen to less than 10% on EBITDA and is now a slight discount to LOW on P/E.
EV / EBITDA | P/E | ||||
| HD | LOW |
| HD | LOW |
2010E | 8.5x | 7.8x | 16.9x | 17.2x | |
2009 | 11.2x | 6.7x | 16.9x | 17.9x | |
2008 | 16.2x | 9.7x | 12.1x | 12.3x | |
2007 | 15.6x | 8.3x | 13.4x | 13.7x | |
2006 | 8.1x | 9.2x | 15.4x | 17.2x | |
2005 | 9.6x | 10.0x | 14.6x | 18.4x | |
2004 | 9.9x | 11.3x | 17.9x | 20.7x | |
2003 | 7.0x | 9.2x | 18.9x | 23.7x | |
2002 | 20.1x | 16.7x | 13.4x | 18.6x | |
2001 | 22.0x | 12.8x | 38.3x | 35.7x | |
2000 | 30.3x | 12.2x | 40.7x | 25.5x | |
1999 | 29.2x | 20.0x | 55.6x | 24.9x | |
1998 | 19.8x | 11.3x | 57.1x | 43.5x | |
1997 | 13.9x | 9.3x | 36.9x | 24.5x | |
1996 | 15.7x | 10.6x | 25.6x | 19.4x | |
Avg. | 15.8x | 11.0x | 26.2x | 22.2x |
If one were to assume a demand environment like the final four frothy years of the housing boom (from 2003-2006), when LOW traded at a premium to HD, then it would follow that LOW is the better investment from here. However, if you expect the visible future to be more similar to the past four years, as I do, then history suggests HD’s valuation gap will widen.
Valuation methodologies
Based on a simple average of DCF and EBITDA multiples I arrive at a target price of $42 for HD and $29 for LOW, implying appreciation of 26% and 17%, respectively. Key assumptions in my DCF include a discount rate of 8% for HD (8.5% for LOW). The two-stage DCF also assumes 8.5% growth for HD for the first five years (10% for LOW) followed by 2% growth and 18x terminal multiples for each after year five. On my 2010 EBITDA forecast I apply multiples of 10x for HD and 8.5x for LOW.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.