Love, Hate and Home Improvement

The retail group is a mess right now, as it should be. That's because the operating leverage in the retail model makes for big winners -- and big losers. There's no room for error: Leading retailers such as Wal-Mart (WMT - commentary - Cramer's Take) and Target (TGT - commentary - Cramer's Take) are happy to generate slim 3.5% net profit margins. Those margins have to be sufficient to cover all cash requirements, including debt service.

In this first installment of a multipart series on the retail group, I'll review the two dominant players in the building-materials retail space: Lowe's (LOW - commentary - Cramer's Take) and Home Depot (HD - commentary - Cramer's Take). A look at their relative valuations shows that Wall Street loves Lowe's and hates Home Depot. Lowe's trades at a rich premium to its sales base with a 23 price-to-earnings ratio, while Home Depot sells at a discount to sales and a 15 P/E. As you can see from the chart below, Lowe's is up 30% over the past year, while Home Depot has fallen more than 30%.

Love Me, Love Me Not Lowe's picks up steam over the past year, while Home Depot falters.

In recent quarters, Lowe's has posted better earnings momentum and same-store-sales numbers than competitor Home Depot. Does that justify a significantly higher relative valuation for Lowe's? No, in fact, the relative valuation should be quite the opposite. A careful review of the financials of these two retail powerhouses clearly shows that Home Depot is a vastly better business.

Here are my notes from my review of the companies:

Debt: With debt of $3.8 billion, Lowe's has a much higher debt load than Home Depot. Lowe's debt-to-equity ratio is 8 times as high as Home Depot's. If Home Depot had the same ratio of debt to equity, it would have $10.52 billion in debt -- vs. its actual $1.3 billion. With a cash hoard of $5.7 billion, Home Depot has net cash of $4.4 billion (cash minus debt). Using the same formula, you'd see that Lowe's has net debt of $2.5 billion.

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Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor specializing in turnaround situations. At time of publication, neither Alsin nor ACM held a position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to [e-mail]. Click here to receive Arne's latest favorite stock picks from his newsletter, The Turnaround Report.