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What it will take for a bullish bet on Lowe's to play out; plus, how rival Home Depot stacks up.

Transcript

The State of the Home Improvement Market Erik Kobayashi-Solomon: Hi, I'm Erik Kobayashi-Solomon, one of the coeditors of Morningstar Option Investor. And today, it’s my great pleasure to welcome Kim Picciola, who is the senior equity analyst in charge of retail companies here at Morningstar. Kim, thanks for coming. Kim Picciola: Thank for having me, Erik. Erik Kobayashi-Solomon: You know, a couple of weeks ago, I wrote up the strategy about how to play Lowe’s using options. And I just want to get a little more color about that. One thing that I worry about, every time I walk in to one these do it yourself retailers lately, everybody is standing around waiting to help me. Two years ago, I couldn’t get anybody to take any time with me. So I mean, business right now is slow. How much is this bullish position kind of a bet that the housing market will return? Are we betting on a return to the good old days in other words? Kim Picciola: No, it’s really not a bet on the housing market or return to the good old days, it’s really a bet on the macro economy picking back up, and consumer spending on more discretionary items such as the home really coming back online. Home Depot and Lowe’s, both home improvement retailers really struggled not only because of the housing market decline, but also as the macro environment really kind of hit consumers wallets and then really have to pull back in terms of their discretionary spending. Erik Kobayashi-Solomon: So as the employment situation gets better, maybe people start5 thinking, you know, it’s time to redo that kitchen or something like that. Kim Picciola: We do. We think the employment situation, we think that’s a big key here. We hear that over 40% of consumers are waiting or delaying a project for their home as they are looking for a more stable environment in which to spend those kind of discretionary dollars. Erik Kobayashi-Solomon: It could be a real bounce back then, I guess, right? Kim Picciola: There could be a bounce back. I mean, we have seen several years of declining comps here. So there is a possible potential of a bounce back. But we do think it’s going to be more of a mild recovery coming from the consumer. So we’re not projecting a bounce back per se, we’re expecting low to mid single digit growth, longer term as consumers start to spend more freely on their homes. Erik Kobayashi-Solomon: Got you. Now, another thing that I'm wondering about. So, when we’re talking about Lowe’s, you can’t help but think about Home Depot. There are two very similar firms, and I know that Home Depot right now is undergoing some internal kind of organizational changes, operational changes. If home depot really gets their act together, is this going to put pressure on Lowe’s or is there enough room for both of these two giants in the retail space? Kim Picciola: We think there is enough room. The home improvement market is very highly fragmented still to this day. And we think there is plenty of room for them to kind of coexist as duopoly, if you will. You know, Lowe’s is definitely the better operator. They really kind of flew under Home Depot’s radar and built out their store base in recent years, and now they are kind of coming up, catching up to Home Depot in terms of store count and their size. And Home Depot really wasn’t paying attention to their internal infrastructure as they were benefiting from a nice economy in the housing market boom. And now, as the market has deteriorated, they really had to look under the hood and try to fix some of the core issues that they are having internally. Erik Kobayashi-Solomon: And work on efficiency and all of that stuff. Kim Picciola: Work on efficiency, they are implanting distribution centers where they are going to be shipping goods now through distribution center, doing less shipping directly to the store. So really, trying to build out some infrastructure that was lacking, that Home Depot has already in place. Erik Kobayashi-Solomon: But Home Depot or Lowe’s. Kim Picciola: I'm sorry, Lowe’s already has in place, and that has really given them an advantage in terms of their efficiencies and operations. And now, Home Depot, I think is kind of trying to play catch up to what was— Erik Kobayashi-Solomon: Okay, so this leads me to my next question. I mean, these two companies are basically kind of macro bets on the same thing. You could look at it. I mean, they have got the same macro drivers, right? Kim Picciola: Right. Erik Kobayashi-Solomon: To me, Lowe seems like a little bit of a safer bet, a little higher betting average bet than Home Depot because it’s not dependant on turning these internal operations around as it kind of partially as in Home Depot’s case. What’s your take on this, which let’s say the safer bet, which is the bet that you think may perform better? Kim Picciola: We do think Lowe’s is the better operator of the two, you know. They have the infrastructure in place, they have the scale that they are able to leverage to purchase things at a low cost, and then pass those savings onto the consumer. And we also think Lowe’s has opportunity to grow. Their store base isn’t quite up to what Home Depot is today, and we think there are markets where Lowe’s has the opportunity to enter and continue to grow their store base. That being said, even if Lowe’s does continue to grow, we do think that the two can act rationally and coexist as they really, it’s still very fragmented market. And today, I think they both have less 10% of share of the home improvement retail market. Erik Kobayashi-Solomon: So they both understand there is no real benefit to like going after each others throats, right? Kim Picciola: Right, we do think that they can coexist. And there might be slight difference in the mix in terms of products. I think Home Depot has more of a tendency to focus on commercial side where Lowe’s is probably a little better at— Erik Kobayashi-Solomon: Higher end homeowner kind of things, right? Kim Picciola: Exactly. So you know, appliances and those types of goods. So we do think there is a slight differentiation between the two. But we do think Lowe’s is the best operator in the space right now, and as soon as consumer starts spending more freely and— Erik Kobayashi-Solomon: They will start spending at Lowe’s. Kim Picciola: That’s what we think. We think 2010, we’re already starting to see consumer spend in this category, in the home category and not necessarily in home improvement but more on the softer side with Bed Bath & Beyond, Williams-Sonoma. So we are seeing some positive trends there and we think Lowe’s and Home Depot, they are both positioned to benefit from that as the consumer spending environment improves. Erik Kobayashi-Solomon: Fascinating. Kim, thanks a lot for coming. Sure appreciate you being here. Kim Picciola: Thank you for having me. Erik Kobayashi-Solomon: And thank you for joining us. Please stop by the Option Investor website where you can help build your portfolio with other terrific option ideas like Lowe’s.