Home Depot Stock Upgraded: What You Need to Know

Markets Motley Fool

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

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Easy come, easy go. Yesterday, Lowe's (NYSE: LOW) investors thrilled to the news that their stock had just become more popular, after analysts at Raymond James upgraded the stock to outperform and assigned it an $87 price target. Today, the number of analysts recommending Lowe's dropped by one, when Atlantic Equities cut Lowe's stock to neutral...and replaced it with a new favorite: Lowe's archrival Home Depot (NYSE: HD).

Here are three things you need to know about that.

1. Good news all around

Now, Lowe's investors needn't get too upset. According to data from S&P Global Market Intelligence, 18 analysts still recommend buying Lowe's stock, and only one recommends selling it. Still, S&P Global data show 25 analysts recommending Home Depot stock as a buy or outperform, and not a single analyst on Wall Street rates Home Depot stock a sell.

Why is that? Atlantic Equities explains, in a note covered on TheFly.com this morning: As was the case with Lowe's, a strong housing market, combined with a big boost to short-term sales from homeowners rebuilding after hurricane damage earlier this year, "should provide a tailwind [to home improvement stores] through the first half of 2018, at the very least."

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Of course, that still leaves the question of why Atlantic Equities prefers Home Depot stock over Lowe's stock.

2. Better than Lowe's?

Here, Atlantic Equities says it's a simple matter of buying the "best-in-class" home improvement store (Home Depot), and putting the second-best (Lowe's) back on the shelf for the time being.

And why does Atlantic Equities call Home Depot "best-in-class?" Well, just look at how the two retailers performed in their recently reported 2017 third fiscal quarters. Lowe's announced 6.5% sales gains over last year's third quarter, while Home Depot performed 160 basis points better -- scoring an 8.1% improvement in sales. Profits were up more at Lowe's, but mainly because Lowe's profits had been so poor in the year-ago quarter. On an absolute basis, though, Home Depot reported a much stronger operating profit margin of 15% last quarter. Lowe's only earned 9.2% profits on its sales.

3. Home Depot or Lowe's: Which stock is really the better bargain?

When you get right down to it, though, whether it's Home Depot or Lowe's that offers the better bargain depends largely on which cstock has the better valuation.

In this regard, as I explained yesterday, Lowe's stock looks not unattractive at its P/E of 22.8 and its (even better) enterprise value-to-free-cash-flow ratio of 17.6. With a 13.2% projected long-term profits growth rate (according to analysts surveyed by S&P Global), and 2.1% dividend yield, Lowe's offers a total return ratio of just 1.15 -- not far above value investors' traditional targeted 1.0 ratio.

And Home Depot? By my calculations, Home Depot's $203.4 billion market capitalization, adjusted to take into account its $22 billion in net debt, gives the stock an enterprise value of $225.4 billion. Against this, I weigh the company's reported profits under GAAP ($8.6 billion) and its actual free cash flow for the past 12 months ($9.8 billion) to arrive at the following valuations:

Home Depot stock sells for a debt-adjusted P/E ratio of 26.2. Its enterprise value is 23 times its actual free cash flow.

So? What's the verdict?

Right off the bat, you can see that investors are valuing Home Depot at much higher multiples than they accord Lowe's stock. On top of that, analysts predict that Home Depot will grow slightly slower than Lowe's over the next five years (12% versus Lowe's 13.2% growth rate) -- and Home Depot even pays a slightly lower dividend yield of 2%. Put it all together, and I simply see little sense in Atlantic Equities downgrading Lowe's today and upgrading Home Depot in its place.

Both Home Depot and Lowe's are fine companies, but Lowe's stock seems clearly the better bargain.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool has the following options: short January 2018 $170 calls on Home Depot and long January 2020 $110 calls on Home Depot. The Motley Fool recommends Home Depot and Lowe's. The Motley Fool has a disclosure policy.