Foolish Face-Off: Home-Improvement Giants

As Fools enter 2007, one of the biggest questions on investors' minds is what will happen to the homebuilding market. Recent existing-home sales trends came in better than expected, but the market is still unsure whether trends have stabilized, or whether large domestic builders such as Toll Brothers (NYSE:TOL), Pulte (NYSE:PHM), and D.R. Horton (NYSE:DHI) will soon return to rapid new-home growth.

Regardless of what happens next year, major home-improvement retailers will continue to build on their 20% share of the $700 billion annual market. Both Home Depot (NYSE:HD) and Lowe's (NYSE:LOW) should be able to continue opening big-box stores and find other ways to serve building and construction contractors for years to come. But which company is the better bet? To help answer which retailer rules the roost, we've hammered out our latest Foolish Face-Off.

Growth rates

Advantage: Lowe's
Top-line growth at Home Depot and Lowe's has been similar, especially over the last year, but overall, Lowe's is growing faster, and it's been better able to leverage sales expansion into 20%-plus earnings and cash flow growth over the past five years.

Future growth is the key metric to track for any stock, and I would also award that advantage to Lowe's. It has roughly 40% fewer stores than Home Depot, and it has yet to enter a number of large metropolitan markets. Home Depot is acquiring market share in the do-it-for-me market via its Home Depot Supply segment, but as fellow Fool David Meier recently pointed out, the unit is currently posting lower overall profitability than the retail side. Despite recent homebuilding turbulence, both Lowe's and Home Depot have further growth opportunities, but the former should be able to continue growing via more stable retail store openings.

Margins

Advantage: Lowe's
The numbers are very close, and Home Depot has posted slightly higher net margins over the past 12 months, but the edge goes to Lowe's, where profitability has steadily improved over the past five years. Its margins now match those of its larger, more orange archrival, and they exceed those of the Depot on a gross and operating basis. Home Depot will also likely see lower margins as lower profitability in its Supply segment persists and becomes a higher proportion of total company sales.

Profitability

Advantage: Home Depot
The Depot still wins on this front, but the margin of victory has shrunk over the past five years, as Lowe's has used its increased clout to more effectively wring cost savings from its corporate structure and enhance overall bottom-line trends. Home Depot continues to post impressive stability in maintaining industry and market-leading returns on invested capital and equity.

Valuation

Advantage: Home Depot
Home Depot has lower valuations across the board; it's growing more slowly than Lowe's, and the market finds Lowe's outlook more compelling. Additionally, the Depot has had some company-specific issues to work through, including a stock-options probe, a bungled annual shareholder meeting, and concerns over CEO Robert Nardelli's generous pay packages. It's also now harried by a number of activist shareholders.

Cash Conversion Cycle

Advantage: Home Depot
This is a close call as well, and though it only covers one year's worth of data, Home Depot seems to have the edge in terms of cash conversion cycles. Its lower DII demonstrates that it turns over inventory faster, and its higher DPO shows that it takes longer to pay its bills. That's a good thing, since it leaves extra money in the till to invest and use for other corporate purposes. Lowe's is superior in its ability to get paid from customers using credit, but Home Depot's better figures in the other two categories takes the cake.

The Foolish final word
Home Depot wins the face-off, with three wins to Lowe's two, but the best strategy may be to consider a weighting in both. The two collectively dominate the DIY retail market, and their strength should continue for years to come. Lowe's is definitely growing faster, but Home Depot generates higher shareholder returns and has a lower valuation. I can't tell you for certain what 2007 will bring, but investors with a three-to-five-year investment horizon would be well-served to take a closer look at the homebuilding retail behemoths.

Home Depot is a Motley Fool Inside Value recommendation. Discover more of the market's best bargains with a free 30-day trial subscription.

Fool contributor Ryan Fuhrmann is long shares of Home Depot but has no financial interest in any other company mentioned. The Fool has an ironclad disclosure policy. Feel free to email him with feedback or to discuss any companies mentioned further.