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The Upper Hand in Home Improvement

Erik Kobayashi-Solomon

Erik Kobayashi-Solomon: Hi, I'm Erik Kobayashi-Solomon, one of the co-editors of Morningstar OptionInvestor, and today it's my great pleasure to welcome Kim Picciola, who's a senior equity analyst in charge of retail companies here at Morningstar. Kim, thanks for coming.

Kim Picciola: Thanks for having me, Erik.

Kobayashi-Solomon: You know, a couple of weeks ago I wrote up this strategy about how to play Lowe's using options, and I just want to get a little more color about that. One thing that I worry about, every time I walk into one of these do-it-yourself retailers lately, everybody's standing around waiting to help me; two years ago I couldn't get anybody to take any time with me. So, business right now is slow. How much is this bullish position kind of a bet that the housing market will return? Are we betting on a return to the good old days, in other words?

Picciola: No. It's really not a bet on the housing market or a return to the good old days. It's really a bet on the macro economy picking back up and consumers spending on more discretionary items such as the home, really coming back online. Home Depot and Lowe's, both home improvement retailers, really struggled, not only because of the housing market decline but also as the macro environment really hit consumers wallets, and they really had to pull back in terms of their discretionary spending.

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Kobayashi-Solomon: So as the employment situation gets better, maybe people will start thinking: "You know, it's time to redo that kitchen" or something like that.

Picciola: We do. We think the employment situation... we think that's a big key here. We hear that over 40 percent of consumers are waiting, are delaying a project for their home. You know, as they're looking for a more stable environment in which to spend those kind of discretionary dollars. So, the bet on Lowe's...

Kobayashi-Solomon: That could be a real bounce back then, I guess, right?

Picciola: There could be a bounce back. I mean, we've seen several years of declining comps here, so there is a possible potential of a bounce back, but we do think it's going to be more of a mild recovery coming from the consumer, so we're not projecting a bounce back, per se. We're expecting low to mid-single digit growth, longer term, as consumers start to spend more freely on their homes.

Kobayashi-Solomon: Gotcha. Now, another thing that I'm wondering about: So when we're talking about Lowe's, you can't help but think about Home Depot. They're two very similar firms, and I know that Home Depot right now is undergoing some internal organizational changes, operational changes. If Home Depot really gets their act together, is this going to put pressure on Lowe's or is there enough room for both of these two giants in the retail space?

Picciola: We think there's enough room. The home improvement market is very highly fragmented still, to this day. We think there's plenty of room for them to kind of coexist as a duopoly, if you will. You know, Lowe's is definitely the better operator. They really flew under Home Depot's radar and built out their store base in recent years, and now they're catching up to Home Depot in terms of store count and their size.

Home Depot really wasn't paying attention to their internal infrastructure as they were benefiting from a nice economy and the housing market boom. Now as the market has deteriorated, they've really had to look under the hood and try to fix some of the core issues that they're having internally.

Kobayashi-Solomon: Kind of work on efficiency and all of that stuff.

Picciola: Work on efficiency... They're implementing distribution centers, where they're going to be shipping goods now through a distribution center, doing less shipping directly to the store. So, really trying to build out some infrastructure that was lacking, that Home Depot has already in place and that really...

Kobayashi-Solomon: Home Depot or Lowe's already has in place?

Picciola: I'm sorry, Lowe's already has in place and that has really given them an advantage, in terms of their efficiencies and operations. Now Home Depot, I think, is kind of trying to play catch-up to Lowe's.

Kobayashi-Solomon: OK. So this leads me to my next question which is...  these two companies are basically kind of macro bets on the same thing. You could look at it, they've got the same macro drivers, right?

Picciola: Right.

Kobayashi-Solomon: To me, Lowe's seems like a little bit of a safer bet, a little higher batting average bet, than Home Depot, because it's not dependent on turning these internal operations around, as it kind of partially is, in Home Depot's case. What's your take on this? Which is the, let's say, the safer bet? Which is the bet that you think may perform better?

Picciola: We do think Lowe's is the better operator of the two. They have the infrastructure in place. They have the scale that they're able to leverage to purchase things at a low cost and then pass those savings on to the consumer. We also think Lowe's has opportunity to grow. Their store base isn't quite up to what Home Depot's is today, and we think there are markets where Lowe's has the opportunity to enter and continue to grow their store base.

That being said, even if Lowe's does continue to grow, we do think that the two can act rationally and coexist as it's still a very fragmented market. Today I think they both have less then 10 percent of share of the home improvement retail market.

Kobayashi-Solomon: So they both understand, there's no real benefit to going after each other's throats, right?

Picciola: Right. We do think that they can coexist. There might be a slight difference in the mix, in terms of products. I think Home Depot has more of a tendency to focus on the commercial side, where Lowe's is probably a little better at...

Kobayashi-Solomon: Higher end, homeowner, kind of things, right?

Picciola: Exactly, so appliances and those types of goods. So, we do think there's a slight differentiation between the two, but we do think Lowe's is the best operator in the space right now and as soon as consumers start spending more freely...

Kobayashi-Solomon: They'll start spending at Lowe's.

Picciola: That's what we think. We think 2010... we're already starting to see consumers spend in this category, in the home category. Not necessarily in home improvement but more on the softer side with Bed Bath & Beyond, Williams-Sonoma... So we are seeing some positive trends there. We think Lowe's and Home Depot, they're both positioned to benefit from that, as the consumer spending environment improves.

Kobayashi-Solomon: Fascinating. Kim, thanks a lot for coming. I sure appreciate you being here.

Picciola: Thank you for having me.

Kobayashi-Solomon: And thank you for joining us. Please stop by the OptionInvestor website, where you can help build your portfolio with other terrific option ideas like Lowe's.