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By Erik Kobayashi-Solomon | 04-05-2011 05:21 PM

The DIY Duo: Home Depot vs. Lowe's

We dig into the competitive dynamics between the two 800-pound gorillas in the home improvement space.

Erik Kobayashi-Solomon: Hi. I am Erik Kobayashi-Solomon. I am co-editor of Morningstar OptionInvestor. Today it's my great pleasure to welcome Peter Wahlstrom, who is the associate director of consumer cyclical sector [analysis] here at Morningstar.

Pete, thanks for coming in.

Peter Wahlstrom: Thanks for having me, Eric.

Kobayashi-Solomon: So, just recently I have been doing some research on home improvement retailers and the real estate space in general, and I wanted to ask you a little bit about Home Depot and Lowe's.

So, the only thing that I knew about Home Depot and Lowe's is basically Home Depot is bigger. I read from your report that Lowe's is more efficient in terms of logistics and so forth. So when I looked at their financials, I expected that Lowe's would have better gross profitability and that Lowe's would have better operational profit. But when I looked at their financials, I didn't find this was the case. Can you explain a little bit what's going on with these companies?

Wahlstrom: Sure, happy to. So, Home Depot is the largest home improvement retailer in the world, and Lowe's is number two, so you'd imagine that they would have pretty comparable financials. Lowe's does not have a couple of ancillary businesses that Home Depot had; so Home Depot had an HD Supply, which sold to commercial contractors. They also had an upscale EXPO Design Center up until a couple of years ago.

Kobayashi-Solomon: I think Home Depot has more exposure overseas as well, right?

Wahlstrom: That's correct. They do have a Canadian and a Mexican operation. They also have a couple of locations in China as well. It's a half dozen or so, so it really doesn't move the needle. But from a Mexico standpoint, it's about 9% of sales, so that is a big component, and there are a lot of moving parts, though, but it's not certainly an apples-to-apples comparison between Home Depot and Lowe's.

Kobayashi-Solomon: So what you're saying is some of those segments muddy the water in terms of the gross profitability?

Wahlstrom: Absolutely. But if you take a step back, the two are fairly comparable from a gross margin and even an operating margin standpoint.

Kobayashi-Solomon: Right. Though, I was surprised especially after reading that you really like Lowe's logistical capabilities, but it seems like Home Depot is actually getting more to that op profit line.

I know that Home Depot, their management has started chasing Lowe's in terms of trying to beef up their logistics. Do you think this is a good idea? I mean they already have better profitability than Lowe's does.

Wahlstrom: It's funny that Home Depot does have better profitability, because two years ago Home Depot came out and said "our supply chain is a competitive disadvantage." So they had really been leveraging solely on just their scale. So now they have switched to a Rapid Deployment Center or RDC model, where they've shifted over all their distribution centers to now run a little bit more efficiently, a little bit more effectively, and they're able to push the right sort of product through the distribution center, route additional product directly to the stores as the case may be. So that has given them a much better foundation now to go after Lowe's and the other competitors in the home improvement retail space.

Kobayashi-Solomon: These are the smaller ones, the Menards and Aces and places like that?

Wahlstrom: That's correct. Exactly right.

Kobayashi-Solomon: If they are kind of boosting up their logistical capabilities, this means increased spending on capex. Are you worried about that at all?

Wahlstrom: The company has done a very good job from a capital spending allocation standpoint.

Kobayashi-Solomon: This is Home Depot.

Wahlstrom: That's right, and they're spending hundreds of millions of dollars, but they're not putting it in big slugs. They're spreading it across 50, 100, 200 incremental projects--on the margin it doesn't seem like a $4 million savings is all that much to a company that generates $66 billion in revenue, but if you add up 50, 100 of those projects with a two, three year payback period, they can really move the needle.

Kobayashi-Solomon: So, they're investing intelligently?

Wahlstrom: They are, and then the flip side of that is both Home Depot and Lowe's have really scaled back their square footage growth projections. Home Depot is looking at adding only eight to 10 stores each year for the next four years, and Lowe's compared to a couple of years ago, when they were opening 150 stores, is looking to open on average 25 stores in the U.S.

Kobayashi-Solomon: So basically they're taking some of the capex spend that they would have put into opening new locations and now trying to beef up their infrastructure?

Wahlstrom: Absolutely.

Kobayashi-Solomon: On both sides I guess, Home Depot and Lowe's?

Wahlstrom: That's correct, yes.

Kobayashi-Solomon: So, as you said, Lowe's and Home Depot, they look very similar to me, similar profitability, roughly similar revenue stream, etc. Right now which do you like better, Home Depot or Lowe's?

Wahlstrom: Both companies we believe are very well positioned to recover as the U.S. economy comes back, unemployment turns around, and the housing market really stabilizes. Home Depot is trading closer to our fair value estimate and has been showing some pretty good momentum in the last couple of months. Lowe's when we take a step back is trading at more of a discount to our fair value estimate and as we look three years out, that's a company that we see a little bit more upside.

Kobayashi-Solomon: Well, Pete, thanks very much for coming and talking about this with us.

Wahlstrom: Thanks, Erik.

Kobayashi-Solomon: Thank you for joining us. Please stop by the Morningstar OptionInvestor website, where you can learn how to control risks and your investment portfolio and leverage Morningstar's fundamental research to profit in the options market.

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