Retail Home Improvement stocks are expected to do well this spring on the thesis of home restoration, recovery and landscape projects following winter.
Our dual cash-flow and accrual analysis of Home Depot (HD) and Lowe's (LOW) has identified some interesting similarities and contrasts investors may want to consider when evaluating either of these two names.
In this discussion we will focus on a comparison of key financial statement characteristics revealed in our analysis for the seven quarters through January 2011.
Cash Flow: Lowe's appears to display the strongest level of "pure" operating cash-flow (OCF) indicating that earnings quality benefits from wider spreads, each as a measure of reported sales and balance sheet generated cash-flows (BSCF) when compared to competitor Home Depot.
However, as you can see in the graph above, LOW experienced far more volatility in its OCF contributions to earnings, whereas HD's levels of OCF have remained fairly consistent.
Accruals: Both HD and LOW utilize accrual accounting as the industry experiences seasonal discounting and surges in hiring and inventory build heading into the key spring selling season.
Here, HD displays the better overall accrual trend (lower ratios are preferred) as a measure of earnings quality. Much of the difference between HD and LOW accrual trends is likely due to depreciation, restructuring and pre-tax charges. LOW is expanding store count while HD has cut its new store pipeline and closed under performing stores in its U.S. markets.
Capital Productivity and Revenue Metrics: Expenses as a percent of sales were very similar between HD and LOW for costs-of-goods-sold and S,G & A. For accounts payable, LOW had more than 41% of its AP's tied to revenues vs. 31.8% for HD in each of their latest periods.
Costs related to working capital were also similar for HD and LOW with regard to inventory and receivables. LOW's costs per dollar of sales for P,P&E was $2.11 vs. $1.66 for HD.
Earnings Quality
HD: B+
LOW: B-
Valuation
HD: UNDERVALUED -7.67% below our estimated fair-value price of $39.99
LOW: OVERVALUED +5.52% above our estimated fair-value price of $24.84
Rating
HD: BUY / HOLD
LOW: HOLD
Summary: Although LOW exhibits healthier spreads in OCF to both sales and balance-sheet cash-flows, we believe HD currently offers better value and overall earnings quality of the two stocks.
Over the past year, HD shares have largely tracked the S&P 500 while LOW has until very recently underperformed the broader index since June of 2010.
Analysts have been raising price targets on Lowe's recently, but it is our opinion that HD's stock price does not yet reflect the company's business rationalization initiatives put into place more than a year ago. Caveats to this would be if HD is unable to or experiences delays in disposing or subletting locations of exited businesses or closed stores as expected.
Consider taking partial positions in HD on any pull-back to the $34 area, full positions up to $32. You can view the full report on HD here and LOW here.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
