This Retailer is Closing the Efficiency Gap
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With housing market metrics being announced seemingly daily that are either dismal or at best stable, it’s easy to overlook how well some of the major home improvement retailers have performed since the S&P 500 index hit its nadir in March of 2009. Since then, Home Depot (NYSE: HD) has seen its share price rise by more than 200%, easily outpacing the S&P 500 and Lowe’s Companies (NYSE: LOW), which have both risen by slightly more than 100%. Sears (NASDAQ: SHLD) has been a laggard in the industry with share price appreciation of only about 75% since March 2009. Given the performance of Home Depot and Lowe's during unprecedented economic turmoil, investors should now be looking for an opportunity to buy these names in a general market retreat.
THE INDUSTRY
The approximately $400 billion, highly fragmented U.S. home improvement retailing industry is made up of the two major players, Home Depot and Lowe’s, and a large number of smaller local and regional businesses. Mid Cap company Sears ($6.5 billion), operates in markets that overlap with the home improvement retailers, mainly in appliances and hardware categories. Home Depot and Lowe’s account for about 16% and 11% of total U.S. retail home improvement sales, respectively. The remaining 73% of industry revenue comes from smaller local and regional businesses, which operate at a competitive disadvantage to the giants in economies of scale. Home Depot & Lowe’s are pursuing different strategies for creating shareholder value even though both plan to deepen market penetration, capture market share, and streamline operations. Sears, for its part, is trying to revive its flagging revenue since its merger with Kmart in 2005 through a broad set of initiatives.
Historically, the much larger Home Depot has chased Lowe’s operational efficiency that stems from Lowe's much more automated regional distribution network. A gradual convergence of operating efficiency is anticipated but based on second quarter 2012 results it seems that Home Depot is rapidly achieving parity in distribution network efficiency.
Home Depot reported better-than-expected selling, general, and administrative expense leverage for the second quarter of 2012. In fact, the company improved its operating margin to 12.5%, the best in five years and 0.5% above its long term target of sustained 12.0% margin. This improvement in operations augers well for when consumer spending and the housing market fully revive and pricing power will allow Home Depot to fundamentally differentiate itself from its primary competitor Lowe’s.
OPERATING EFFICIENCY
Investors buying Home Depot at the recent price of $57 per share are paying a price to earnings to growth (PEG) multiple of only about 1x compared to about 1.3x for Lowe's shares. Analysts are projecting continued revenue declines and net losses at Sears thus the PEG metric is not meaningful to compare against Home Depot and Lowe's. Home Depot is now closing in on Lowe's operational efficiency and may quickly bring its superior economies of scale to bear in capturing excess industry profits and generating intrinsic value. Because Home Depot has narrowed the efficiency gap so quickly, I am skeptical that the 30% premium in Lowe’s PEG will be sustained. A narrowing of the PEG gap by Home Depot tells me to avoid Lowe’s shares and that Home Depot is likely to enjoy share price growth (or at least a smaller price decline) as its multiple expands relative to Lowe’s. For now, Home Depot is the better buy to gain exposure to the reviving U.S. economy and housing market.
The domestic economy is still in a fragile state with European debt problems, the upcoming Presidential Election, and a slowing China all overhanging the market. These and other issues are frustrating the nascent U.S. housing recovery which in turn is constricting the revenue growth of the retailers. However, investors should remember the solid performance of Home Depot and Lowe's shares in the face of economic weakness since 2009 and consider going long these names when a buying opportunity arises from a market correction. More specifically, I prefer Home Depot now as it closes its efficiency gap with Lowe's which in turn should drive PEG valuations closer to parity with Lowe's.
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