Number One in its Market for Good Reason

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In some industries there are leaders and followers and the separation between the two is huge. However, in the home-improvement industry, Lowe's (NYSE: LOW) and Home Depot (NYSE: HD) have been battling it out with each company showing strength. However, as the economy improves, it is very likely one of these companies will turn in better results, and at this point the unquestioned leader has to be Home Depot.

Since both companies report earnings around the same time, investors get a chance to compare the results side-by-side. This is not a two horse race however, as both Wal-Mart (NYSE: WMT) and (NASDAQ: AMZN) have their sights set on this all important market. Wal-Mart has expanded its home-improvement section to cater to the weekend warrior. Given that Wal-Mart is visited more frequently, this presents a challenge to the category leaders. In addition, seems to want to be everything to everyone, and with a huge home-improvement selection, and extremely fast delivery times, the company seems poised to disrupt this market as it has so many others.

However, contractors are conditioned to go to either Home Depot or Lowe's for their needs, because they need supplies immediately. Amazon may offer fast deliveries, but it's hard to tell a contractor to wait even one day for a tool that he or she needs now. This is a key difference in the home improvement market, that helps insulate the industry from online competition. Based on Home Depot and Lowe's recent results, we can see that each company is performing well, but Home Depot's results look better across the board.

If overall sales were the determining factor in which company was a better buy, Home Depot's overall sales increase of 4.6% looks much better than Lowe's increase of 1.9%. In addition, the all-important measure of comparable sales is also a win for Home Depot. In the last three months, comparable sales at Home Depot increased 4.2% versus a 1.8% increase at Lowe's. Each company saw significant increases in their earnings-per-share, but this was primarily due to cost-cutting and share repurchases over the last year. Both companies have been aggressive in their share buybacks, with Home Depot retiring over 3% of diluted shares, and Lowe's retiring almost 10% of their diluted shares. While it might seem that Lowe's more aggressive share repurchase program would favor investing in the company, there are at least two other measures where Home Depot is beating its rival.

If you compare each company's operating cash flow, Home Depot managed to increase its adjusted operating cash flow by over 9% on a year-over-year basis. By comparison, Lowe's adjusted operating cash flow increased by 6.2% compared to last year. While Lowe's repurchased more shares, this came largely at the expense of the company's balance sheet. In fact, Lowe's added almost 28% more long-term debt over last year, with this figure jumping from $7 billion to over $9 billion today. Home Depot on the other hand, has seen its cash and long-term debt essentially stay the same. This indicates that Lowe's financed its massive share repurchases, while Home Depot used free cash flow. Though it's true that Lowe's higher amount of retired shares should benefit the company in the future, the additional interest cost of carrying more than $2 billion of additional debt makes the company a riskier bet. The good news for investors in both companies is, the home improvement business comes with high margins relative to standard retail.

Since both Home Depot and Lowe's primarily sell home-improvement goods, they don't have the drag of lower margin businesses like food or electronics. This is why both Wal-Mart and Amazon carry gross margins of roughly 25%, versus Home Depot and Lowe's report gross margins of over 34%. In addition, each of these companies report better relative free cash flow due to their higher-margin business. In the current quarter, Home Depot generated about $0.04 of free cash flow per dollar of sales, and Lowe's generated about $0.03 of free cash flow using this same measure. By comparison, Wal-Mart and Amazon generated just over $0.01 of free cash flow per one dollar of sales in their current quarters. Home Depot and Lowe's also have analysts support over the next few years as well due to an improving housing market.

In the next five years, analysts expect Home Depot to grow earnings by over 16%, and Lowe's should grow earnings by about 15.5%. While this sounds extremely similar, there are three factors that favor Home Depot. First, though both companies have similar PEG ratios, Home Depot's higher growth rate should bring their ratio down slightly quicker than Lowe's. Second, Home Depot's yield is just slightly higher at about 1.87% versus 1.8% at Lowe's. In addition, Home Depot's free cash flow payout ratio is significantly lower, at about 34% compared to 47.5% at Lowe's. Last but not least, Home Depot generates more free cash flow per dollar of sales. This means their faster growth and lower payout ratio should allow the company to increase their dividend at a faster pace than their competition. As you can see, whether its sales growth, comparable sales growth, dividend yield, or future growth, Home Depot leads its industry and for good reason.

MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of Motley Fool newsletter services recommend, The Home Depot, and Lowe's Companies. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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