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Home Depot and Lowe's: Renovation under way

The leading home-improvement chains are poised to recover from the effects of the weak housing market.

By Michael Sivy, Money Magazine editor-at-large

NEW YORK (Money) -- I recommended both Home Depot and Lowe's Companies in the January issue of Money magazine. Since then, both do-it-yourself retailers have reported earnings declines, and analysts expect results for the current year to be up only slightly - or even down.

It may seem somewhat surprising, then, that the prices of both stocks have risen more than 8 percent since I wrote about them.

The explanation is that the worst appears to be over for the home-improvement retailers, even though both companies need some serious renovations. And although it's impossible to know how quickly they will rebound, both stocks continue to look like long-term values.

Lowe's (Charts), the second-largest home-improvement chain, is in better shape than Home Depot (Charts), the category leader. And it will be easier for Lowe's to get back to double-digit earnings growth.

But in my January column, I concluded that Home Depot was more deeply depressed - and the greater value. That still seems to be the case.

Both companies are on fiscal years that ended in early 2007. For the most recent quarter, Lowe's reported a 7 percent decline in earnings per share. That result was better than analysts expected. By contrast, Home Depot's earnings per share plummeted 23 percent.

More significant, Lowe's sales at comparable stores were flat for the year, while Home Depot's were down 2.8 percent. And Lowe's increased its square-footage by 12 percent over the year, while Home Depot's retail space grew by only 4.2 percent.

Not only is Lowe's doing better in the short run, but Home Depot also faces considerably more complicated problems. Home Depot CEO Robert Nardelli left in January. And his successor Frank Blake is just starting to grapple with the company's strategic issues.

During the turmoil toward the end of Nardelli's tenure, Home Depot's popularity declined among retail customers and investors. And Home Depot has been losing market share to Lowe's, a trend Blake hopes to reverse as quickly as possible.

In addition, Nardelli tried to maintain Home Depot's growth by acquiring wholesale companies that sell to contractors rather than to individual do-it-yourselfers. That business was growing rapidly but has now been hit hard by weakness in the housing market.

Blake will have to decide whether to hang on to the wholesale division, sell or spin it off fairly quickly, or wait to get rid of it until the housing sector is booming again.

But these complex problems all create the potential for a bigger ultimate rebound. A recovery in market share and sales growth at Home Depot's existing stores would give earnings a boost. And successful disposal of the wholesale division could liberate unrecognized value.

What's more, Home Depot has repurchased 19 percent of its outstanding shares since 2002. That creates great leverage for gains in earnings per share once business finally improves. The company has also increased its dividends rapidly. The stock now yields 2.2 percent, compared with 0.6 percent for Lowe's.

Finally, there is valuation. While Lowe's trades at nearly 17 times estimated earnings for the fiscal year that has just begun, Home Depot's P/E is less than 15. As a general rule, the cheaper stock with the greater potential earnings swing gets the bigger bounce.

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.