Why One Analyst Would Prefer To Build A Position In Lowe's Rather Than Home Depot

The do-it-yourself home improvement sector has benefited from the multiyear improvement in the housing sector. But the key question moving forward is which is the better holding: Dow component Home Depot Inc HD or its smaller rival Lowe's Companies, Inc. LOW?

The Analyst

KeyBanc Capital Markets' Bradley Thomas. 

The Rating

Thomas initiated coverage of Home Depot with a Sector Weight rating with no assigned price target.

Thomas also initiated coverage of Lowe's stock with an Overweight rating and a $98 price target. (See Thomas' track record here.)

The Case For Lowe's

Lowe's may have disappointed investors in its first- and second-quarter earnings reports due to poor execution, but its competitive positioning has since improved and should exceed the Street's estimates moving forward, Thomas said. Looking forward, the home improvement market should continue growing at a mid-single digit to a high-single digit rate, and Lowe's boasts a large enough scale to make any necessary investments for future growth, he said. 

While both Lowe's and Home Depot have similar cost structures, Home Depot's higher sales productivity gives it an edge in operating margin, Thomas said. But Lowe's lower operating margin and improved competitive positioning gives it greater financial leverage versus Home Depot for each 10 basis points of margin expansion, the analyst said. 

Lowe's stock is trading at a discount versus its five-, 10-, 15- and 20-year average forward valuation, which implies upside can be seen moving forward, Thomas said. It's trading at a 23-percent discount to Home Depot ,which happens to be the widest valuation gap seen over the past 15 years.

Home Depot Already A Rich Stock

Home Depot is not only the market leader in the home improvement sector, but a best-in-class retailer that offers investors consistent execution, healthy growth and strong financial returns, Thomas said. The company is expected to continue reporting strong same-store sales and ROIC gains, according to KeyBanc —  impressive given its already large size.

Home Depot's stock may already be rich with limited upside potential over the next six to 12 months, Thomas said. The stock is trading at a forward P/E basis of 20x, near the high end of the 15-year range of 10-22x. The stock is also above its 15-year average of 17x which may be justified given its market-leading position, but investors may want to wait for a lower valuation to become aggressive on the stock, Thomas said. 

Price Action

Shares of Lowe's are higher by more than 8 percent since the start of 2017, up by 16 percent over the past year and 133 percent over the past five years. Shares of Home Depot are higher by more than 22 percent since the start of 2017, up by 35 percent over the past year and 165 percent over the past five years.

Related Links:

Lowe's Earnings Report Shows It's No Home Depot

Which Is A Better Investment For Home Improvement Sector: Home Depot Or Lowe's?