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. 

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.