Home Depot, Lowe's Both "Holds"
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Home Depot (NYSE: HD) and Lowe's (NYSE: LOW) used to be distinctly undervalued stocks until the market finally caught on and sent shares flying by 50% or more over the last 12 months. At current levels, both look expensive and worthy of no more than a "hold." Although top management leads both companies, the housing market is still unstable and will put downward pressure on improvement retailers. Below, I review the fundamentals of each stock.
Home Depot
Home Depot trades at a respective 20.5x and 17x past and forward earnings with a dividend yield of 2% and a beta that is 20% less than the broader market. EPS has been more or less consistently on the upwards trend as earnings have moderately beaten expectations over the last five quarters. This, by itself, cannot justify the tremendous surge in shareholder value.
Moreover, the PE multiple is now well above its historical 5-year 16.8x average. FCF growth has been tremendous - going from $4.6 billion for the TTM ending 2Q11 to $5.2 billion for 2Q12 - but this was no surprise. What has been surprising is the amount shareholder value has increased. Valuation is at 16.6x 2Q12 FCF (ttm), which is overly high given market uncertainty.
Analysts forecast 13.5% annual EPS growth over the next five years. Assuming they are accurate, 2016 EPS would come out to $5.06, which, at a 15x multiple, translates to a future stock price of nearly $76. Discounting backwards by 10% yields a present value of $47.79, which means that 17% of the current market assessment is overly optimistic.
Lowe's
When it comes to fundamentals, Lowe's is in a worse position than Home Depot. Investors appear to have nevertheless recognized this weakness, since Lowe's has underperformed Home Depot by 2,841 bps over the last 12 months. While I recommend staying away from the stock for its woes in competition, there is a case to be made that multiples could start to expand as growth trends towards, let alone exceeds, Home Depot's.
In fact, the forward PE multiple of 13.9x isn't incredibly bad. But the firm has still lost share against its bigger competitor. During the second quarter, the top line declined 2% y-o-y as domestic same store sales fell 0.2%. Although unusually warm weather cut into sales for both Home Depot and Lowe's, the negative impact was particularly pronounced at Lowe's. The latter, after all, continues to lose in the improving, but uncertain, home improvement market.
Free cash flow trends have also been shaky. FCF for the TTM ending 2Q12 was $2.3 billion versus $2.9 billion in 2Q11 and $1.7 billion in 2Q10. In context with the share losses explained above, this factor warrants holding out until visibility improves.
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