Home Depot Earnings Signal a Strong Housing Market

In an earnings season marked by talk of slowing U.S. growth, Home Depot's (NYSE second quarter served notice that the housing market remains in good health. The market would have been excused for some apprehension ahead of the earnings report. After all, painting company Sherwin-Williams, which works in an industry closely allied with spending on housing, was forced to reduce its full-year guidance amid talk of "unprecedented rainfall" that reduced end-demand growth in the United States. However, Home Depot raised full-year guidance, and the market promptly took the stock to an all-time high. Let's take a closer look at the earnings


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Home Depot and Lowe's Companies on the Housing Market

The U.S. housing market has unquestionably had a weak start to the year, and there is no shortage of top-down analysis on where the market is headed. Analyzing the macro-economic climate is one thing, but investors can also get a good view from what Home Depot and Lowe's Companies are saying.

What's going wrong?
Essentially, many are concerned a combination of rising mortgage rates and insufficient inventory are holding back housing turnover. Indeed, house price growth appears to have stalled since September 2013.

Source: S & P/Case Shiller

The question now is whether the housing market is going to stall, or if employment gains and an increase in credit availability (which would help counter any affordability issues) will push the housing market higher.

Evidence from Home Depot and Lowe's indicates that the underlying picture in the housing market is stronger than what the headline data suggested in the first quarter.

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Home Depot and Lowe's Equity Research

There was no shortage of reasons for investors to worry before Home Depot and Lowe's Companies gave results recently. The slowdown in the housing market in the second half of 2013 had the market concerned going into the earnings reports. Moreover, some recent lackluster earnings reports from retailers encouraged some investors to conclude that Home Depot and Lowe's would disappoint. In the end, they both delivered sold results. But the question is: What are their prospects going forward?

Home Depot and Lowe's report earnings
As ever with retailers, the key is to follow movements in their comparable-store sales. The latest data confirms that Home Depot is outperforming Lowe's, and it also suggests that growth is slowing for the home-improvement retailer.

 

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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.

Despite The Sell Off, Lowe's Looks Good Value

Investors in Lowe's  must have felt they were living in some kind of parallel universe after the company's excellent set of results were greeted by a 6.2% markdown on the day. As ever, the usual knee-jerk response from journalists was to seek out any possible negative in the company's report or commentary. Lowe's results were a lot better than many made them out to be.

What really happened?
Perhaps the most relevant news on Lowe's results was the old news! The stock had such a major run up before the results that almost anything it said could somehow have been construed as a disappointment.

Not only had Lowe's share price increased by more than 50% in the last year, but it was also outperforming its main rival Home Depot .

Home Depot data by YCharts

While it's true that economic commentators have been becoming a little more cautious on the housing market due to higher interest rates, you certainly wouldn't have noticed it from Lowe's stock performance prior to the results.

Frankly, the sell-off after the results looked like a correction of an overbought move and possibly some hedged pairs trading going on with Lowe's versus Home Depot. In other words, traders might have favored buying Home Depot and shorting Lowe's. 

In reality, there were a number of positives from this report.

First, full-year earnings-per-share guidance was raised for the second time this year and now stands at $2.15.

Second, Lowe's management gave a positive industry outlook. Management forecast that growth would persist in the fourth quarter and went on to state "we expect further acceleration of industry growth next year."

Third, it confirmed that its program of product resets achieved around 100 basis points in gross-margin improvement once the product lines "reached stabilization."The reset program is a project to adjust the products the company sells in order to normalize inventories across categories. Stabilization just refers to when it has cleared out the old inventory.

Clearly, the project is working and Lowe's said that only 66% of its business was stabilized by the end of the quarter. Investors can look forward to margin improvements from the remaining 34% in the future, as well as from the 20% of its business that hasn't even been subject to resets yet.

Finally, the makeup of its sales is suggesting industry strength. Lowe's declared that its Pro sales "continue to outpace our [do-it-yourself] consumer." Indeed, only a day earlier, Home Depot said a similar statement when its management declared "the recovery of our pro business continues in the third quarter, our pro business grew at a slightly faster pace than our consumer business." Both companies see this as a sign of cyclical strength in housing.

