When long-term investors research a business, that research should (among other things) teach them as much as it can about the competitive landscape and industry in which the business operates. In other words, rigorous research on one company means also studying the competitors and the drivers of value for the industry as a whole. That’s why I've been grouping my earnings reports together this quarter.

You might remember earnings stories I filed earlier this month along these same lines. First, I reported on three mega-cap tech stocks (and honestly I wanted to include a fourth but that just made an already long article even longer). Then I put out a combined report on three IT services firms.

Today, I’m taking a look at the two largest home improvement retailers in the world. To best understand one, you should really follow and understand them both. Both companies serve a crucial economic need and are exceptionally well-run, profitable growers with wide moats. Home Depot (HD 0.67%) is the largest of the two and also, in my opinion, one of the best companies in the world. But Lowe's (LOW 0.47%) is another one of my favorites. It has structurally lower margins and returns on invested capital (ROIC) than Home Depot, but I still think it’s a great business and a great stock.

Read on to find out why two earnings reports can be better than one.

A man wearing gloves, a hoodie, and an apron lifts a piece of lumber off a stack of boards in a warehouse full of cut lumber supplies

Image source: Getty Images.

Home Depot fiscal 2021 Q2 earnings

Home Depot's second-quarter 2021 earnings were strong. Its sales increased 8.1% year over year and earnings per share increased 12.7%. Management says it is confident that the company is taking market share and that its growth will continue to outpace the home improvement industry.

Gross margin decreased largely because of higher lumber and transportation costs, but operating margin increased slightly because of lower pandemic-related employee expenses compared to the same quarter last year. The company's ROIC surged to nearly 45% using Home Depot's calculation or to 38% according to New Constructs. Whichever ROIC number you consider more accurate, the important thing is that Home Depot's ROIC is very high and rising.

According to New Constructs, Home Depot's ROIC has increased for five consecutive years and its five-year average ROIC is 31%. Its rise is driven by pretty steady net operating profit after tax, or NOPAT, margins in the 11% to 11.5% range and five years of consistent increase in invested capital turnover. That suggests Home Depot is consistently improving the efficiency of its balance sheet.

Comparable-store sales increased 4.5% year over year and Home Depot generated more than $40 billion in quarterly revenue for the first time in its history. If 4.5% comp sales growth doesn't sound all that impressive, remember that this growth was lapping 23.4% comp sales growth in the same period last year. This is solid growth on top of unprecedented growth! Home Depot CEO Craig Menear summed it up on the Q2 earnings conference call:

We remained agile and flexible and were pleased with our ability to respond to strong home improvement demand and comp to comp in the second quarter. We had positive comps every week despite unprecedented compares last year, and grew sales by $3.1 billion in the second quarter, and more than $12 billion year to date. Over the last six quarters, we have grown the business by more than $34 billion, a level unmatched in our market.

Global supply chain disruptions in the quarter lead to a drop in in-stock inventory, but Home Depot has been aggressively investing in its omnichannel supply chain over the past three years. It recently took the extra step of contracting several container ships that are 100% devoted to importing goods for Home Depot. Home Depot's massive scale, combined with its massive balance sheet, first-class business economics, and incredible management are the reasons it has been able to expand its market share in the current uncertain economy.

A Home Depot employee uses a rubber mallet to seal a paint can lid sitting on a countertop

Image source: Home Depot.

Investors should expect Home Depot to emerge from the pandemic (whenever it finally ends) with the most scaled and efficient supply chain in the industry. This will ensure it has the most in-stock items of the brands in highest demand, at everyday low prices, and with the fastest delivery times. Management says its ultimate goal is to be able to deliver any product of any size to 90% of the U.S. population with same-day or next-day delivery.

Among other performance indicators, Q2 sales of big-ticket items (those over $1,000) increased 24% year over year, and sales from professionals (which the company calls Pros) outgrew sales from do-it-yourselfers for the second quarter in a row. Management said its Pro customers report that backlogs of work "are bigger than ever." Pros tend to spend more and are higher-margin customers, making up 4% to 5% of Home Depot's customers, but generating roughly 45% of sales. Home Depot’s large Pro business drives higher sales per square foot and higher sales per store, which drives higher ROIC and free cash flow, which creates more money to reinvest in exclusive products, supply chain, digital, and other growth initiatives to ensure the best experience for both Pros and DIY customers. Home Depot's strategy of leaning into its Pro business is a smart move.

