The Only Home Improvement Stock To Own

Joseph Hogue's picture

Tuesday, March 31, 2015 - 1:30pm

by Joseph Hogue

The housing market is currently giving mixed signals. New Home sales are rising, but sales of existing homes have been disappointing.

One of the key headwinds is the issue of affordability.

There are only 1.9 million homes for sale, as many potential sellers decide to keep their house off the market for now. That lack of availability is driving prices, up 7.5% over the last year. The National Association of Realtors' Chief Economist Lawrence Yun called this an "unhealthy" price increase.

Perhaps the housing recovery will merely be slow-and-steady, rather than the more robust rebound that many have been anticipating. Millennials have yet to embrace home ownership in the same way as prior generations, and weak wage growth is an impediment for buyers seeking to move to bigger homes.

Rising prices and weak availability of homes for sale may mean that people decide to stay in their current home and remodel instead of looking for other options in the market. This is contributing to an aging stock of homes with roughly two-thirds of U.S. houses more than 27 years old.

This could all turn out to be good news for home improvement retailers. Sales for these firms are expected to increase between 2% and 4% above general economic growth, which is estimated at 3%.

Slow And Steady Rebound

The world's largest home improvement retailer, The Home Depot, Inc. (NYSE: HD) has a sales base of around $83 billion. Its largest rival, Lowe's Companies, Inc. (NYSE: LOW), has roughly $53 billion in annual sales.

The two share very similar business models, with a primary focus on North America. However, they differ in key respects, which leads me to believe that one of them could provide outsized returns.

Despite strategic missteps (such as an ill-fated foray into the Chinese market), Home Depot has outperformed Lowe's in many profitability and efficiency metrics. Home Depot has higher margins and inventory is moved more quickly. Lowe's does have a more favorable debt-to-equity ratio, but Home Depot's return on invested capital is nearly twice that of the smaller peer.

Shares of Home Depot may have a good shot of outperforming over the next year on new initiatives as well. After decades focusing on growth, Home Depot is now targeting efficiency and is reorganizing its distribution network. That could drive margins even higher. Management predicts a 60 basis point improvement in that metric to roughly 13%.

HD recently launched an intuitive smartphone application with an integrated mobile checkout that could improve customer service. Management expects sales to grow in the 3.5%-to-4.7% range this year, contributing to 10% growth of earnings per share, or EPS. Some of the EPS growth is attributable to a $4.5 billion share buyback.

Shares of Home Depot are relatively cheaper at 25.5 times trailing earnings, versus a multiple of 28.4 for shares of Lowe's.

Investors may also question the current consensus EPS growth forecasts. While analysts expect Home Depot to boost EPS by 14% in fiscal (January) 2016 (higher than management's guidance of 10% noted earlier), Lowe's per share profits are expected to grow by a more robust 24%. That looks like a stretch when you consider that sales are expected to rise around 5%.

Risks To Consider: The correlation in returns of the two companies shows that larger macroeconomic forces dominate prices. While Home Depot may be a better bet, both retailers could take a hit on economic weakness.

Action To Take --> Take advantage of housing tailwinds for home improvement retailers and position your portfolio in best-of-breed Home Depot for upside potential against its main rival.

Want to avoid the hassle of digging into a company's financials and decoding corporate lingo? StreetAuthority's Stock Of The Month delivers full analysis of one premier investment to your inbox each month. To learn more about this service, click here.

Joseph Hogue does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.