This Number Two Tries Harder

05/19/2008 12:00 am EST

Focus: STOCKS

Paul Larson

Editor, Morningstar StockInvestor

Paul Larson, editor of Morningstar StockInvestor, says that Lowe's, the runner-up in home improvement, should get through the current economic slowdown nicely.

While housing market worries could pressure sales over the next few quarters, we like Lowe's Companies (NYSE: LOW) long-term prospects and expect continued share gains 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 Companies is the second-largest home-improvement retailer in the world and operates approximately 1,500 warehouse-format stores throughout the US The company's stores offer products and services for home decorating, maintenance, repair, and remodeling. Lowe's targets retail customers [and] commercial business clients.

For Lowe's to succeed, it must offer consumers a compelling reason to shop its stores rather than Home Depot's (NYSE: HD)-the primary competitor in virtually every market-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, among other customer-focused initiatives. Not surprisingly, Lowe's routinely outshines Home Depot in customer satisfaction studies.

We're also encouraged that Lowe's is sticking to its core retail strategy of aggressively opening new stores in the US and Canada, as well as Mexico beginning in 2009. (In 2008, we expect Lowe's to open about 150 stores in the US and Canada.) With less than 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.

While Home Depot's renewed focus on retail should lead to increased competition, we're convinced the North American market can support this emerging duopoly. Despite its runner-up position to Home Depot, Lowe's can capitalize on its scale advantages. Thanks 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, who previously served as president of Lowe's, became chief executive officer and chairman in 2005 after his predecessor retired. While senior managers are relatively young (no one on the executive team is older than 60), they do average several years of experience with the company.

We assume the US housing market remains soft during the next few quarters and that same-store sales decline slightly in 2008. We estimate that same-store sales growth will improve slightly during the next five years as the housing market rebounds. Weak same-store sales growth should reduce operating margins this year.

During the following five years, we expect modest operating margin improvement as the housing market rebounds and fixed costs, such as salary and rent, are leveraged over a growing revenue base.  We think Lowe's is worth $39. (The stock closed below $25 Friday-Editor).

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