HOME DEPOT

Lowe's

Meanwhile, both companies are making less money amid the housing downturn. This week, Lowe's reported an 18% year-over-year drop in quarterly profit, while Home Depot posted a 66% decline in earnings in part due to a hefty charge related to its store-cutback efforts. The stocks, however, are holding up: Home Depot shares are up nearly 5% year to date, and Lowe's shares are up 7%. The S&P 500 index is down 2% so far in 2008.

Since down markets don't last forever, each company is trying to position itself now to come out on stronger footing once real estate recovers.

When Home Depot announced at the beginning of May that it's cutting back on expansion, its shares gained 3.7% a sign investors liked the move. But Lowe's shares notched a bigger gain that day of 4.3%, an indication the Street thinks Lowe's could benefit from fewer Home Depot stores in the future.

The companies' shares have tended to move in tandem over the years. But Home Depot is more mature and, therefore, slower growing. After finishing lower on Tuesday, Home Depot is down 11% from five years ago, while Lowe's shares are up 22%. In the past decade, Home Depot's stock is up 31% while Lowe's shares have nearly tripled in value. Last year, Home Depot shares fell 34%; Lowe's lost 29%.

"Some people would argue Lowe's has more new-store potential. On the other hand Home Depot has more potential to improve their operating performance," says Wayne Hood, an analyst at BMO Capital Markets, who is bearish on both stocks while consumer spending is weak. "What's driving them now is the housing market and overall macro [economic] environment."

Home Depot's aging stores and uneven service has hurt it with consumers, so it's good that the company is focusing on improving its existing locations. Starting next year, Home Depot will expand its store square footage just 1.5% a year, saving $1 billion over the next three years. "By building fewer stores, in the best locations, and making sure our existing stores are profitable, our company will be in a much stronger competitive position," Chief Executive Frank Blake said earlier this month.

In contrast, Lowe's, which beat Home Depot in the first quarter in terms of market share, opened 20 new stores in the past quarter alone and is on track to open another 100 this year, a square footage increase of 7% to 8%. In a conference call with investors this week, Chief Executive Robert Niblock said, "We really believe that this is an opportunity for us to gain substantial market share over the next several years." Home Depot has 2,258 stores, vs. 1,554 for Lowe's.

From a valuation perspective, neither stock is screaming cheap. Lowe's is trading at more than 15 times earnings with an estimated long-term growth rate of 13%, putting it at a slight premium to the S&P 500. Home Depot is trading at about the same price-to-earnings ratio, but has a slower estimated growth rate of 11%.

"If I had to hold one company I would hold Lowe's based on their strategy. But it's marginal," says Geoffrey Gerber, president of Twin Capital Management. "The difference between Lowe's and Home Depot is not as great as the effect of the housing market on both of them. But we do like Lowe's growth prospects a little more and they have a better credit rating. We go with the stronger company."

Lowe's was "clearly the share gain leader" in the first quarter, according to Morgan Stanley's Gregory Melich. Compared with Home Depot and Sears Holdings, Lowe's posted the largest share gains across the board in tools, appliances, and lawn and garden. Home Depot posted gains only in tools. Melich, in his note, says Lowe's "appears to be the best value and risk-reward" in the sector.

That said, home-improvement retail sales fell 4.8% in the first quarter, year over year, according to Melich. That's a larger decline from the fourth quarter, when sales fell 1.5%. With the housing market weak and both Lowe's and Home Depot casting muted outlooks for the rest of 2008, it's a safe bet neither stock will be a big winner in the near term. Generally, home-improvement retailers lag the housing market by about two quarters, analysts say. But if the past is prelude, Lowe's is well positioned to outgrow its older rival down the road.