Can Lowe’s (LOW) Give Us Clues About Home Depot (HD)?

Lowes Companies (LOW) Sometimes, as traders, we have to work with what we have and that’s not always a bad thing. What we currently “have” as of Monday morning is the knowledge of how Lowe’s Corp. LOW performed in the last quarter, which can help us theorize the likely performance of a close peer, Home Depot HD.

Part of Lowe’s strategy has been to open their stores extremely close to existing Home Depot Stores. Not to mention that both stores are fairly similar in layout and selection (although each has their own unique brands). This has not only made the pair of retailers close rivals, but also similar in their sensitivity to consumer spending in the sector.

Today, Lowe’s reported strong first-quarter results, posting earnings of 34 cents a share, which were higher than consensus estimates of about 30 cents. The home improvement giant noted favorable weather, strong appliance sales, and increased shopper interest in more discretionary items. Lowe’s also gained market share in 11 of 20 product categories, according to Chief Executive Robert Niblock. He said that overall, the company gained 10 basis points of total-store market share during the quarter.

From these results and statements, one would think that LOW should be rallying as a result this morning, but it’s actually the contrary. The stock was down 4% midday and has been down for the past four days including today. The reason for this is most likely that LOW offered less-than-stellar forward-looking earnings estimates. Niblock said “We still view 2010 as a year of transition for our industry, and it will likely be 2011 before we [see] significant growth.”

With current data and earnings estimates (and a price of $25.00 per share), LOW has a trailing price-to-earnings (P/E) ratio of about 20.7 times and a forward P/E ratio of about 14.5. Price-to-earnings is a key ratio that many analysts use to justify the price of a stock.

Home Depot, which reports its results tomorrow, is expected to earn 40 cents per share. Going into the report, HD is trading at 22 times trailing earnings and 15.5 times forward. These figures will change once we have the latest earnings data.

Given the strong results from LOW, one would expect the same from HD, but this is certainly not a given. If you take a look at retail sales and industrial production for April, they were stronger than expected. Sales increased 0.4% in April after a 2.1% gain in March that was also greater than analysts had expected. This would confirm growing strength in consumer spending.

The tricky part with stocks is not only gauging the strength of the underlying company’s report, but how investors will react to that news. HD is down 2% today on the LOW news and it seems like investors are already “baking in” some disappointment in HD’s earnings or forward-looking statements.

HD stock is currently trading at about $34.50 and options traders who want to hedge an existing long stock position can employ strategies that don’t necessarily take a bet on direction, but rather neutralize risk in their underlying stock position at little or no upfront cost.

The collar strategy is the combination of one short call and one long put (for every 100 shares of stock owned). Typically both options used are out-of-the-money so they create a “collar” around the long stock position. Generally, the collar is used by traders who are concerned with a pullback in the stock and believe the stock has a minimal chance of rising above the short call strike.

In HD, the June 35 call/34 put collar can be sold for a two-cent credit, which means the maximum risk (with the stock at $34.50) is 48 cents, even if HD were to drop sharply. This also means that the maximum gain is 52 cents. Breakeven for the strategy is $34.02. For investors who believe that LOW performed better than HD by eroding its market share, the collar may be a strategy to examine. A collar strategy, like other option strategies, can be exited at any time from execution through expiration.

Those who are bullish on HD ahead of earnings may just choose to keep a long stock position or sell at-the-money puts to lower their cost basis and take a short vega position (while also taking a very bullish stance). Remember that the risk to short puts is that they obligate you to purchase 100 shares of stock at the strike price of every put you sell.

Whatever strategy you choose, always manage your risk accordingly.

Photo Credit: doortoriver

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