Why This Company Offers Plenty of Upside

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Allow me to shamelessly rewrite a famous quote. It’s usually attributed to Gary Player and basically involves claiming that the more he practiced the luckier he got.  However, when investing in companies I think that it’s often a case of the luckier they get, the more chance they get to practice. In other words it’s a lot easier to increase operational performance when they are blessed with favorable end markets. I would argue that this is the story with Lowe’s (NYSE: LOW), and the stock deserves a closer look.

Same Tune, Different Band

A slew of companies have come out recently and reported some tangible signs of a housing recovery. Let’s be clear on this though: It’s not a return to the glory days of 2006, which ultimately proved unsustainable, but more of a slow, sustained recovery that allows corporations to leverage up profitability from a lower cost base. As such, the house builders have had a great year with stocks that have lots and approvals, like DR Horton (NYSE: DHI), doing very well while others that lack them, like Beazer Homes (NYSE: BZH), have struggled. The key point is to have operational leverage at the right time. All of which leads me back to Lowe’s.

Lowe’s is facing better end markets but, by its own admission, has not been executing well enough to take advantage. This leaves the company in classic value proposition territory. In other words, a value investor might compare its metrics with a key rival like Home Depot (NYSE: HD) and then argue the case that it should be able to play catch-up, particularly if end markets are helping it. I quite like this argument, but I confess as more of a GARP based investor I prefer quality rather than value.  Of course there is no right or wrong way to invest. It’s all about doing what works for you. So how is this thesis playing out for Lowe’s?

Coming off the Lowe’s

Lowe’s pretty much confirmed what Home Depot recently outlined. The consumer remains cautious and is struggling, but housing is making a slow comeback. Moreover, there was broad based strength with 12 of its 14 product categories showing positive comparisons. In concert with Home Depot, it reported that it is seeing some strength now in bigger ticket items and items focused on discretionary spending, like cabinets and appliances.

Another area of strength is in paint, and with Home Depot also reporting good signs here this means that Sherwin-Williams (NYSE: SHW) stockholders should look forward to good numbers from the company. It has large exposure to the US housing and construction marketplace.

All of these things are good signs for the sector, whereas previously much of sales growth was driven by general repair work plus the affects of Katrina last year. As for the ‘practicing’ I referred to earlier, Lowe’s is starting to see some traction with its management initiatives. The idea is to simplify the product range in order to generate operational efficiencies. So far so good, and Lowe’s reported good sales growth in the items that it has subjected to closer management scrutiny.

I don’t think the initiatives are anything more than retail ‘blocking and tackling,’ but that is the good news. It shouldn’t be too hard for experienced retail managers to get things like store layouts, purchasing, in-store promotions and inventory management right. This sort of know-how already exists within the management, and Lowe’s has the opportunity to start to close the gap on Home Depot in terms of operating margins and sales per store etc.

Where Next for Lowe’s?

On current metrics, I don’t think the stock is particularly cheap, but if you believe that they will improve via initiatives and end market growth then there is a strong case to be made for buying the stock. If so, then working capital requirements should not be as high next year, so cash flow conversion is likely to be better and the stock will attract more investors. Lowe's is talking about reducing inventory by up to 10% as a long term aim, and so far only up to 20% of its product categories have been 'reset.' There should be plenty more improvement to come.

The key thing going forward will be successful implementation. As ever, investors will make the comparison with Home Depot (I hold the stock), but no one ever said that you can’t buy both stocks. My preference would be to stick with the stock that offers less execution risk and therefore has more thematic exposure to housing (which means Home Depot); but investors looking for more upside via stock specific risk can just as easily buy Lowe’s.


SaintGermain has a position in Home Depot. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend The Home Depot, Lowe's Companies, and Sherwin-Williams. 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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