Home Depot Has 10% More To Rise, Will Outperform Lowe's

Includes: HD, LOW
by: Takeover Analyst

Since I first presented my bullish article on Home Depot (NYSE:HD), the stock has soared by 25.9% - more or less in-line with the return from Lowe's (NYSE:LOW). Although much of the value gap has since been closed, I continue to expect the firm to outperform its competitor. This is a sentiment shared by the Street which rates Home Depot a "buy" versus a "hold" for Lowe's.

From a multiples perspective, Lowe's is the cheaper of the two. It trades at a respective 19.7x and 15.2x past and forward earnings while Home Depot trades at a respective 19.5x and 16.5x past and forward earnings. With that said, Lowe's is trading 148% above its 5-year average PE ratio versus only 123% for Home Depot.

At the third quarter earnings call, Home Depot's CEO, Frank Blake, noted strong geographical performance:

Sales for the third quarter were $17.3 billion, up 4.4% from last year. Comp sales were positive 4.2% and our diluted earnings per share were $0.60. Our U.S. stores had a positive comp of 3.8%.

From a geographic perspective, we saw positive comps in all but 5 of our top 40 markets, with particular strength in areas such as our New Jersey and South Atlantic regions, where there were significant storm impacts.

The firm's free cash flow yield is around 5%, but it will trend upwards with its strong brand name and impressive ROIC. Over the last decade, management has done a stellar job saturating the market through geographical expansion. The attention has since shifted more towards driving efficiency through divesting non-core assets, like its solid professional supply business. On another note, the firm recently purchased Redbeacon, an online home services business that helps connects consumes with contractors. Morningstar estimates that free cash flow is heading towards $4.7B and will be $22B cumulative over the next five years.

Consensus estimates for Home Depot's EPS forecast that it will grow by 17.7% to $2.39 in 2012 and then by 15.1% and 13.5% in the following two years. Assuming a multiple of 18.5x and a conservative 2013 EPS of $2.69, the rough intrinsic value of the stock is $49.77, implying 9.5% upside.

While Home Depot still has room for appreciation, Lowe's value gap has been, in my view, entirely closed. The firm has struggled to outcompete Home Depot, as evidenced by how it has slowed its expansion - especially in areas near rival stores. Margins are heading upwards with promotional spending being more than offset by overall expense management. In addition, the acquisition of ATG Stores helps add to Lowe's online presence. FCF yield is trending upwards to 11% from 5.1%.

Consensus estimates for Lowe's EPS forecast that it will grow by 11.8% to $1.51 in 2012 and then by 11.2% and 20.1% in the following two years. Modeling a CAGR of 14.3% for EPS over the next three years and then discounting backwards by a WACC of 9% yields a fair value figure of $27.22.

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