Home Depot and Housing Have Further to Run

Despite delivering two strong earnings reports, and raising  guidance in each of them, shares of Home Depot   have oscillated between $75 and $80 since June. As such, investors must be starting to wonder what exactly it's going to take for the stock to break out of its range.  

Moreover, if the naysayers are right, buying Home Depot or other housing-related stocks like Whirlpool , Masco, Williams-Sonoma  or Lowe's  could prove a costly error made at the peak of optimism over the housing market. 

The bear case
A pessimistic outlook sees the housing market as stalling at the altar of higher interest rates. In this scenario, the positive news that Home Depot and Lowe's have been reporting is merely a lagging indicator poised to follow the housing market lower in due course.

As this graph shows, both companies have been reporting much stronger same-store-sales growth this year.

Source: company presentations

Against this backdrop, there is no doubt that the housing market has endured a slowdown as a consequence of higher rates. For example, existing home sales have noticeably weakened since interest rates started rising.

Source: National Association of Realtors

If sales continue to weaken and drag home prices down with them, then the housing recovery could easily be snuffed out.

Housing trap being set?
If this scenario is correct, then stocks tied to the US housing market like Home Depot, Lowe's, Whirlpool, Masco, and Williams-Sonoma are almost perfect traps for growth investors. The trap will be sprung if they report strong results in the fourth quarter, as their demand tends to lag the housing market. Investors would then be induced to buy in, only to see their dreams crushed as housing turns downward in 2014.

Indeed, home-furnishings company Williams-Sonoma recently beat estimates and raised fourth-quarter guidance. Moreover, its growth platforms of Pottery Barn, West Elm, and PBteen recorded comparable-brand revenue growth of 8.4%, 22.2%, and 16.7%, respectively. These numbers are a clear indication of discretionary spending returning, but it doesn't stop there.

Building-products company Masco reported that its North American sales were up 12%, with faucet and toilet sales up "in the mid-teens." Masco's plumbing products are a good indicator of spending in the new-home-sales market, and in general, Masco is more geared toward new residential construction.

And finally, appliance-maker Whirlpool has progressively raised its expectations for full-year industry demand as the year has progressed.

Full Year Industry Demand Assumption	First Quarter	Second Quarter	Third Quarter
North America	2% to 3%	6% to 8%	9%
Europe	flat	flat to (2%)	flat
Latin America	3% to 5%	1% to 3%	1%
Asia	3% to 5%	flat	(2%)

Source: company presentations

All of these companies are reporting strong conditions, but is it all just a bear trap that's about to be sprung?

Rates are only part of the picture
Frankly, it would be a mistake just to look at interest rates in isolation. Moreover, the economy tends to behave like a supertanker--it has its own momentum and takes a while to turn around. Right now, employment remains in a steady growth mode, and usually when that happens consumers tend to feel more comfortable about spending.

In turn, financial institutions start seeing better conditions and lending opportunities, so they start to loosen lending criteria. A credit expansion follows, which then drives the economy onward. In usual recoveries, this is accompanied by rising interest rates because there is more demand for capital.

Indeed, Home Depot's management touched on the issue during its conference call when CFO Carol Tome said, "We've regressed ourselves both against 10-year Treasuries and 30-year mortgages, to see if there is any sort of correlation and we can't see it."  

In other words, the housing market isn't just dependent on interest rates. However, Tome did go on to say Home Depot monitored housing turnover (the rate at which houses are sold) and prices. She continued, " If home prices were to decline, then we might have a different point of view on the housing recovery".

The good news is that despite slowing existing home sales, US home prices are rising.

Source: S & P Case-Shiller

The outlook remains positive for housing.

The bottom line
While all of the companies discussed above have their own internal dynamics, the underlying question is the same: is the housing market about to stall or not? If you share the opinion that it won't, then Home Depot is probably the best pure play.

Lowe's is similar, but it also needs to deliver with its plan to reset its product sales. Masco gives you heavy exposure to new home construction. Whirlpool has significant overseas exposure and heavy competition in appliances, while Williams-Sonoma competes in some highly competitive markets too.

Bed, Bath & Beyond and Beyond

With the housing market seemingly at the start of a multi-year recovery, the market has been keen to bid up any stock related to the sector. Usually this is for good reason, because the earnings outlook is improving for these companies. However, in the case of homeware retailer Bed Bath & Beyond (NASDAQ: BBBY), I think the market is giving it the benefit of the doubt over the prospects for its restructuring, acquisition and expansion strategy. The stock is already up 26% this year. How much further can it run without definitive evidence of success?

