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As consumer spending and the housing market stabilize and continue to improve, domestic home-improvement retailers will directly benefit from this economic recovery trend. Home Depot (NYSE:HD) and Lowe's (NYSE:LOW) are the 2 major players in the home-improvement sector with significant market shares. I believe they are better positioned than other smaller players to ride the trend, as their sound fundamentals and competitive advantages in their distribution networks allow them to continue seizing market shares and expanding profit margins.

In addition, the 2 companies are shareholder-friendly and historically returned most free cash flows to shareholders by issuing dividends and buying back shares. In this article, I will run you through my quick quantitative analysis for these 2 stocks. Although your further research is warranted, I believe this article will be a helpful introductory to identify quality dividend investment opportunities.

Introduction

Being the world's largest home-improvement retailer, Home Depot operates 2,250 stores throughout the U.S., Canada, Mexico, and China. The stock is now trading at $49.59, It returned 16.4% and 42.7% on YTD and 1-year basis, and is currently trading just off its 52-week high of $52.88.

Lowe's is the second largest home-improvement retailer in the world. The firm operates 1,745 stores with primary focus in the U.S. market. LOW shares gained 4.1% and 15.6% on YTD and 1-year basis, and are now trading at $26.91, the mid-point of its 52-week range between $18.07 and $32.29.

Growth and Profitability

The following table summarizes the 2 companies' historical and estimated growth rates, as well as various margin metrics.

(click to enlarge)

Except for the estimated 2-year EPS CAGR, HD slightly outperformed LOW on all of the above shown financial measures.

Leverage Positions

The following table shows the 2 companies' leverage positions

They have comparable debt levels. Although HD has a higher interest coverage ratio, LOW's 8.6x is still solid and in the safe zone.

Valuations

We see that both companies are fairly valued given that their PEGs are hovering around 1.0x. It makes perfect sense that HD is valued at a premium to LOW, as it demonstrates a history of higher profitability and stronger FCF generating ability.

I also checked both stocks' current market prices against my DCF models with the following fair assumptions:

For HD:

Revenue GrowthDeclining from 4.0% to 2.5% over the next 10 fiscal years
EBIT MarginAn average of 9.5% (lower than consensus estimate)
D&A Expense2.6% of revenue (historical average)
Share-based Compensation0.3% of revenue (historical average)
CapEx2.0% of revenue (lower than the historical average of 2.4%)
Change in NWC6.5% of change in revenue
Tax Rate37.5%
Terminal Growth Rate2.5%
WACC8.7%

The HD model yields a fair stock value of $49, which is in line with the current market price.

For LOW:

Revenue GrowthDeclining from 3% to 2% over the next 10 fiscal years
EBIT MarginAn average of 7.6% (historical average)
D&A Expense3.4% of revenue (historical average)
Share-based Compensation0.2% of revenue (historical average)
CapEx3.5% of revenue (lower than the historical average of 5.1%)
Change in NWC3.0% of change in revenue
Tax Rate37.5%
Terminal Growth Rate2.0%
WACC8.7%

The LOW model arrives at a value of $27, very much the same as its current market price as well. Both DCF models reaffirm that the two firms are currently fairly valued.

Sustainability Analysis of Dividends and Share Buybacks

Dividend sustainability is the key for income investors, thus I have performed the following free cash flow analysis to provide you a sense of how well these two firms can grow their dividend payouts and maintain, or even increase, the scale of their share buybacks in the future.

The following table is for HD:

(click to enlarge)

Based on the DCF model's projected FCFs over the next 10 fiscal years, the FCF streams can sustain a dividend growth of 3.2% so as to maintain the ratio of dividend/FCF at 35% range. With the stable dividend growth, HD can also spend the remaining FCF on gradually increasing the value of its buyback programs.

The following table is for LOW:

(click to enlarge)

Again, based on the DCF model's projected FCF streams over the next 10 fiscal years, LOW could sustain an annual dividend growth of 2.4% and gradually increase the scale of share buyback by spending up the remaining FCF.

Tables are created by author and financial data is sourced from company 10-Q, 10-K, press release, Yahoo Finance, YCharts, Wall Street Journal, Thomson One and Morningstar.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in HD, LOW over the next 72 hours.

Source: 2 Quality Dividend Plays With Sustainable Payouts And Share Buybacks