In addition, Lowe's performed well with its large product categories such as flooring, kitchens, and appliances. This is in line with what appliance makers like Whirlpool  are saying about the marketplace, and customers' willingness to replace appliances that they bought 10 years ago at the height of the housing bubble. It also confirms the positive outlook in the remodeling market index by the National Association of Home Builders.

Weak spots?The report was generally positive, but there were some points of caution. While appliance sales were strong, the level of promotions was significant enough to reduce the gross margin by 10 basis points. Such developments will obviously concern Whirlpool investors, especially as LG has now been added to Lowe's appliance offerings.

In addition, Lowe's has Samsung and LG appliances highlighted on its floors. This is especially relevant given that Whirlpool won an anti-dumping ruling against LG and Samsung earlier this year.

The second possible sore point was that its forecast of 5% full-year comparable- sales growth implies 4th quarter comps growth of around 4%. As the graph shows, this is somewhat lower than the last two quarters.

Source: company presentations

On the other hand, last year's fourth quarter was positively affected by sales due to Hurricane Sandy. Furthermore, the full-year forecast of 5% is an upgrade from the second quarter guidance of 4.5% and first-quarter guidance of 3.5%. It's hardly bad news.

The bottom line
In conclusion, this wasn't a bad report at all. It's just that the stock had run up too much and investor expectations were probably too high Provided the housing market stays on track, the stock looks to be a good value on a P/E ratio of 17.8 times forward earnings as I write. 

What GE's Results Say About the Sectors You Should Invest In

Industrial conglomerates like General Electric (NYSE: GE  )  make good bellwethers for different sectors of the global economy -- and if its most recent quarter's any judge, the economy's looking pretty good. 

GE reports broad-based strength

With the sole exception of health care services, each of its six industrial segments reported growth in equipment and services orders. 

The most surprising aspect of GE's report was how strong its power & water segment orders were. The segment has been GE's Achilles' heel this year, but wind units posted strong results, with 477 orders vs. 87 last year. Moreover, GE expects fourth-quarter power & water orders to come in at the higher end of its previous guidance. 

Source: Company presentations.

While it was posted a strong quarter all around, GE's quarterly results always need to be put into the context of ongoing trends, because big-ticket capital machinery sales tend to be lumpy at the best of times.

The key takeaways from GE's third-quarter results

 While this quarter saw broad-based growth, there have been four consistent areas of strength in GE's results throughout the year.

• Commercial aviation
• US home appliances
• Emerging-market health care
• Global transportation

GE's aviation revenue was up 12% in the quarter, but this increase belies a clear distinction between commercial and military aviation. For example, its military orders were down 30% in the quarter. In fact, this story has been replicated throughout the year, as investors have played a game of trying to find the aviation stocks whose revenue is weighted toward commercial aviation.

One obvious beneficiary of this trend is a company like B/E Aerospace (NASDAQ: BEAV  ) . The company makes commercial aircraft cabins, and the stock has soared 57% year to date on the back of record order books at Boeing and Airbus.

Moreover, BE Aerospace just reported its own record order book of $900 million in the quarter, and it announced the first delivery of its modular advanced lavatory system. While that doesn't sound glamorous, the toilet gives airlines a few extra seats on their planes, which could help them increase revenue for each flight for years to come.

GE also announced that household appliances within its home & business segment increased 11% -- an ongoing source of strength. Similarly, Whirlpool has twice upgraded its expectations for end demand from the US.

This must be good news for the home improvement stores like Home Depot or Lowe's Companies (NYSE: LOW  ) . Not only is the current upturn in the housing market helping out spending at Lowe's, but investors need to recall that we are coming up against the 10-year anniversary of the housing boom. In other words, Lowe's should start to see customers coming in and looking to replace white goods that they bought at the peak of the boom. Moreover, Lowe's is strategically resetting its product lines, which is a lot easier to do when markets are picking up.

