More Upside to Come with this Housing Play

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Lowe’s Companies (NYSE: LOW) gave numbers on a bad day for the market and the subsequent fall in the share price means investors could be forgiven that for thinking that there was something wrong with them. Then again, that just shows that you should never take the market’s word for it! I thought the results were good and although I also hold Home Depot (NYSE: HD) I bought some Lowe’s too. No one said you can't buy both!

Lowe’s has upside

They may appear to be identical twins but I think Lowe’s has a bit more upside. Analysts are forever trying to make quarter on quarter conclusions over whether Home Depot or Lowe's is taking market share from each other but I don’t think analyzing their relative prospects is as simple as that. In this case, Lowe's has had a lot more execution difficulties than Home Depot following the housing market slump. The good news is that it now has upside from executing its strategy of making product line reviews and resets. In other words, it can play catch up with Home Depot by simply undergoing blocking and tackling measures in its stores.

Of course these things are much easier to do when the housing market is showing signs of strength and Lowe’s recent results reflect this. Ten of its fourteen categories showed growth in the quarter with strength in the larger ticket and more discretionary items like lumber, cabinets, and countertops. The relative weakness in its outdoor and garden sales is only to be expected after the unseasonally warm winter last year made for tough comparables.

Sandy did its bit too and overall comparable same store sales did well, rising 1.9% in the quarter.

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 What the market worried about

One issue that concerned the market was the promotional activity that saw some pricing cuts. However, the promotions were targeted at specific items and are part of the program of product line reviews and resets. Lowe's is trying to normailze inventory levels across all its lines. In addition, Lowe's usually has promotions in the fourth quarter, so it’s nothing unusual. The difference this year was actually on the positive side, with the promotions being described as much more balanced than in recent years.

Lowe's has completed 80% of its product reviews and 30% of the resets and its management feels confident that when the other 70% are completed by the end of 2013, gross margins will rise as a consequence. Indeed, it achieved mid-single digit growth in the categories that have already been reset with a 100 basis point improvement in margins. The strategy is working.

I was expecting Home Depot to give a good set of results and it didn’t let the market down. Home Depot confirmed that there was broad based strength in spending across its product categories and geographically the worst affected areas of the property recession are now making sequential improvements. We can see this broad-based strength in the results of home goods companies like Whirlpool (NYSE: WHR) and Masco. Whirpool is doing well in the US (although its international prospects appear less certain) and it has late cycle prospects because new home starts (which should kick in this year) will generate new business when they are sold and inhabited later in the year.  It is a similar story with Masco, which reported North American sales up 12% and its businesses selling into new home construction were up 25%. Both stocks remain good plays on housing.

Guidance

Putting these issues together, Lowe's forecasts total sales growth of 4%, with comparable same store sales growth of 3.5% with 3% of the latter coming from internal sources. If you assume that there is a better than expected housing recovery to come, than there could be upside to company guidance.

Analysts have Lowe's on $2.09 EPS for 2013, which implies a near 24% rise in earnings to put it on a forward PE of around 17.7. In addition, it is starting to generate significant cash flows with $2.5 billion in free cash flow generated this year and $3 billion estimated for 2013. This equates to around 6.2% of its current enterprise value and if you share my belief that housing ups and downs tend to be multi-year events, then the stock still looks attractively priced given the outlook.


SaintGermain has positions in Lowe's Companies and Home Depot. The Motley Fool recommends Home Depot and Lowe's. 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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