A special situations play

Going into this year, BB&B was challenged to adequately integrate its World Markets and Linen Holdings acquisitions, restore same-store sales growth and margins, and successfully continue is store expansion plans.

It needs to do these things because It has been suffering from margin contraction as its sales mix has been shifting towards lower margin item sales. Meanwhile, its acquisitions have increased selling, general, and administration (SG&A) costs.

Here's a graphical representation of how its margins have moved in the last few years:

Source: Company financial statements.

Readers will note that there wasn’t much improvement in the recent quarter.

Latest scorecard from the Q1 results

The bad news in the quarter was that the acquisitions continued to increase SG&A costs by 100 basis points, while gross margins declined thanks to increases in couponing and redemptions. Meanwhile, sales have continued to drift toward lower-margin categories.

The good news was that same-store sales increased by a healthier 3.4%. This was put down to an increase in transactions and transaction amounts. While this is a good sign – and Q1 was a difficult retail environment -- I can’t help but remark that it should be able to sell more items if it is offering more coupons. Unfortunately, the drive to increase sales is coming at the expense of margins. Furthermore, its guidance of 2%-4% same-store-sales growth for Q2 and the full year was nothing to write home about.

So the acquisition integration appears to be holding back margins, but the company hasn't slowed down its expansion plans. In fact, store space (including acquisitions) increased by 16% for the year, and capital expenditures for 2013 are forecast to increase to $350 million in 2013 from $315 million last year.

The company plans the number of new stores opened in 2013 to be in the "mid thirties," although the management gave notice that it would update investors in the final figure as the year progresses.  And finally, a significant amount of investment is being made to upgrade Bed Bath & Beyond's websites and e-commerce facilities in order to drive multichannel sales. Will it all work?

The benefit of the doubt?

Are investors being too keen to cut the company slack over its performance and prospects?  It’s not hard to see why they would, because so much has being going right for this subsector of retail in 2013.

On the other hand, each company must be judged on its own merits. For example companies like Williams-Sonoma (NYSE: WSM) and Pier 1 Imports (NYSE: PIR) have done very well by increasing their multichannel sales efforts. But they are way ahead of where Bed Bath & Beyond is right now.

Williams-Sonoma is trying to increase its Direct to Consumer (Dtc) revenues (things like catalogue and online sales) because they tend to fetch higher margins than selling through retail and wholesale channels. Indeed, its DtC-based revenues rose to 22.9% of total revenues from 20.8% last year. This helped its operating margins rise by 60 basis points in the last quarter. Similarly, Williams-Sonoma is engaging in a program of opening new stores and expanding existing ones -- albeit mostly abroad. It's also increasing capital expenditure plans this year to $200 million-$220 million, this year, compared to $205 million last year.

The difference is that Williams-Sonoma is firing on all cylinders. It is expanding margins and demonstrating success with its expansion plans, and it generated 7.2% overall growth in its comparable brand revenue.  This is a far cry from Bed Bath & Beyond’s 3.4% same-store sales growth.

As for Pier 1 Imports, it recently reported comparable store sales growth of 5.9% and has just reached the anniversary of its e-commerce enabled site. It has seen its e-commerce contributions to total revenue make ‘progressive increases’ since their launch (even though investors will have to wait until Q1 2015 for a breakout of its comparable-sales calculation for DtC sales), and it is investing heavily in that effort as an integral part of its plans.

Pier 1’s strategy is to arrange for in-store pick up capability (customers seem to use this extensively), and it's rolling out an in store point of sales system (90% of its stores are already operating it). Pier 1 grew its overall sales by 9.3% in the quarter. Again, this company is executing very well within a favorable end market. Furthermore, note that Pier 1 is well ahead of Bed, Bath & Beyond with its online plans.

Where next for Bed Bath & Beyond?

Of course, what BB&B does have going for it is its valuation. On these grounds it compares quite favorably with the two other companies mentioned in this article.

BBBY PE Ratio TTM data by YCharts

Moreover, if it hits analyst estimates for $5.02 in EPS it will trade on a forward PE ratio of around 14.4 as I write.

Ultimately, an investment decision here is going to depend on your level of belief in the successful execution of the plans outlined above and an ongoing belief in the housing market recovery. The company will see better end market conditions thanks to an improving market, but I don't think that is enough of a reason to buy the stock.

Moreover, If the the housing market stalls, then this stock’s prospects will be called into question. There are always risks with expansion plans, not least from a company that has been seeing margins falling and lackluster same-store sales growth. Sentiment will likely take the stock higher, but I think the company needs to demonstrate better underlying performance before justifying buying in at this level.