E-commerce sales in Q2 were flat, but it was lapping 100% digital sales growth in the same quarter last year. On a two-year stack basis, e-commerce sales are up 100%. Home Depot's 2,000-plus stores serve as the hub of its omnichannel shopping experience. Over 55% of online orders were fulfilled by its stores in the quarter.

The long-term thesis for Home Depot is pretty straightforward: A great industry and strong housing market plus a market share leader plus a location advantage plus a business model advantage plus a tech advantage plus excellent management and culture equals a long-term winning investment. These structural advantages create a perpetual free cash flow and reinvestment machine that is very hard to replicate by the competition. Let's break down each in more detail:

The housing industry: This is a fundamental building block of the U.S. economy and the American dream. For most people, their home is their largest financial asset and people will always invest in their homes. In good times, they may spend on larger remodeling projects and in tougher times they still need to spend on maintenance and repair.

Location, location, location: This gives Home Depot a structural advantage that is very hard to replicate. More than 90% of the U.S. population lives within 10 miles of a Home Depot store. That compares to 90% of the U.S. population that lives within 20 miles of a Lowe's store. Additionally, in the top 25 metro markets, Home Depot has 80% more stores than Lowe's has. Home Depot's roughly 2,300 stores make up a massive competitive advantage because they serve as the hub of a shopping experience. Customers can buy online and pick up in-store, buy online and the store delivers, buy online with delivery and return to the store, etc. Having the best locations in dense urban areas also contributes to higher sales per store and higher sales per square foot, which leads to higher ROICs and free cash flow, which means Home Depot has more cash to reinvest in serving its employees and customers, growing the business and strengthening the moat. This advantage is very hard to replicate, gives Home Depot an edge over Lowe's, and makes it exceptional.

Business model advantage: Home Depot tops Lowe's here because of its strong connection to Pros (45% of sales versus only about 25% at Lowe's). Pros spend a lot more than DIY so they are higher-margin customers and help boost key retail metrics. While DIY customers spiked at both Home Depot and Lowe's stores over the past year, as DIY customer traffic begins to revert back to more traditional levels, Home Depot's Pro business should help it stay more resilient in the transition. So if DIY traffic slows, Home Depot’s Pro business can pick up the slack better than Lowe’s Pro business can. To be fair, Lowe's management admits to not having a strong Pro strategy in the past decade or so, but it is working to change that and win over more Pro customers.

Tech advantage: Home Depot is an underappreciated tech powerhouse. Its online sales grew 86% in 2020 and now represent around 15% of total sales. Home Depot has grown to become the fifth-largest online retailer in the U.S. Home Depot's tech efforts are led by Chief Information Officer Matt Carey. Salesforce.com founder Marc Benioff called him "a legend in information technology."

Excellent management: Home Depot is led by Craig Menear and an exceptional leadership team.

Taken together, these advantages make this retail stock worth investing in.

An employee at Lowe's works the cash register while wearing COVID-19 protective equipment as a customer completes a transaction

Image source: Lowe's.

Lowe's fiscal 2021 Q2 earnings

Lowe's is benefiting from the same tailwinds -- a strong housing market and the pandemic-related work-from-home trend -- as Home Depot, so it also had a very strong second quarter. Its comparable sales decreased 1.6% year over year, but it was lapping unprecedented demand in the prior-year quarter. On a two-year stack basis, Lowe's comp sales increased 32%, which is phenomenal.

Key indicators suggest the retailer has a lot of business momentum right now. Online sales grew 7% year over year, which is on top of 135% online sales growth in Q2 2020. Sales to Pros grew 21% year over year, and 49% on a two-year stack basis. The strong Pro sales growth paired with overall sales up only 1% affirms the outsize weight DIY customers have on Lowe's business model (roughly 75% of sales are DIY-related).

As already mentioned, Pros have an outsize influence on key retail operating metrics, which improve operating margin, which pushes higher ROIC and free cash flow. Growing Pro sales also diversifies the revenue stream. Lowe's management team has gotten the message on this. Joe McFarland, executive vice president of stores, emphasized as much on the second-quarter earnings call, saying, "Every day, we are striving to demonstrate that Lowe's is the new home for pros."

