In an earlier article here, I argued that Home Depot (HD) would outperform Lowe's (LOW). While both companies appreciated substantially by 25.7% and 27.9%, respectively, I was fairly surprised with the latter's growth. For the last 10 straight quarters, Lowe's has had slower comps than its competitor and continues to show its weakness by removing underperforming stores. Not surprisingly, these underperforming stores are often located nearby Home Depot stores. Based on my multiples analysis and DCF model, I continue to find that Home Depot has more favorable risk/reward than its competitor.
From a multiples perspective, Home Depot is more attractively valued. It trades at a respective 18.8x and 16x past and forward earnings while offering a dividend yield of 2.7% and a beta of 0.8. Lowe's trades at a respective 19.6x and 15.1x past and forward earnings while offering a dividend yield of 2.1% and a beta of 1. As Home Depot is experiencing faster growth, greater margin and ROIC expansion, it follows that it should be trading at a larger premium. I believe that the market could be giving Lowe's the benefit of the doubt and - in doing so - it is setting itself up for disappointment.
At the third quarter earnings call, Lowe's CEO, Bob Niblock, noted continued challenges:
"Sales for the quarter increased 2.3% while comparable store sales were positive 0.7%. Comp traffic increased 0.7% in the third quarter, and comp average ticket was flat. Gross margin contracted 99 basis points in the quarter.
We had good operating expense control in the third quarter, however, we recognized charges related to store closings and discontinued projects, which in aggregate reduced pretax earnings for the quarter by $336 million and diluted earnings per share by $0.17. Including this charge, we delivered earnings per share of $0.18 in the third quarter. Excluding the charge, we delivered earnings per share that exceeded our guidance for the quarter.
As I said before, our performance is not at the level we expect relative to the market or, frankly, that we demand of ourselves."
The company has had around five years of negative comps on a two-year basis. While the second and third quarters showed turnaround activity with comps turning positive, growth continues to fall well behind Home Depot's growth. Traffic further remains slow and consumers are not making major purchases, indicating hesitancy in the home improvement market generally. Furthermore, management will be closing 10 more underperforming stores in the fourth quarter and has lowered store builds down to 10-15 from 30 previously. As its everyday-low-pricing model cuts into margins, the company also limits free cash flow potential during a recovery.
Consensus estimates for Lowe's EPS forecast suggest that it will grow by 11.8% to $1.61 in 2012 and then by 10.6% and 20.2% more in the following two years. Assuming a multiple of 18.5x and a conservative 2012 EPS of $1.69, the rough intrinsic value of the stock is $31.27, implying 16.7% upside. However, modeling a CAGR of 14.1% for EPS over the next three years and then discounting backwards by a WACC of 9% yields a figure of $27.10. The latter estimate is more realistic since Lowe's is not likely to stay on the same multiples basis as its strong competitor is.
While Home Depot has closed much of its value gap, the company still has more appreciation to come. Third quarter sales were up 4.4% y-o-y to $17.3B and 35 of the top 40 markets showed positive comps. The company is further trending toward EBIT margins of 10% by 2013 and is well positioned through international exposure to hedge against domestic stagnation. Furthermore, ROIC is forecast to arrive at 16.7% in 2014, driven by top-line acceleration and buyback activity. Implementation of enhanced technology and RDC networks will additionally improve customer satisfaction.
Consensus estimates for Home Depot's EPS forecast suggest that it will grow by 17.7% to $2.39 in 2012 and then by 14.6% and 13.5% more in the following two years. Assuming a multiple of 18.5x and a conservative 2013 EPS of $2.68, the company has roughly 13.4% upside. This upside has meaningfully greater certainty that that of its competitor.