Williams-Sonoma is Firing on All Cylinders

The housing sector remains a favored play amongst investors and Williams-Sonoma’s latest results highlight the attraction of the sector. The company is firing on all cylinders and benefiting from a number of growth drivers that are helping to push its stock to all-time highs. Is now the time to pile in or to start to take profits?

Williams Sonoma confirms growth momentum

I last looked at the stock in a previous article. The salient points raised then related to the necessity for the company to expand its online activities and international expansion programs. Both are needed in order to allow the stock to grow into its evaluation.

With a price-to-earnings ratio of around 20 times, it was hardly cheap. The company was stepping up capital expenditures this year to a range around $200 million to $220 million. All expansion programs come with risk, and there are no guarantees that international markets will take to its products as well as they do in the U.S.

The good news is that, if the latest set of results are an accurate precursor to future events, I think that the company is slowly de-risking these fears. Here are its key profit growth drivers, as previously discussed by the company.

• Overseas expansion with an immediate focus on Australia and the Middle East

• Investing in expanding West Elm and Pottery Barn

• Expanding its e-commerce facilities and direct-to-consumer (DtC) offerings in general

• Supply chain investments in order to drive multi-channel sales and margin expansion

• Continue to offer differentiated products in order to remain competitively relevant against online competition

One thing that is clear from these expansion plans is that all these measures are integrated into one coherent plan. Williams-Sonoma is one of the most integrated multi-channel distributors in the U.S., and as it expands internationally that approach is being taken there as well.

The Australian expansion is working very well so far. Management describes itself as being "literally overwhelmed" by the response rates in its retail stores and e-commerce sites. It is currently planning on opening a new West Elm store in Melbourne, Australia, and moving in to London as well. Of course, the company needs these launches to go well because it needs to counteract the effects of short-term margin contraction that occur when investing in new sites. I would read the new store plans as a marker that the expansion plans are going well.

Moreover, the investments in e-commerce and multi-channel sales efforts are also working well. For example, the company managed to achieve a credible 1.9% growth with the core Williams-Sonoma brand in comparable-brand revenues. The brand hasn’t been growing in a while and it’s not a big part of the expansion programs as a result, but the improvements were cited as a consequence of more efficient e-marketing activities. To put this into context, total company revenues grew 8.6%, with debt to cash up 11.9% (including high-teen growth in e-commerce), while retail channel growth was only up 5.8%.

Interestingly, the company is seeing strong demand from online purchasers who wish to pick up products in-store. This apes the strategy of Pier 1 Imports , which has invested significantly in ensuring that its customers can engage in in-store pickups.

The company's key growth brands West Elm and Pottery Barn recorded double-digit and high-single-digit increases in comparable-brand revenues, respectively. Moreover, the company can expect more growth to come because new home purchases tend to spur home furnishings purchases. This is something to look out for because thus far we haven’t seen large increases in new home purchases in this recovery. What we have seen, however, has contributed to earnings upgrades at home improvement stores like Home Depot and Lowe’s Companies.

What the industry is saying

In general, there have been a strong set of earnings for the home furnishings sector and it has momentum going into the second half of 2013. What makes the sector interesting is that a number of retailers within it have some good internal drivers to go along with positive end demand.

For example, Restoration Hardware  is engaging in a growth strategy which involves rolling out new full-line stores. The idea is to try and put more of its product offering on display in showrooms. The existing full-line galleries are exceeding expectations, and the company recently upgraded its revenue and earnings forecasts. In addition, the company is seeking to generate revenue and margin expansion through expanding into categories like art and objects of curiosity.

Like Williams-Sonoma, Pier 1 Imports is also aggressively engaging in developing a multi-channel approach to retailing. Its plan is to invest in point-of-sale in-store systems that will help to drive e-commerce sales in future. I noted that the Wiliams-Sonoma’s management cited how strong the growth in revenues was from online customers who wanted to pick up good from the store; this has actually been a key part of Pier 1’s strategy, and the fact that a fellow home furnishings company is saying the same thing suggests it is following the right path.

Where next for Williams Sonoma?

Having previously looked at the company and concluded that its stock looks fairly valued at 20 times earnings, I now find myself saying the same thing! Of course, the stock has gone up from around $50 to mid $50’s (as I write this) but I would argue this is largely a consequence of the upgrade to its forecasts that was contained in its recent earnings results. And therein lies the rub. The company is performing very well, but much of this is already considered in the price and investors seem to be relying on earnings upgrades in order to take the stock higher.

It’s not a stock I would be chasing right now but it is well worth a look if we see a dip in the markets because it does have good prospects and the management is executing very well with its multi-channel approach.