2/19/2010
By Brian Sozzi, Research Analyst

We have been hard at work in preparation for the upcoming 4Q09 earnings releases from Home Depot Inc. (HD) and Lowe's (LOW) next week.  These reports, in many respects, will be some of the most important we have heard from the home improvement retailers in quite a while (despite the fourth quarter usually being the smallest component to the annual base for the sector) given the tangible signs of a turn of the U.S. housing market in recent months.  Will improving demand trends in existing home sales and the remodeling market find their way into the FY10 outlooks by the companies?  We will touch upon this in our earnings previews.  However, we believe it's a prudent exercise to breakdown the companies at the respective points in their life in anticipation of a housing recovery reflecting more prominently on sector sales and earnings in FY10 and FY11.  While theoretically each company should benefit from new homeowners/existing homeowners returning to the remodeling market or house flippers sprucing up recently purchased foreclosed/short sales properties, one stock stands to outperform the other.  In our view, the outperformer is Home Depot, and is why we have had a buy rating on the stock since March 24, 2009. 

When all is said and done, we think the news next week from Home Depot will be good in terms of 4Q09 results and the FY10 initial outlook.  There are many positive happenings unfolding at Home Depot, more so on the operating expense/process improvement side of the profit equation, but increasingly on the comparable store sales side.  The rise in lumber prices recently, the weak dollar (y/y), and renewed consumer interest are likely to accentuate going forward the positive shift in Home Depot's average ticket and transaction value that began in the middle of 2009.  Sales comparisons should still be favorable on the currency front perhaps until 4Q10; in the first nine months of 2009 unfavorable currency translation hurt Home Depot's sales by a whopping $750.0 million.  The company operates in Mexico, China (in six cities), and Canada. 

Amazingly (and this is one of the reasons why Home Depot reigns supreme in our evaluation procedure of the two companies), the company now gets about 30% of its merchandise shipped directly from suppliers, while Lowe's is still highly inefficient and is around 72% on this measure.  By essentially removing a step in the sourcing process through the opening of RDCs (rapid deployment centers), Home Depot is gaining previously unforeseen efficiencies and reducing lead times that will lead to fresher appearing stores and heightened markdown optimization.   Coming into 4Q09, Home Depot was serving 1,000 of its store base (50% of the store base) by operating 10 RDCs (company was covering 25% of its store base at the end of 4Q08).  By the end of 2010, that number may be closer to 80%.  Lowe's, on the other hand, has fewer than 20 RDCs serving around 150 stores.  Again, Home Depot's greater efficiencies stand to translate into stronger return metrics, relative to Lowe's, as sales and net earnings continue to normalize over the next two years. 

Also a lesser known fact is that through the opening of these smaller distribution facilities, Home Depot is closing its larger distribution facilities.  By the end of 2009, Home Depot will have contributed close to 1.3 million in square feet to the commercial real estate market just by closing distribution centers alone.  This benefits the company as the land under the property is sold (eventually), machines sold off, and don't have the cost of operating (taxes, utilities, etc.) these huge facilities.  However, we would imagine it causes not only job loss, but an eyesore in the community.  Akin to "dead" malls, these distribution facilities are likely to remain unproductive given the undesirable proposition of opening up new malls and the glut of dwellings on the market. 

Brian Sozzi
Wall Street Strategies