Investor legend Peter Lynch once said, "If you stay half-alert, you can pick the spectacular performers right from your place of business or out of the neighborhood shopping mall, and long before Wall Street discovers them." With that in mind, you may notice home improvement retailers Home Depot (NYSE:HD) and Lowe's (NYSE:LOW) at your local shopping center. Together these two companies dominate the home improvement retailing sector, but which represents the better investment? A case could be made for Home Depot and here's why.
First, Home Depot operates more stores than its rival Lowe's. Home Depot operated 2,263 stores as of the end of last year versus roughly 1,832 for Lowe's. This gives Home Depot a greater ubiquity in the marketplace and also increases its economy of scale allowing the company greater negotiating power in addition lower cost per unit of inventory. According to the Bloomberg Industry Leaderboard Home Depot maintains a leadership position in the North American retail discretionary sector versus a No. 3 spot for Lowe's. This enables Home Depot to keep more money as profit translating into higher margins. Home Depot showed a net profit margin of 6.8% versus 4.3% for Lowe's in 2013.
Higher cash and capital efficiency
Second, in addition to higher margins, efficiencies at Home Depot translated into a higher return on equity for the company with it clocking in at 43% at the end of last year versus 19% for Lowe's. Moreover, Home Depot's cash balance registered at $1.9 billion versus just $576 million in cash and short term investments for Lowe's in 2013. However, it's worth noting here that Lowe's isn't resting on its laurels. Lowe's grew its revenue and free cash flow 5.7% and 21% respectively last year while Home Depot grew its revenue and free cash flow 5.4% and 10.8%. Lowe's also possesses less long-term debt than Home Depot with long-term debt to equity ratios coming in at 85% and 117%, respectively.
Third, Home Depot pays its shareholders $1.88 per share per year and yields 2.4%. Lowe's pays its shareholders $0.72 per share per year and yields only 1.5%. Lowe's dividend to free cash flow ratio stood at 23%, making it slightly more sustainable, versus 35% for Home Depot in 2013. Home Depot did take on $4 billion in debt to help fund a 2013 dividend increase, share repurchases and capital expenditures.
Lowe's does face more room for expansion due to its smaller store base. Lowe's plans to open 15 home improvement stores and five hardware stores in 2014. Home Depot plans to open sevenhome improvement stores this year. However, Home Depot's higher cash balance means greater potential for dividend raises and investment in new stores. Greater ubiquity and cash means Home Depot possesses the superior economic might to withstand another housing downturn and provide shareholders with an income to help them wait out any correction in the company's stock price. The defensive bet here lies with Home Depot.
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William Bias has no position in any stocks mentioned. The Motley Fool recommends Home Depot. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.