Will Home Depot and Lowe’s Continue to Heat Up?

The recovery of the housing market has also contributed to the higher revenues of home-improvement companies such as Home Depot (NYSE: HD  ) and Lowe's (NYSE: LOW  ) . Which of these two companies has benefited more from the housing market's rally? Looking forward, will these companies continue to grow at their current levels? Let's examine these issues in greater detail.  

Home-improvement sales continue to rise
Let's start by examining how the home-improvement market performed in the past 10 months. This will give us a benchmark to compare these two companies' performances.  

According to the latest retail-sales report, in the first 10 months of 2013 furniture and home-furniture-stores sales rose by 4.1% compared to first 10 months of last year; sales of building material and garden equipment and supplies dealers increased at a higher rate of 6.6%. Total retail sales rose by 4.2% during this time frame.

Based on the above, home-improvement and renovation sales have risen by a slightly faster pace than the entire retail market. How have Home Depot and Lowe's done so far? In the past three quarters, Home Depot's sales increased by 8.2%. In comparison, Lowe's sales grew by only 5.8%. This means Home Depot has done better than its leading competitor and the market average. 

Let's break down these companies' sales to their average store to get a better understanding of the driving forces behind the rise in sales. 

Sales per store
Home Depot increased its revenue by 7.4% in the third quarter. Most of the growth came from higher sales per average store. The company opened only 10 stores in the past year.

Therefore, the rise in number of stores had a very moderate effect on the increase in revenue: Home Depot's sales per store rose by 6.9%. In terms of profits, the company's operating profit grew by 32.3%, while its average store's profit increased by a similar rate of 31.7% during the third quarter. The table below summarizes this data. 

Source: Home Depot's website

Let's examine how Lowe's has done.

Lowe's sales have increased by a similar rate to Home Depot's. Nonetheless, nearly one-third of this growth is due to an increase in the number of stores. During the past year, Lowe's opened 81 stores. The company's growth in sales per store was only 4.6%. This means Lowe's average store's sales grew at a slower pace than Home Depot's average store. 

In the table below is the data related to Lowe's.

Source: Lowe's website

Home Depot isn't only leading the way in growth per store. The company's profitability continues to be higher than Lowe's. The chart below shows the developments in the profit margins of both companies in the past several quarters. 

Home Depot's higher profit margin has also reflected in its slightly higher dividend yield.

Looking forward, will these companies continue to benefit from steady growth in sales? One factor that will determine this is the direction of the housing market.

Housing market is cooling down
The housing market continues to recover but at a slower pace: According to the U.S. Census Bureau, the number of new home sales reached 421,000 in August -- a 7.9% rise compared to last year. A year earlier, the growth rate was 12.6%. Further, the Federal Reserve is likely to taper its current asset-purchase program in the near future, which will pressure mortgage rates higher. This turn of events is likely to cool down the housing market.

These factors are likely to catch up with the growth in the housing market and impede the rise in both Lowe's and Home Depot's sales. Besides growth in sales, market valuation is another factor that investors should consider.  

Valuation
To determine these companies' valuation, I will use enterprise value and the EV-to-EBITDA (earnings before interest, taxes, depreciation and amortization) ratio in order to compare Home Depot and Lowe's valuation with the industry average. 

The table below presents the summary of data of both companies and the average household-products market. 

Source: Google Finance Damodaran's website, and wikinvest

This calculation accounts for Lowe's and Home Depot's different financial structure including their debt and cash. The yearly EBIT is based on the last four quarters (ending in the third quarter of 2013).

As you can see, Home Depot's EV-to-EBIT ratio is higher than Lowe's and the industry average. Further, Lowe's current valuation is slightly lower than the industry average. Therefore, the higher growth rate and profitability is already reflected in Home Depot's valuation. 

The Foolish bottom line
Lowe's has some strong points but comes in second after Home Depot. Home Depot is a great company with higher organic growth in sales and a wider profit margin despite its slightly high valuation. Finally, the potential slowdown in the housing market could eventually be reflected in the home-improvement market and curb the growth in sales of Home Depot and Lowe's.

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