Over the last three years earnings growth has been driven by three things: revenue growth, gross margin expansion, and operating margin expansion. The second quarter saw both gross margin and operating margin grow, putting both at record levels. Operating margin for the past six months was 12.3%, higher than any year in the past decade. Operating margin grew from 6.1% in 2008 to 10.4% in 2012, and it seems that any further growth will be difficult. Even during the boom years before the crash operating margin peaked at 11.5%.
Because of this I would expect earnings to grow at a similar rate to the revenue going forward, with per-share numbers boosted a bit by share buybacks. Low-teens EPS growth seems reasonable, making the 20+ P/E ratio seem a bit optimistic.
I think that the market is pricing in continued margin expansion, and I doubt that this can continue for much longer. The Home Depot, Inc. (NYSE:HD) shares are not outrageously overpriced, but it seems high enough to warrant caution.
A different story
Shares of Lowe’s Companies, Inc. (NYSE:LOW) haven’t shot up nearly as much as The Home Depot, Inc. (NYSE:HD). Lowe’s has failed to grow revenue by very much at all over the past few years, as the operating margin has remained well below peak levels. EPS is sill well below the high in 2006, and it seems that Lowe’s has been struggling to compete with the larger Home Depot.
This could be changing. Lowe’s Companies, Inc. (NYSE:LOW) earnings report was solid, with a 10.3% increase in sales and a 37.5% increase in EPS year-over-year. Operating margin jumped from 8.4% in the second quarter last year to 9.59% this year, still well below the 11% peak in 2006. Lowe’s guided for EPS of $2.10 for the full year, putting the forward P/E ratio at around 22.
This is similar to The Home Depot, Inc. (NYSE:HD)’s valuation, but I would argue that Lowe’s Companies, Inc. (NYSE:LOW) has not only more room to grow revenue since it is a smaller company, but more room to grow margins as well. Because of this I expect EPS growth for Lowe’s to outpace EPS growth for Home Depot considerably over the next few years. This makes Lowe’s a better value today.
The bottom line
Neither stock is particularly inexpensive, with the market pricing in strong margin and revenue growth going forward. But with Home Depot reporting record margins there seems to be little room for improvement, and I expect growth to slower from here on out. Lowe’s Companies, Inc. (NYSE:LOW), on the other hand, still has room to grow its margins and has the capacity for much faster earnings growth. While both stocks trade at a premium, Lowe’s offers the better deal.
The article Can The Run In Home Improvement Stocks Continue? originally appeared on Fool.com and is written by Timothy Green.
Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Home Depot and Lowe’s.
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