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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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.

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.

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.