Home Depot Is Well-Positioned Against Lowe's

Includes: HD, LOW
by: Takeover Analyst

With a stagnating US economy, investors have reason to be worried about the consumer services sector. As discretionary income falls, consumers tend to tighten their budgets and substitute towards lower margin products. This means that consumers will spend a greater percentage of their incomes on essentials, do-it-yourself home improvement products being one such essential.

Although the CEO of Home Depot (NYSE:HD) argues that the company is tied with GDP, I find that it is less correlated, and thus less vulnerable, to this variable than what is appreciated by the market. For one, the stock has a beta of 0.76. In addition, shareholder value increased by more than a third since 2008. While much of this was due to the positive actions taken by management (like supply chain improvements and product offerings), Home Depot also fared well during the recession due to the inelastic price elasticities of some of its products.

The propensity to pay for home improvement services simply declined during the macro collapse and was supplanted by heavier demand for substitute and cheaper do-it-yourself goods, a scenario that the market may very well not have fully accounted for. In short, I find that Home Depot is a much safer bet than what current market commentary suggests.

But what makes me most attracted to Home Depot is its competitive position against Lowe's (NYSE:LOW), especially geographically. Lowe's will be closing 20 stores and launching between 10-15 new units each year. Nearly half of these 20 store closings are in the Northeast and nearby competing Home Depot stores. Accordingly, Home Depot stands to benefit from market share gains, a major catalyst for the firm going forward.

And at the second quarter earnings call, CEO Frank Blake noted:

Sales for the second quarter were $20.2 billion, up 4.2% from last year. Comp sales were positive 4.3% and our diluted earnings per share were $0.86. Our U.S. stores had a positive comp of 3.5%. From a geographic perspective, we saw positive comps in all but 3 of our top 40 markets, with particular strength in our Midwest and South Atlantic regions.

While the retailer is proving itself geographically, the market share gains thus far have been disappointing for some investors. As management is working successfully to increase scale and promote during a depressed economy, I remain nevertheless confident that the firm will be well-positioned after a full recovery.

One fear that investors rightfully has concerns the weak housing market. However, despite soft housing markets in Florida, Arizona, California, and Nevada, for example, sales were still positive in these regions during the second quarter, which I expect to be the case during the third quarter. The rolling out of "Buy Online, Pickup In-Store" will further aid sales across all regions, and will be beneficial for growing shareholder value in the long-term. By the end of the third quarter, this option will be offered to all of the 2,200+ stores. Although Home Depot's efforts will be challenged by the stronger promotional environment at Lowe's, I find that it has done a well enough job marketing "value" to forgo competitive discounting.

Analysts currently rate the stock between a "buy" and a "strong buy," with consensus growth estimates for EPS of 15.8%, 13.6%, and 15% in 2012, 2013, and 2014, respectively. I model revenue growing by 4.7% to $69.1B and then by 4.3% in the following year. Much of the gains are a result of decreased competition from Lowe's, targeted promotion to drive comps, and improved inventory management.

When it comes to valuation, Home Depot is more expensive than Lowe's at 13.5x and and 12.2x forward earnings, respectively. At the same time, Home Depot offers higher dividend yields (2.8% vs. 2.6%) and is committed to share repurchases. During the first half of 2011 alone, management repurchased $2.3B worth of shares and plans on repurchasing $1.2B more during the second half. The home improvement store is also gearing up for margin expansion as it shifts to an online platform and contains costs. At the same time, investor fear over the housing market and macroeconomy will drive high risk-adjusted returns for the stock. As the leader in its field, it may even stand to benefit from industry challenges as competitors will struggle even more. Given this environment, I recommend Home Depot as a buy-and-hold for a five-year period.

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