The third key takeaway is that emerging markets offer far better growth prospects for health care companies. Within its health care segment, GE's developed markets grew 1%, while the emerging markets grew 14% with 33% in China alone. This is a clear sign that investors should be favoring a company like Covidien (NYSE: COV  ) , which can outgrow its health care markets. Covidien's big plus is that its products aren't big-ticket items -- an important quality when selling to emerging markets. Moreover, it can demonstrate a tangible return on investment with things like minimally invasive surgery, and its key endo-mechanical  and energy products still haven't gained much of a presence in emerging markets.

Where next for General Electric?

In conclusion, it was a pretty good quarter for GE, and the return to strength of its power & water segment confirms it's on track to hit analyst earnings estimates of $1.63 this year. This would put the stock at P/E ratio of around 16 -- not a bad value for a stock with a near-3% dividend yield and a good chance of growing faster than GDP over the next few years.

Whirlpool is Still Good Value

Investors in home appliance manufacturer Whirlpool (NYSE: WHR) have seen a near-90% rise in its share price over the last year, and many of them must feel tempted to take some profits. But the company has a number of positive things happening for it in 2013. And  if it continues to execute in moving towards hitting its long-term targets, Whirlpool could have plenty of upside left.

Whirlpool upgrades guidance

In line with many other companies in the current reporting season, Whirlpool reported that North American conditions were strengthening, while Europe remained weak and Asia weakened somewhat. Indeed, a quick look at its updated expectations for industry demand tells the tale:

Industry Demand Assumptions	Previous Outlook	Current Outlook
North America	2% to 3%	6% to 8%
Europe	flat	flat to -2%
Latin America	3% to 5%	1% to 3%
Asia	3% to 5%	flat

Source: Company presentations.

Eagle-eyed readers will note that only the forecast for North American was raised, but the good news is that this is the key region for the company. Whirlpool generates nearly 55% of its revenues from North America, and a graph of its regional profits illustrates that its importance:

Source: Company accounts.

With regard to revenue, North America makes up nearly 54.8%, with Latin America contributing 25.3%, EMEA around 15.4%, and Asia with only 5.2%. For those of you worried about a potential slowdown in China’s housing market, the good news is that Whirlpool is not particularly exposed.

For this reason alone, the stock is more attractive than home-improvement toolmaker Stanley Black & Decker (NYSE: SWK). A large part of Stanley Black & Decker’s growth prospects come from its strategic growth initiative. The plan involves aiming to increase revenues by $350 million within emerging markets, and China makes up a big part of its growth intentions. Although Stanley Black & Decker has a similar exposure to Whirlpool in North America, the market won’t waste any time in marking down the former if its growth prospects diminish in China.

The really good news for Whirlpool investors was that its overall guidance was upgraded. Ongoing diluted EPS forecasts were raised to $9.50-$10.00 from $9.25-$9.75 previously. Equally importantly, its forecast for free cash flow was raised to $650 million-$700 million from $600 million-$650 million. Some investors have worried about Whirlpool's lack of cash flow generation in recent years, but given ongoing margin expansion, the company looks set for strong growth in free cash flow.

The three reasons why Whirlpool’s prospects will get better

Firstly, its ongoing productivity improvements and restructuring are seeing genuine improvements in margins. Whirlpool’s long-term target is to get operating margins up to 8%, and on current trends, that looks achievable.

Source: Company accounts.

The second reason is that the U.S. is approaching the 10-year anniversary of the housing market boom. This is important, because the large number of appliances bought at the top of the market will increasingly need replacements.

For example, here is the data on total home laundry product shipments from the Association of Home Appliance Manufacturers:

Source: Association of Home Appliance Manufacturers.

Obviously, home-improvement stores like Home Depot (NYSE: HD) and Lowe’s will also be beneficiaries from these trends. Indeed,  in a  sign that the cycle is turning, Home Depot is starting to see its professional sales outpacing its consumer revenues. Moreover, the segments of its sales that outperformed in the last quarter involved things like kitchens, electrical, décor, lighting and hardware. These trends are positive for Home Depot because they imply an increased willingness among consumers to spend on discretionary items. Moreover, they are the kinds of goods that Whirlpool sells.

