Building a Position in Home Depot

NEW YORK ( TheStreet) -- There's no question Home Depot ( HD), whose shares have soared 190% over the past five years, has been one of the best plays in the housing recovery.

When you consider Home Depot has more than doubled the performance of rival Lowe's ( LOW) during that span, there's little debate as to which of the two wins the title for head of household.

However, I have always had a tough time reconciling Home Depot's valuation to that of other leading retailers such as Wal-Mart ( WMT) and Costco ( COST). I'm not suggesting the stock lacks value. It's clear the Street has never minded paying a higher multiple for Home Depot. It's worked out very well over the past five years, yes. But how about the next five?

With revenue growth of more than 7% in the recent quarter, which outperformed the 1% sales decline posted by Lowe's, Home Depot is certainly doing its part to make this debate, well, not much of a debate at all.

Unlike Lowe's, which is struggling with declining same-store sales (comps), Home Depot has figured out ways to not only capitalize on a revitalized housing recovery, but sustain its post-Hurricane Sandy momentum.

Profits soared 18%, helped by continued margin improvements including a year-over-year, 20-basis-point climb in gross margin. Operating margin expanded by 130 basis points contributing to a 22% surge in operating income. The company earned $1.22 billion, or 83 cents per share, which beat Street estimates by 8%.

Equally impressive was the company posted a solid 4.3% growth in overall comps, which is the metric that tracks sales performances of stores that have been opened at least one year. Just to give you an idea of how impressive this is, Lowe's just posted 70 basis-point decline in comps while Wal-Mart U.S. comps dropped 1.4%.

Given the fact that Home Depot has a solid record in comps over the past five years, I should not have been surprised by this outperformance, but I was -- particularly since the management at both Lowe's and Target ( TGT) attributed quarterly weakness to weather. What this tells me is the housing recovery is progressing much better in Home Depot's neighborhood.

Along similar lines, Home Depot's outperformance raises the possibility the company is stealing market share in some very important categories including building supplies, which surged following Hurricane Sandy, as well as housing fixtures.

It is also possible the weakness that Lowe's has experienced in merchandising has been driving more customer traffic to Home Depot. I don't expect this will continue indefinitely. Home Depot management, however, may have other ideas as the company boosted its EPS outlook by 4.5%, while raising full-year revenue growth estimates to 2.8%, up from 2%.

Since the crash of the housing bubble both Home Depot and Lowe's have been in a neck-and-neck race to prove to investors that not only "home where the heart is" but it is also where to shelter profits. But as the race continues, the question of value gets a bit more complicated.

While both companies have produced solid returns over the years and offer two of the best yields on the market, it's still hard to believe the divergence seen in this quarter in terms of performance will continue for the next two to five years. Although Home Depot's earnings report demonstrated the strength in its management team, I expect Lowe's to catch up.

This is no slight at Home Depot but the market is still pricing the stock at a premium that still seems too rich for me. I'm not suggesting current investors shouldn't anticipate more gains from Home Depot, but I nonetheless believe shares of Lowe's, which seem undervalued, will outperform shares of Home Depot in the next five years. Lowe's only has to improve in areas such merchandising and show slightly-to-better comp growth.

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.
Richard Saintvilus is a private investor with an information technology and engineering background and the founder and producer of the investor Web site Saint's Sense. He has been investing and trading for over 15 years. He employs conservative strategies in assessing equities and appraising value while minimizing downside risk. His decisions are based in part on management, growth prospects, return on equity and price-to-earnings as well as macroeconomic factors. He is an investor who seeks opportunities whether on the long or short side and believes in changing positions as information changes.

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