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.

Time to Buy Stanley Black & Decker?

There are three positive earnings drivers to look out for with Stanley Black & Decker( NYSE: SWK), and if they all come together in 2013, then this stock has significant upside potential. It is a nice mix of value and growth.The company offers a nice mix of improving end markets, ongoing cost savings from synergies created via acquisition integration, and it has a strategic growth initiative in place in order to drive revenue growth and return on capital. In this article, I want to look at how these three facets are playing out so far this year.

End market prospects

The recent results were a mixed bag, as estimates were missed but the full year guidance for EPS and free cash flow was maintained at $5.40-$5.65 and $1 billion, respectively. The strength in its mix of business is undoubtedly coming from its construction and do-it-yourself (CDIY) segment and it is set to continue. Meanwhile, its security and industrial segments have more subdued prospects this year.

A breakdown of segmental profits in the quarter.

The results were superficially disappointing. Organic revenue declined 1% overall, and it was only the 4% contribution from acquisitions that caused the top line growth of 3%. Moreover, cash outflows were greater than expected in the quarter and its core CDIY segment saw flat revenue. It gets worse. Security revenue fell 1% on an organic basis as did industrial revenue. So, is this a story of declining organic growth and an over reliance on acquisitions? And where does the confidence to maintain full year guidance come from?

The 2013 guidance is for mid-single digit revenue growth in CDIY, and flat to low single digit growth for security and industrial, respectively. With regards to CDIY, there were three issues of which two look like they will be rectified in due course.

Firstly, there is a late start to the North American outdoor season which was primarily caused by the weather. Secondly, there has been some temporary weakness in Latin America due to a variety of reasons. Interestingly, Whirlpool (NYSE: WHR) said a similar thing about the region, and in particular with Brazil. Both of these companies are arguing that this is a temporary setback and Whirlpool shareholders should take heart from the positive trends expressed for Latin America in these results. Sequentially, things got better in Q1 and this gives confidence that Q2 will be better for both companies.

The third issue is -- you guessed it -- Europe, but investors need to recall that comparisons are likely to get easier going forward. Security’s exposure to Europe is worrying (and there was some temporary weakness in the Nordic regions), but an extra $15 million of cost synergies from the Niscayah acquistion are expected. This should help out margin growth. It’s a similar story with industrial where moderate U.S. growth is hopefully going to offset weaker conditions in Europe.

Another company displaying confidence in the North American outlook is Masco (NYSE: MAS). This is more of a leveraged play on new housing construction, and its margin expansion and operational leverage opportunities will come from new builds, but its repair and remodeling market is also expected to grow moderately. Frankly, I think the latter tends to key off the former, and as long as there is good turnover in housing, then prospects will get brighter for all the companies discussed here.

Acquisitions working well

The scorecard over its acquisition strategy over the last few years is positive. It has been a difficult few years for housing and construction related stocks, but I think it has done the right thing in trying to drive cost synergies with its acquisitions. As discussed above, there is an extra $15 million to come from Niscayah (security) which should bring the total for 2013 to $50 million, and management is currently evaluating the potential for increasing the targets for 2014.

Strategic growth initiative

I’ve haven’t got the room to discuss this in great depth here, but investors wanting more color on this can find it in an article linked here.

A graphical summary of the plan to increase revenue by $850 million and profit by $200 million within three years is shown below.

Its early days, but the plans were declared as being ‘on track’. Indeed there was a bit of extra investment in this program although there was no adjustment to the targeted CapEx/Revenue figure of 2.5%-3.5%.

The bottom line

This is an attractive proposition and if it can hit its $1 billion in free cash flow, then the stock would be generating nearly 6% of its enterprise value (based on the current share price of $77). This is cheap for a company expected to grow revenue in mid-single digits and earnings in the mid teens for the next few years.

Ultimately, investors will have to price in the uncertainty that it will hit these targets. If you are positive on the global economy, then this stock is going to give you some upside potential and I think a target price in the mid $80’s is not unreasonable. A good GARP candidate.

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.