The final reason is that the housing recovery is encouraging new housing construction. This is good news for Whirlpool, because it will spur sales growth 6-9 months down the line as new homeowners start to purchase home appliances. In addition, this trend could boost profits, because the types of appliances bought by new homeowners tend to carry higher margins.

The bottom line

In conclusion, Whirlpool has some very positive trends in its favor. If it hits the targets of expanding operating margins and cash flows, then the stock can appreciate from here. Analysts have it on a consensus forecast EPS of $11.85 for 2014. This puts the stock on a forward valuation of less than 11 times earnings, as I write. That number looks too cheap. Provided the company hits expectations, Whirlpool shares represent a good value  for long-term investors.

Why Costco is Outperforming

The retail sector usually makes sense,or at least we can delude ourselves that we can make sense of it all. There are obvious macroeconomic trends filtering through into the results of the companies in the sector. From the dollar stores to the high end, through the specialty stores and the online based companies, there are discernible patterns we can use to gauge future performance. And then there is Costco Wholesale (NASDAQ: COST).

Costco executes

I last looked at Costco in an article linked here and highlighted how well the company was doing but also inquired as to where the value was in the stock price.  The answer to my question was that it lies within its ongoing execution and ability to service its customers with the goods they want. As investors, we are more interested in its stock price potential rather than its company performance per se, but in this case I think the stock’s evaluation of 24x trailing earnings is at a level where the two things are correlated.

This chart helps to outline how well the company has been doing over the last year:

Clearly gross margins have been expanding over the last five quarters (note that the yearly comparisons are starting to get tougher too) while comparable sales growth remains good too. Overall revenue growth remains in the high single digits, and the company’s expansion program (particularly internationally) remains on track. Indeed, Costco expects to finish the year with 28 new openings as opposed to 16 last year. Of the nine more expected for 2013, three are planned for the U.S. and the other six are international.

What is Costco doing right?

And, more pertinently, can it continue to do these things right? I have a five main points to discuss from its recent Q3 results.

Firstly, Costco’s traffic remains strong and it reported year to date frequency up 4-5%. Costco cited the draw of its gas sales (30% of people buying gas go on to shop at Costco), fresh food (which has seen increased demand as the slow economy has reduced the demand for eating out), and the ‘wow’ factor of many of its items.

Second, I think the psychological effect of inducing people to shop at Costco after they have paid a membership fee is a sound one based on many of the principles inherent in work on behavioral studies. I think a membership fee is looked at as a sunk cost, but since people will ‘pay’ more to avoid a ‘loss’ they will shop at Costco in order to do this. Of course if that cost increases (and Costco has hiked membership fees in recent years) than the feeling of 'loss' will increase and customers may be induced to shop more at Costco.

Third, membership fee increases have not encouraged churn. In fact business renewal rates started and finished the quarter at an impressive 93.9%. New membership signups increased 19% with particular strength in Asia. Membership fee income increased 12% to $531 million.

Fourth, Costco continues to generate growth where others can’t. In particular I was struck by the strength within hard lines where it recorded strong growth in lawn and garden and consumer electronics.

And lastly, Costco continues to reduce its stock keeping units (SKUs) in order to optimize inventory turns and profitability.

Costco is, of course, not alone in many of these activities but it compares very well across the sector because it does all of them well. For example Lowe’s Companies (NYSE: LOW) has an ongoing plan to reset its product lineups in order to reduce SKUs and ‘normalize inventory.’ While this may appear routine stuff, Costco has been doing it well for years while Lowe’s has had to adjust because it wasn’t doing it well. With that said, Lowe’s actually has some upside potential from successful execution of this plan.

Moreover, Lowe’s (and Home Depot for that matter) both reported that outdoor and garden items were a bit soft in the last quarter thanks to the late spring. In comparison Costco cited these categories as being strong.

Whither Wal-Mart?

Costco isn’t alone in its membership fee model as BJ Wholesale and Wal-Mart’s (NYSE: WMT) Sam’s Club also take membership. Wal-Mart is following Costco by increasing its membership fee but its execution is nowhere near Costco. For example its comparable sales growth (ex fuel) was only up .2% in the last quarter with traffic up 1.3% compared to Costco’s 4.5%. In addition its ticket value was down 1.1% while Costco’s was flat.

