Number Two Retailer, Number One Stock

04/16/2009 1:00 pm EST

Focus: STOCKS

Paul Larson

Editor, Morningstar StockInvestor

Paul Larson, editor of Morningstar StockInvestor, and analyst Brady Lemos say the second largest home improvement retailer will be a good investment in coming years.

Although housing market worries will pressure sales, we like Lowe's (NYSE: LOW) long-term prospects and expect the retailer to continue to gain share in the fragmented home-improvement market. We believe Lowe's can leverage its industry-leading customer service, shopper-friendly stores, and proven business model to profitably expand domestically and abroad.

Lowe's is the second-largest home-improvement retailer in the world and operates approximately 1,700 warehouse-format stores throughout the US and Canada. For Lowe's to succeed, it must offer consumers a compelling reason to shop its stores rather than Home Depot's (NYSE: HD), and we think it does. Given that the two firms' pricing and merchandise selection are largely comparable, the key differentiating characteristics become customer service and shopping convenience.

We believe Lowe's has excelled in these areas by keeping stores well staffed and designing intuitive store layouts. Not surprisingly, Lowe's routinely outshines Home Depot in customer-satisfaction studies.

With less than a 10% share of the US home-improvement market, Lowe's still has plenty of room to expand, particularly in the quickly growing installation services segment. Plus, Lowe's stores' superior shopping experience allows them to prosper even in locations where they overlap with other home-improvement retailers.

However, taking share from Home Depot will probably become more difficult, now that Home Depot has sold its HD Supply business in order to focus on improving its retail stores. While HD's renewed focus on retail should lead to increased competition, we're convinced the North American market can support this emerging duopoly.

Due to substantial buying power and efficient store operations, Lowe's consistently earns returns on invested capital well in excess of its cost of capital, and we expect that trend to continue.

Robert Niblock became chief executive officer and chairman in 2005 after his predecessor retired. In 2007, Niblock was given about $6.1 million worth of salary, stock, and option awards, and other incentive compensation. Overall, we believe executive compensation is reasonable, given the company's history of impressive operating results.

We assume that Lowe's, like many retailers, will struggle in 2009 because of the weak domestic housing market and a slowdown in consumer spending.

We anticipate fiscal 2009 sales will decrease in the low-single-digit range year over year, driven by a high-single-digit decline in same-store sales partially offset by revenue from new stores. Despite negative same-store sales, we expect that Lowe's will maintain a healthy gross margin, a testament to its sound merchandising and inventory controls.

However, because operating expenses will increase at a faster pace than sales, 2009's operating margin will probably fall to about 6%. Lowe's operating margin averaged 10% during the past five years. We believe same-store sales will turn positive in 2010, and operating margins will approach 10% by 2012. Increased competition from Home Depot and sales cannibalism from its own store expansion will keep store productivity and margins from reaching historical peaks.

Our fair value estimate is $36. (The stock closed below $20 Wednesday-Editor.)

Subscribe to Morningstar StockInvestor here.

Related Articles on STOCKS