Where Is the Best Value in a Strong Home-Improvement Industry?

Home Depot (NYSE: HD  ) and Lowe's (NYSE: LOW  ) both had very strong third-quarter reports, adding to an impressive year-and-a-half. Both companies have benefited hugely from the growth and reemergence of the housing industry. However, are either Home Depot or Lowe's the best value within the home-improvement space? Or, is a smaller peer such as Restoration Hardware (NYSE: RH  ) leading the pack?

Quarter(s) at a glance
There's absolutely zero debate: Home Depot's fiscal fourth-quarter earnings report was incredible! After its report, Home Depot traded higher by more than 1%; Lowe's traded lower by more than 5%. Nonetheless, when compared to other retail industries, both companies had a great showing.

Both Home Depot and Lowe's saw total revenue growth of more than 7%, but what really separated Home Depot from Lowe's with investors was comparable-store sales. Lowe's saw its comparable-store sales rise 6.2% in the quarter, which is very strong, but Home Depot announced an unprecedented 10% rise.

With that said, there's one thing you should keep in mind, and that is we're not talking about small retailers that can expand rapidly to drive growth; these are massive retailers among the top tier within the U.S.

Thus, consider the fact that Wal-Mart saw its comparable sales decline 0.3% in its most recent quarter, or that Macy's 3.5% growth forced shares to trade higher by nearly 10%. Given these comparisons, you can really grasp how strong of a performance we're seeing in the home-improvement industry.

Which is better?
If you're considering an investment in either Lowe's or Home Depot, it's really hard to go wrong. Home Depot is growing slightly faster by driving growth at existing stores. Yet, Lowe's is guiding for total revenue growth of 9% in 2013. Therefore, we are discussing a marginal difference in regards to total growth between these two companies.

Hence, to determine the best opportunity, we're best served by comparing valuation metrics.

 

Home Depot

Lowe's

Market Cap

$114.5 billion

$50.2 billion

Price/Sales

1.5

0.9

Price/Operating Cash-Flow

15.5

11.6

Forward P/E Ratio

18.3

18

Operating Margin

11.2%

7.7%

After looking at key metrics of valuation, Lowe's is clearly the cheapest. Sure, Home Depot has a higher margin but with the two companies operating in the same industry, it seems reasonable that Lowe's has the most room to improve.

Considering Lowe's discount to both sales and operating cash flow, I think it is presenting the most upside and value.

Is there an even better value?
Remember, this is a very strong industry compared to other retail segments, and there are several reasons to be bullish on either of these two companies. Yet, when you consider valuation and upside potential, Lowe's does look to be slightly better for value investors. However, Restoration Hardware might have significantly more upside and value.

First off, Restoration Hardware is in the same industry but has a different kind of business, with remodeling services for the high-end or wealthy. Restoration Hardware is a company growing at 30% annually, and what's impressive is that all of that growth comes from existing stores!

Restoration Hardware has not expanded its number of stores since prior to becoming a public company late last year. It grows the old fashioned way, via catalog. The company simply adds a new line of remodeling products, such as kitchen, patio, or nursery, and its high-end consumers flock while attracting new consumers.

In many ways, Restoration Hardware has become the latest fashion trend, but one that is finally set to expand. According to the company, it is currently exploring 20 markets for expansion, meaning that growth will continue, or possibly accelerate.

Final thoughts
With a trendy crowd and fewer than 100 stores, it'd be foolish to believe that growth can not continue at a rapid rate. While Home Depot and Lowe's are great companies, both are at the mercy of low interest rates and the public's willingness to build new houses and remodel existing homes. As we've seen with Kors and even Apple, high-end products typically perform well regardless of the broader market.

Hence, at two times sales, Restoration Hardware is twice as expensive as Lowe's, and trades at 33 times next year's earnings -- also twice as expensive. However, Restoration is growing three times faster, making it worth the premium, and has a significant amount of room to expand. This fact makes Restoration the best value in a very strong home-improvement space.

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