Following the strong quarter, Lowe's management raised its full-year guidance. It now expects revenue of about $92 billion (up from $86 billion) and an operating margin of 12.2% (up from 12%). Most importantly, Lowe's management increased its long-term operating margin target from 12% (which it will achieve this year) to 13%.

While it has structurally lower margins and returns on capital than Home Depot, Lowe's is still a great business and a great stock. It's the second-largest home improvement retailer, and even though it has some structural disadvantages relative to Home Depot, Lowe's is a great business that is getting better and it makes no sense to me that Lowe's trades at a three-point discount to the market. Lowe's has a forward P/E ratio of 18, but the S&P 500 trades at a forward P/E of 21. I think the stock will continue to gain and at least achieve a P/E ratio in line with the market (and should be even higher since far-above-average businesses deserve to trade at above-market multiples).

Here's another way to think about Lowe's valuation. Lowe's has an enterprise value of about $166.5 billion. According to S&P Global, analysts expect Lowe's to generate about $7.5 billion in FCF in 2021 (this is down from a pandemic-elevated 2020 total). Together, those figures create a very attractive FCF yield (FCF/enterprise value) of 5%. Now let's assume Lowe's only generates $7 billion in 2021 FCF (a too conservative estimate, I think). That would be an FCF yield of 4%. This is still highly attractive when compared to the 10-year U.S. Treasury (currently yielding 1.3%). At an FCF yield of 4% to 5%, Lowe's only has to grow FCF by 7 to 8 percentage points annually to generate 12% expected annualized returns. That is not a high hurdle.

A Lowe's sales associate stands in an aisle of the gardening section of the store holding a plant while explaining something to a customer.

Image source: Lowe's.

Marvin Ellison took over as CEO of Lowe's in July 2018 with a mandate to make some changes in how the company operates. Let's look at how the turnaround he initiated is going so far.

In March 2019, I shared a note on The Motley Fool's internal research management system that said:

Ellison worked at Home Depot for 12 years and is often credited with helping to lead the turnaround at Home Depot a decade ago. So, he knows what needs to be done, and I'm betting that his turnaround at Lowe's leads to market share gains, faster comp growth, improved sales per square foot and inventory turns, improved operating margins, improved returns on invested capital (ROIC), higher free cash flows (FCF), and large share price appreciation (resulting from both EPS growth and P/E multiple expansion). That's my thesis, Fools. Lowe's remains one of my high-conviction ideas for long-term investors!

Lowe's was one of my highest-conviction ideas then and it remains so today. Under Ellison Lowe's has:

  • Refocused on the core business by shedding underperforming, lower-margin businesses. It closed all Orchard Supply stores, closed underperforming stores in the U.S. and Canada, and it exited retail operations in Mexico.
  • Restructured the leadership team by eliminating several positions and appointing new leaders for CFO as well as head of merchandising, stores, and supply chain.
  • Aggressively rationalized inventory by reducing low-demand inventory and increasing higher-turn inventory.
  • Invested heavily in supply chain, omnichannel retail, and other digital initiatives (including revamping Lowes.com, moving Lowes.com to the cloud, implementing digital signage, putting 115,000 smart handheld devices in associates' hands, etc.) to drive higher levels of customer satisfaction and productivity.
  • Implemented dynamic pricing tools which enable the company to quickly change prices on its inventory to reflect current market pricing. This has allowed Lowe’s to shift away from a promotional pricing strategy and toward an everyday low-price strategy. The elimination of most promotions (or markdowns) has boosted gross margin from about 32% to 33%.
  • Invested in growing its sales to Pros and increasing its assortment of top branded merchandise (sometimes through exclusive deals).
  • Implemented a "true expense reduction culture" to improve operating margins and ROIC.

The turnaround efforts are showing up in the numbers. From 2018 to 2020, Lowe's sales per square foot increased 26%, adjusted operating margin increased by 2.25 percentage points, customer satisfaction scores increased 4 percentage points, and earnings per share grew 70%. The result was that from 2018 to 2020 Lowe's provided a total shareholder return (stock price appreciation plus dividend yield) of 71% compared to the S&P 500, which returned 37% over the same time frame.

I think Ellison and his team are just getting started and that the investors will benefit from both continued EPS growth and P/E multiple expansion. My conviction on the stock hasn't changed.