Tuesday, August 22, 2006

Big Box Battle: Home Depot vs. Lowe's

News Analysis
August 22, 2006

Business Week Online

Big Box Battle: Home Depot vs. Lowe's

The home-improvement giants have been hammered by housing-market worries. Which can better withstand a slump?

A tough year for home-improvement retailers just got tougher. Home Depot (HD ) reported soft second-quarter earnings on Aug. 15 and cautioned that it expects only slight gains for the rest of 2006 (see BusinessWeek.com, 8/16/06, "Wal-Mart, Home Depot Hit Potholes"). Fast-forward nearly one week, and it's a similar story: Lowe's (LOW ) echoed its larger rival on Aug. 21, posting lackluster second-quarter results and warning of a sales slowdown.

Higher energy prices and a weakening housing market have already helped pour cold water on both companies' stock prices. Adjusting for dividends and splits, shares of both Atlanta-based Home Depot and Mooresville (N.C.)-based Lowe's were down about 15% for the year through Aug. 21. By comparison, the broader Standard & Poor's 500 stock index gained 3.9% over the same period.

By and large, analysts expect both of the fix-it chains to grow impressively over the long term. In the months ahead, however, the company best known for its big orange boxes may be a better bet to ward off the retail blues. Home Depot's expanded wholesaling business could help insulate its stock against a consumer-spending freeze, analysts say.

BATTEN DOWN THE HATCHES.  Either way, the economic headwinds blowing against the chains are formidable. The latest data suggest the worst is yet to come in the housing slowdown (see BusinessWeek.com, 8/21/06, "Why the Housing Market Looks a Little Rickety"). An Aug. 23 report is expected to show that existing home sales declined again in July. Specialty retailers, such as home-improvement stores, are "particularly sensitive" to existing home sales, according to Jack Ablin, chief investment officer at Harris Bank.

Meanwhile, a closely watched gauge of consumer sentiment recently hit its lowest level since the aftermath of last year's hurricanes (see BusinessWeek.com, 8/18/06, "Those Gloomy Consumers"). Energy prices remain high, with West Texas Intermediate crude oil futures holding above $70 a barrel despite a Mideast ceasefire.

Home Depot's advantage? The chain has diversified away from its 2,079-store retail business. In the past three years, the company has spent more than $7 billion on acquisitions. Home Depot projects that its new commercial wholesale division, dubbed Home Depot Supply, will reach about $12 billion in revenue this year. The unit posted same-store sales growth of 12% in the second-quarter vs. the year-earlier period.

WHOLESALE CUSHION.  Home Depot Supply gives the company a foothold in the commercial building market. Nonresidential construction is growing at double-digit rates while residential business is floundering, according to investment-research outfit Action Economics (see BusinessWeek.com, 8/22/06, "Construction: A Tale of Two Sectors").

The company's wholesale exposure could ease the pain on its bottom line if retail shoppers tighten their purse strings, analysts say. "If the whole economy slows, that part of the business should remain pretty stable," says S&P industry analyst Mike Souers, who covers the specialty retail sector. Souers has a strong buy recommendation on Home Depot and a buy recommendation on Lowe's.

All is not rosy for Big Orange. Home Depot fell to last place in the University of Michigan's annual American Customer Satisfaction index, 11 points behind Lowe's (see BusinessWeek.com, 6/19/06, "Home Depot: Last Among Shoppers"). More recently, Home Depot has unveiled plans to invest $350 million on in-store programs, including customer-service initiatives.

BUYING OPPORTUNITY.  Home Depot raised Wall Street's ire when it said it would stop disclosing the key retail benchmark of same-store sales—sales at stores open a year or more—but the company reversed that decision in the second quarter. Home Depot Chief Executive Robert Nardelli has drawn criticism over his $38.1 million in total 2005 compensation (see BusinessWeek.com, 5/23/06, "Home Depot's CEO Cleans Up"). In addition, the chain has gotten caught up in the Securities& Exchange Commission's stock-options probe, though company executives say they do not anticipate a "material adverse impact."

However, the negative publicity may already be reflected in Home Depot's shares, which fell 1.35%, to $34.30, on Aug. 21. The stock "is pricing in more bad news than good news," says Merrill Lynch analyst Danielle Fox in an Aug. 15 report, citing a price-to-earnings (p-e) ratio of 11. Fox has a buy rating on both Home Depot and Lowe's. (Merrill Lynch has an investment banking relationship with the two companies and makes a market in their securities.)

Lowe's latest dip, too, may represent a buying opportunity, analysts say (see BusinessWeek, 7/3/06, "Lowe's Is Not Riding High"). In an Aug. 21 report, Fox says Lowe's p-e of 13.3 times her forward earnings estimate is the stock's lowest multiple since 1991. Shares fell 3.96%, to $28.35, at the close of trading on Aug. 21.

That's not to say that the North Carolina chain's stock has been stagnant. Since scraping a 52-week low in mid-July, Lowe's shares had been on the rise going into the second-quarter earnings report. From July 14 to Aug. 18, shares of the company climbed 7.8%, adjusting for dividends and splits, compared to a 2% increase for Home Depot.

LONG-TERM OUTLOOK . On the big box front, Lowe's stores may be positioned to continue grabbing market share away from Home Depot, says Michael Tesler, president of RetailConcepts.com, a retail consulting firm based in Norwell, Mass. "Lowe's has more positive momentum right now," Tesler explains. Moreover, women typically find the chain to be more comfortable than Home Depot, he adds.

Despite short-term challenges, some analysts see both home-improvement chains building up gains in the long run. "They will have very good growth prospects as they continue to open new stores and take market share," says Morningstar stock analyst Anthony Chukumba. "We think for the most part they both have great store models and great management teams."

The economic environment may leave the fix-it chains hoping for some quick repairs. While both Home Depot and Lowe's both have plenty of tools at their disposal, Big Orange's recent efforts to extend its reach beyond the weekend handyman may give it a better chance of staying warm while the housing market cools.

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