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Customer Demand Still Strong at Home Depot, Lowe's

Jaime M. Katz, CFA

Jaime Katz: Recent financial reports from Home Depot and Lowe's imply to us that housing fundamentals remain strong. We think this is thanks to multiple factors that include lower interest rates, high housing turnover, improving wealth effect, low unemployment, amongst other economic metrics which bode well for the willingness to spend in the home-improvement category. However, Lowe's second-quarter earnings report this week was relatively weaker than Home Depot's as the company continues to attempt to rightsize its labor structure and staff at stores appropriately, pressuring near-term operating margin potential.

We think there were three factors that weighed on Lowe's share price after its report. First, the company now expects 2017 operating margin expansion of around 20 basis points versus 50 basis points on an as-adjusted basis previously due to those labor changes. Second, a wide gap remains between Lowe's and Home Depot's same-store sales results, with Lowe's trailing Home Depot by about 180 basis points this quarter and averaging more than 200 basis points on deficit over the last four quarters, implying that either merchandising or labor efficiency has failed to support as rapid a sales growth. We don't think that the comps that Lowe's is posting, at 4.5% in the second quarter, is particularly bad for a mature brick-and-mortar business; however, they do look weaker on a relative basis to its larger competitor. Finally, we think consensus expectations were a tad high with both sales and earnings-per-share expected higher than actual results versus our model, which had had both of those numbers below actual results.

The company did maintain its top-line growth outlook for 5% sales growth for the year and 3 1/2% same-store sales, which were in line with our prior outlook. We don't plan to change our long-term forecast for the business, which include same-store sales that temper to a 2% pace, which would lead to low-single-digit revenue growth and very minor operating margin expansion on an annual basis. This gets the company to achieve 12% operating margins over the next decade, still at about 400 basis points below its closest competitor, Home Depot. We don't plan to make any material change to our $93 fair value estimate and view shares as undervalued training at an a 20% discount at this time.