This 1 Number Explains Why Lowe's Is in Second Place

This 1 Number Explains Why Lowe's Is in Second Place

Just a few years ago, both Lowe's and Home Depot were struggling with a weak housing market. It wasn't unusual for each company to report negative same-store sales, and some articles even suggested that the traditional housing market had changed. Others still suggested that the American dream of owning a home was dead.

Just a few years later, Lowe's and Home Depot are benefiting from housing's recovery. Unfortunately, Lowe's needs to improve one number if it hopes to take the crown from Home Depot.

Strong results
If Lowe's were the only company in the home-improvement industry, this quarter's results would be impressive. However, Lowe's not only must compete with Home Depot but also with traditional retailers like Wal-Mart Stores .

Home Depot seems to be at the top of the housing food chain with its focus on professional customers and knowledgeable sales staff to help the casual home-improvement customer. Lowe's seems to be content to focus on the retail customer while Wal-Mart offers roughly twice the stores of Lowe's or Home Depot and has expanded its home-improvement section as well.

If we look at Lowe's revenue growth in the current quarter, the numbers look impressive. With revenue growth of slightly more than 7%, Lowe's matched Home Depot's revenue growth. Wal-Mart is focused heavily on the grocery business, and this slower-growing industry contributed to the company's revenue growth of just 2.4%.

In the same way, Lowe's same-store-sales growth of slightly more than 6% was very close to Home Depot's 7%-plus growth. In similar fashion to each company's revenue growth, Wal-Mart's domestic same-store sales growth lagged Lowe's and Home Depot's severely. As you can see, Lowe's investors have a lot to be excited about.

Strong tailwinds support this growth story
One of the inescapable truths of Lowe's and Home Depot is that their fortunes are tied to the homebuilding industry. Whether it's new homes being built and furnished or existing homes being upgraded and updated, each company benefits from a stronger housing market. Wal-Mart also benefits from an improved housing market but to a lesser extent, as its sales are more diversified.

The good news for all three companies is that multiple homebuilders are reporting strong backlog growth. For instance, Toll Brothers and Lennar both reported backlog unit growth of more than 30%. In addition, Toll Brothers, Lennar, PulteGroup, and KB Home all reported strong pricing gains. With this tailwind supporting the recovery of Lowe's and Home Depot, each company should continue to report strong growth.

The one problem
While Lowe's and Home Depot reported relatively similar revenue and same-store sales growth, their expense management is one key difference. Wal-Mart might report lower revenue growth, but the company is relatively more efficient.

If you look at each company's spending on selling, general, and administrative expenses, you can clearly see where Lowe's can improve. Wal-Mart's huge size and efficient use of resources allowed the company to report SG&A expenses as a percent of revenue of slightly more than 19%. While Home Depot reported its SG&A expenses used 21% of revenue, Lowe's reported SG&A expenses of more than 24%.

Though a few percentage points of SG&A expenses might not seem like a big deal, keep in mind each of these companies reports billions of dollars in sales. If you want to see what a difference a few percentage points of SG&A expense makes to the bottom line, consider the difference in cash flow generated by Lowe's relative to its competition.

The bottom line is, this affects the bottom line
In the last nine months, Home Depot generated $0.08 of core free cash flow (net income + depreciation - capital expenditures) per dollar of revenue. By comparison, Lowe's reported $0.06 of core free cash flow from each dollar of revenue. Wal-Mart's slower revenue growth and focus on the grocery business caused the company to generate just $0.03 of core free cash flow per dollar of revenue.

As you can see, while Lowe's yield of 1.5% looks similar to Home Depot's yield of around 2%, and is less than the 2.5% yield of Wal-Mart, there are differences below the surface. Wal-Mart is expected to grow earnings by around 9% annually in the next few years, compared to earnings growth of around 18% for both Lowe's and Home Depot.

However, if Lowe's continues to carry a higher and higher SG&A expense, the company's free cash flow generation will likely continue to lag Home Depot's. Since both stocks sell for nearly the same forward P/E ratio, it's hard to recommend Lowe's while Home Depot is available to purchase. The company has been improving, but until its SG&A expense percentage drops, Lowe's will continue to finish in second place.

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