So while the economic environment is difficult and Wal-Mart on the whole has been a bit disappointing (a net sales increase of only 1.8% in the last quarter), Costco has outperformed, particularly against Sam’s Club.

The bottom line

In conclusion, while something like Wal-Mart is largely a play on the economic environment, Costco has demonstrated that its superior performance can justify an evaluation premium over Wal-Mart. The problem is that it will be pressured to continue this execution in order to be rewarded by the market. Any slip-up and/or step-up in competition from Target or Wal-Mart and its current PE of 24x will start to get hard to justify.

Is Home Depot Stll Good Value?

Investing in anticipation of a housing recovery has been one of the best trades of the last year, but with things like the home improvement stores Home Depot (NYSE: HD) and Lowe’s Companies (NYSE: LOW) hitting new highs is it time to start thinking about reducing your weighting in the sector?

My rationale in asking this question is not to question the validity of the housing recovery but rather to highlight the fact that there may well be other stocks related to it that are have better valuations. Moreover a recovery in the U.S. housing market usually precedes recoveries in other areas of the economy where investors may find investment opportunities.

Home Depot and Lowe’s Companies report

Home Depot’s recent results were certainly better received--initially at least--than Lowe’s Companies, but no matter; both stocks rose afterwards. The truth is that the market has woken up to the housing recovery and wants a piece of investing in it. As for the results, Home Depot continued its recent tradition of raising full year guidance.

Here is how Home Depot has tended to hike guidance over the last few years.

As the housing recovery as strengthened so Home Depot has continued to upgrade its full year revenue estimates. It is now three quarters in a row that it has done this, and in this set of results it noted that its pro business had started to grow quicker than its consumer business. This is a positive sign of recovery, as pro sales are seen as more discretionary-based.

Furthermore the recovery it is seeing in its end markets is becoming geographically spread with areas that were at the epicenter of the housing crisis (California, Florida, Arizona, etc) starting to recover as well.

With that said there were some challenges in the quarter with the spring weather starting a lot later than last year. This made comparables for things like garden and outdoor products a lot lower for Home Depot. However, it said that April saw a strong snap back in growth following a weak March, and May is similarly strong so far.

It was a similar story with Lowe’s Companies. It reported comparables down 10% in March, with April rising 10% and May continuing the positive momentum. In addition, the weather affected its outdoor comparables so that they were down 7%, with indoor rising 3%.

In fact the message from the macro front was pretty much the same. The key operational difference between the two is that Lowe’s has execution risk/return from its reset program. I’ve discussed this initiative in more length in a previous article. Lowe’s is aiming to complete the resets by the end of the year and announced that the percentage increased from 30% to 50% in this quarter. Unfortunately the weather effects helped to ensure that inventory normalization only increased from 20% to 30%, but if what both these companies are saying comes true, then this number should increase in future for Lowe’s.

A note of caution

In summary, both these stocks have upside from a recovering housing market and upside prospects in the current quarter as spring weather finally kicks in. Moreover, Lowe’s should see some upside potential as the benefit of the resets drops into the bottom line.  So, why the note of caution?

My only concern here is that these stocks have come a long way, and now most investors will have somewhat priced in a housing recovery. A look at their evaluations suggests that they are at levels above what they were when the housing industry entered a recession in 2006.

LOW PE Ratio TTM data by YCharts

Frankly I think that momentum and ongoing positive news on housing is going to take these stocks higher. However, investing is about trying to find the optimal ways to generate returns from your views. With this in mind I think it is time to look beyond the evaluations at the home improvement stores and look at some of the wider housing and construction plays.

Two housing and construction plays

Housing recoveries usually predate construction related improvements. New housing projects get developed which leads to new commercial construction. In this regard I think Whirlpool (NYSE: WHR) and Stanley Black & Decker (NYSE: SWK). The interesting thing about Whirlpool is that it offers upside from its push to increase margins. Given that home improvement stores are reporting good numbers it is reasonable to expect that Whirlpool will see a strong spring too. Moreover, we are hitting the 10 year anniversary of the peak of the housing boom so the replacement cycle should start to kick in soon as well. The stock trades on a forward PE of 13.3x and traditionally generates large cash flows.

