Lowe's Needs a Reality Check

Source: Lowe's

The past five years have been somewhat depressing for investors of Lowe's Companies (LOW -0.14%). Despite seeing sales rise 13% from $47.2 billion to $53.4 billion, the home improvement chain's performance has lagged larger rival The Home Depot (HD -0.31%), whose revenue has climbed 19% from $66.2 billion to $78.8 billion. Over the same timeframe, the company's profitability has been even less exciting, growing 28% from $1.8 billion to $2.3 billion while Home Depot's has jumped 102% from $2.7 billion to $5.4 billion. Given these issues, should Lowe's be written off as a bad prospect or does the company have the ability to improve itself?

Margins are a big concern
One of Lowe's biggest issues appears to be its cost controls. Between 2009 and 2013, Home Depot's selling, general and administrative expenses have fallen from 24% of sales to 21.1%. During the same five-year period, Lowe's has seen its same category of expenditures inch down from 24.9% of sales to 24.1% with its average selling, general and administrative expenses coming in at 24.6% compared to Home Depot's 22.7%.

Source: Lowe's

Although this disparity in costs may not seem that big of a deal, eliminating the difference between Lowe's and Home Depot in just this category alone would have increased the retailer's net income in 2013 from $2.3 billion to over $3.3 billion. Put another way, the company's net profit margin would have risen from 4.3% to 6.1% vs. Home Depot's 6.8%.

Unfortunately, Lowe's does not offer its shareholders a complete breakdown of its costs, but it has disclosed how much it allocates to advertising:

Source: Lowe's and Home Depot Corporate Filings

As we can see in the table above, Lowe's invests nearly as much on advertising as Home Depot does. As a percentage of revenue, however, the company's dedication to marketing its goods and services is certainly higher, especially in recent years. In the event that these efforts resulted in higher sales or profits, management's decision to advertise more would make sense, but the company's performance over the past five years suggests that the added activity offers no additional benefit.

Don't overlook disappointing sales either
Aside from margins, there is another thing holding Lowe's back; poor sales per selling square foot. In 2013, the retailer posted sales per selling square foot of $267. This represents a 20% shortfall compared to Home Depot's $334 in sales per selling square foot and comes in spite of Lowe's posting an average ticket per transaction of $64.52, 14% higher than Home Depot's $56.78.

Source: Lowe's and Home Depot Corporate Filings

This data implies that while Lowe's is able to sell its goods at a higher price (or at greater quantities) on a per-customer basis, the company is processing fewer transactions. In fact, in 2013, the company recorded just 828 million transactions compared to Home Depot's 1.4 billion, which suggests the company's higher ticket may be resulting in fewer customers. One way to correct this might be for management to lower the cost the company charges for its products.

Source: Home Depot

At first, this kind of move may seem intuitively wrong, but given the high fixed costs the retailer likely has (because of its large store base), decreasing product prices would raise the number of transactions and lower its fixed costs as a percentage of sales. This, in turn, would lead to greater margins, should sales gains exceed fixed costs, and added sales growth. The downside to this maneuver is that lower sale prices would cause the company's cost of goods sold to rise in relation to sales, but as its growth rate increases, management may have greater market power to push those costs down.

Foolish takeaway
Based on its number two market position in the home improvement industry, Lowe's presents shareholders with a great deal of opportunity over the long run. However, management seems to be unaware or unwilling to make some of the changes necessary to properly capitalize on its market power, which could lead to the company falling even further behind Home Depot.

This could prove disastrous in the future, but if the retailer decides to cut back on advertising and places a greater emphasis on increasing sales by offering lower prices, it's possible that shareholders could see a resurgence in market share. In the event that management begins making these kinds of moves, it could serve as a signal for the Foolish investor to consider the retailer as a serious prospect, but absent these changes, Home Depot may make for a more sensible play.