11/20/2009
By Brian Sozzi, Research Analyst

Recently, we issued a downgrade to our institutional rating on Lowe's Companies (LOW) shares, citing valuation that did not properly reflect the apparent fundamental differences between the two home retailers at this stage in the economic cycle.  Through investments in store level forecasting tools, customer service initiatives, and rapid deployment of merchandise through highly automated RDCs, in tandem with modest sales growth in FY10, we believe Home Depot (HD) is in a prime position to generate stronger ROA, ROIC, and ROE measures relative to Lowe's.  By extension, we expect Home Depot to be much more aggressive than Lowe's in returning value to shareholders next year through a mix of dividend payments and share purchases, which would arise despite a $1.0 billion note maturity.  The company's focus on its existing store base is working, leading to improved customer service ratings and comp trends.

Home Depot's 3Q09 U.S. comps at -7.1% outpaced Lowe's by 90 bps, and represented the third consecutive sequential quarterly rebound.  Ultimately, it suggests that Home Depot's low price value message to consumers is resonating stronger as opposed to its prime competitor's marketing campaign.  Gross margin was 33.98%, surpassing consensus by 16 bps.  As we have stated before, Home Depot has made structural changes to how it runs its business, which is feeding into the gross margin line (gross margin ahead of consensus for three straight quarters).  Encouragingly, operating margin touched 7.77% pro forma on an 8.0% y/y sales decline.  Considering 3Q09 sales comparisons were still tough, structural changes to the model, and a healthier sales backdrop in the aggregate it's hard to dispute Home Depot's operating margin not expanding in 2010.

Similar to Lowe's, management served up a platter of cautiously optimistic guidance for 4Q09; we have reasoned that housing market stabilization in the West and Southeast (California and Florida comprise 19.0% of Home Depot's store base) is a key determinant in the home improvement retailer finally turning the corner on the sales line.

Turning Tide on Display

Through the paring of unproductive stores in hard-hit housing regions and those planned to open that no longer made economic sense, as well as disciplined working capital management, Home Depot began to pull ahead of Lowe's in the all important return on equity measure in 4Q07.  During the period since, Lowe's was mostly focused on unit additions in the U.S. and growing the working capital base required to operate new locations.  It's apparent that Lowe's strategies have disappointed investors, and conversely rewarded shareholders of Home Depot.  Now that Home Depot is arguably regaining ceded market share, as evidenced by the shift in same-store sales between the two companies in 3Q09, the gap in return measures is set to widen.

Brian Sozzi
Wall Street Strategies