Lowe’s Companies (LOW) and Home Depot (HD) are an emerging duopoly in the $725 billion home improvement industry, with a market share approaching 16% between the two.
In 2009, Home Depot’s full-year sales reached $67 billion to Lowe’s $47 billion.
Both companies are attractive to the contrarian value investor in an environment where sales are down, margins are pressured, and unemployment in construction services hovers in record figures.
Share prices of both retailers reflect a continuation of weakening housing prices and starts, the primary driver of home improvement projects.
The market also appears to shrug off international store growth in the short-term.
Home Depot operates over 250 stores outside of the US, but only a handful are outside of North America. Lowe’s international footprint of approximately 20 stores is even smaller, with a reach that only extends to Canada and a token number in Mexico.
Nonetheless, the business model works.
Big-box retailing with its focus on distribution and supply-chain management presents opportunities to operators to eat away at the market share of smaller competitors. The presence of sustainable, competitive advantages of these two retailers is likely why Buffett entered positions in both Lowe’s and Home Depot in 2005.
Given the pessimism reflected in each company’s share price, both present an opportunity to value investors. We anticipate 2010 will mark the first year in a series of growth in sales, earnings and margin expansion.
For Lowe’s we expect sales growth averaging 5% and a low single-digit increase in average store footage as Lowe’s emphasizes sales of branded goods. Lowe’s should also be able to keep administrative, selling and IT costs in check, consistent with its recent operating history. As a result, margins should gradually inch northward from last year’s 6.8%.
Shares are worth more than $32 apiece with reasonable assumptions.
Home Depot has benefited greatly from Bob Nardelli’s replacement with the current CEO, Frank Blake. Executive compensation is much more reasonable and the board of directors sports eight independent directors including corporate-governance consultant Bonnie Hill. Blake sold off most of the lower-margin HD supply business in 2007 and wound down the Home Depot EXPO design centers that were a distraction to the core business.
Going forward, we estimate sales growth of 5%, comparable to Lowe’s, with operating margins reaching 10% after several years relative to last year’s 7.3% as the company capitalizes on a revamped supply chain, merchandising and pricing automation.
Shares are worth $45 apiece.
Lowe’s sells at a 31% discount to our estimate while Home Depot shares sell for a discount approximating 30% off fair value.
Thus, at the moment, the market is mispricing both equally, presenting an excellent entry point for the contrarian value investor.