Turning to Stanley Black & Decker, this stock has upside potential from a housing recovery and a strategic growth initiative with which it intends to generate growth via expanding in selected verticals while benefiting from ongoing merger synergies.

 Its recent results were a bit disappointing, but like Whirlpool it was affected by some temporary weakness in Latin America (both companies argued that it will rectify in future quarters) and from the weather effects of a late spring. At the time of both these companies results I was slightly skeptical over the weather argument but now that Home Depot and Lowe’s have confirmed its effect and, more importantly, argued strongly that growth will come back.I think this is a good sign for Stanley Black & Decker. Moreover the stock trades on trades on a forward PE ratio of 14.6x and is forecasting $1 billion in free cash flow this year.

Lowe's Companies is Still Good Value

Lowe’s Companies gave numbers on a bad day for the market and the subsequent fall in the share price means investors could be forgiven that for thinking that there was something wrong with them. Then again, that just shows that you should never take the market’s word for it! I thought the results were good and although I also hold Home Depot  I bought some Lowe’s too. No one said you can't buy both!

Lowe’s Equity Research

They may appear to be identical twins but I think Lowe’s has a bit more upside. Analysts are forever trying to make quarter on quarter conclusions over whether Home Depot or Lowe's is taking market share from each other but I don’t think analyzing their relative prospects is as simple as that. In this case, Lowe's has had a lot more execution difficulties than Home Depot following the housing market slump. The good news is that it now has upside from executing its strategy of making product line reviews and resets. In other words, it can play catch up with Home Depot by simply undergoing blocking and tackling measures in its stores.

Of course these things are much easier to do when the housing market is showing signs of strength and Lowe’s recent results reflect this. Ten of its fourteen categories showed growth in the quarter with strength in the larger ticket and more discretionary items like lumber, cabinets, and countertops. The relative weakness in its outdoor and garden sales is only to be expected after the unseasonally warm winter last year made for tough comparables.

Sandy did its bit too and overall comparable same store sales did well, rising 1.9% in the quarter.

 Why Lowe's is a Good Stock to Buy

One issue that concerned the market was the promotional activity that saw some pricing cuts. However, the promotions were targeted at specific items and are part of the program of product line reviews and resets. Lowe's is trying to normailze inventory levels across all its lines. In addition, Lowe's usually has promotions in the fourth quarter, so it’s nothing unusual. The difference this year was actually on the positive side, with the promotions being described as much more balanced than in recent years.

Lowe's has completed 80% of its product reviews and 30% of the resets and its management feels confident that when the other 70% are completed by the end of 2013, gross margins will rise as a consequence. Indeed, it achieved mid-single digit growth in the categories that have already been reset with a 100 basis point improvement in margins. The strategy is working.

I was expecting Home Depot to give a good set of results and it didn’t let the market down. Home Depot confirmed that there was broad based strength in spending across its product categories and geographically the worst affected areas of the property recession are now making sequential improvements. We can see this broad-based strength in the results of home goods companies like Whirlpool  and Masco. Whirpool is doing well in the US (although its international prospects appear less certain) and it has late cycle prospects because new home starts (which should kick in this year) will generate new business when they are sold and inhabited later in the year.  It is a similar story with Masco, which reported North American sales up 12% and its businesses selling into new home construction were up 25%. Both stocks remain good plays on housing.

Lowe's Analysis

Putting these issues together, Lowe's forecasts total sales growth of 4%, with comparable same store sales growth of 3.5% with 3% of the latter coming from internal sources. If you assume that there is a better than expected housing recovery to come, than there could be upside to company guidance.

Analysts have Lowe's on $2.09 EPS for 2013, which implies a near 24% rise in earnings to put it on a forward PE of around 17.7. In addition, it is starting to generate significant cash flows with $2.5 billion in free cash flow generated this year and $3 billion estimated for 2013. This equates to around 6.2% of its current enterprise value and if you share my belief that housing ups and downs tend to be multi-year events, then the stock still looks attractively priced given the outlook.