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3 myths put Home Depot, Lowe's in a fix
While housing stocks soar, the fix-it chains are getting hammered. Is there a good reason? Not really, and once reality sets in they'll head upward again.
By Michael Brush
Apparently the market thinks it's OK to build a home, but not fix one.
Until very recently, housing stocks like Toll Brothers (TOL, news, msgs) and NVR (NVR, news, msgs) continued to march higher in the face of rising interest rates that are supposed to snuff out growth in the sector.
But since last fall, the market has taken a buzz saw to Home Depot (HD, news, msgs) and Lowe's (LOW, news, msgs), the nation's largest home fix-it chains.
Why the disconnect? You'd think if investors were still bullish on the housing market, they'd equally like the two leading home-center chains that sell everything people buy as they set up in a new home, from appliances and lighting to outdoor furniture.
Not so. While the 12-biggest homebuilding stocks have continued to thrive since the middle of November, climbing an average 12%, Home Depot and Lowe's are down 17.3% and 12.1% as of April 27, respectively.
Both stocks are victims of three myths that are holding them back, for now. Once reality sets in and these myths are dispelled, these two stocks should march higher. That makes them good buys right now. Here's a look at the three issues haunting these two stocks, and why they are simply myths.
Myth 1: When rates rise, renovations slow
The fear here is that as interest rates go up, homeowners will have less money from refinancing to spend on home improvement. Or the housing market will cool off, hurting sales.
Both fears are misplaced.
"Historically, repair and remodel sales have been resilient in both up and down housing markets. They have grown throughout," says Kevin Grant, who co-manages the Oakmark I fund (OAKMX), which owns Home Depot shares.
Related news and commentary on MSN Money
Indeed, studies by Home Depot find that home-center business strength does not correlate at all with interest rates or housing starts. Instead, the niche's fortunes are linked to factors like consumer confidence and employment levels -- both of which bode well for the industry now, because these two indicators signal the consumer will stay strong.
"Refinance is just one source of cash people use to refurbish or renovate their houses," says Zu Cowperthwaite, an analyst Evergreen Investments, which holds shares in the home center stocks. "You also have to look at the jobs picture. Job growth and real wage growth will offset any change in refinancing."
With government spending still high and interest rates still relatively low (see my recent column here), it still doesn't look like the continuing series of Federal Reserve rate hikes will kill this economic expansion.
Another main indicator that correlates with strength in business at home centers is the sale of existing homes. Here, strength continues. And if history is a guide, we are not near a slowdown. Toll Brothers finance chief Joel Rassman says that historically, housing-market growth doesn't really start to cool off until the 30-year mortgage rate moves to 8%. We are far from that.
What's more, if the market for new houses cools off a little because of rising rates, that can benefit home centers too, says Anthony Chukumba, a Morningstar analyst. The reason: When rates rise and people can't buy new homes, they stay put and remodel their existing homes -- which sends them to Home Depot and Lowe's.
There is one wild card in all this: The price of oil. Oil has backed off from recent extremes of $57 per barrel. But if it moves back up into that range and stays there, it's not clear how long the economy and consumer buoyancy would hold up.
Myth 2: The home fix-it chains are too big to grow
According to this theory, new stores will only cannibalize business from nearby locations. The too-big-to-grow fear is more of a concern for Home Depot, since it's bigger. Home Depot has 1,890 stores; Lowe's has 1,237.
Yet both chains -- in reality -- have been growing nicely. And that should continue. Home Depot, for example, saw year-over-year earnings grow of 11.9% in the fourth quarter, on sales gains of 11.2%. Lowe's, meanwhile, saw earnings grow 30% on sales gains of 17.9%. Those are not laggards' numbers.
And both project double-digit growth going forward. Home Depot, for example, hopes to expand earnings by as much as 14% this year on sales growth of up to 12%. Lowe's is looking for earnings gains of 22% on sales growth of 17%.
But how will they get there? Both companies have discovered there's lots of territory beyond the core do-it-yourself home-repair market.
First, they're helping customers line up the labor for home projects. "You buy the lumber to build the deck, and they have someone come in to do it for you," explains Morningstar's Chukumba. "They both see this as a huge opportunity, especially as baby boomers get older and stop being do-it-yourself customers and more do-it-for-me consumers." The chains are seeing brisk double-digit growth here.
Next, the two home-center giants are expanding sales to homebuilders and professional contractors. "They have both discovered there is very healthy demand in the professional-contractor market," says Cowperthwaite, of Evergreen Investments. Another trick: They are expanding their product lines in areas like appliances, storage and outdoor furniture.
And aggressive store growth is still part of the picture. Lowe's is small enough that it can focus on growth in the U.S. alone. For Home Depot, conquering new territory means expanding in Mexico and Canada, as well. Home Depot is also setting up smaller stores in urban areas like New York and Chicago, where residents welcome a break from cramped mom-and-pop hardware stores that charge top dollar for basic supplies. Home Depot plans to open 175 new stores this year. Lowe's will launch 150.
All told, there's a $1 trillion market out there -- if you include the professional home-repair market, foreign stores and the core do-it-yourself space, estimates Home Depot. "So while we are the largest in the industry, there is significant room for growth," says Diane Dayhoff, vice president of investor relations for Home Depot.
Myth 3: No longer hot, they're hard to value
During its heyday in the 1990s, Home Depot was a hot growth holding, posting 20%-plus annual sales and earnings growth as it expanded rapidly across the country. Those days are gone. Now, investors aren't sure where the valuations for Home Depot -- or Lowe's, for that matter -- should find a base. So they are reluctant to buy shares.
In reality, both companies are popping up more and more on stock screens of value-oriented investors. Sure, in today's market, Home Depot and Lowe's could fall more. But there are two factors supporting these stocks.
First, you find solid financial strength. Home Depot generated over $6 billion in cash flow last year -- of which $3.1 billion went for share repurchases and $719 million was used for dividends. The chain has $2.2 billion in cash and short-term investments and long-term debt of $2.1 billion. "The balance sheet is in great shape," says Oakmark's Grant. Home Depot also just approved another $2 billion share repurchase plan. The company has been buying its own shares in the recent market weakness. Lowe's also has positive free cash flow -- but more debt. It has $3.7 billion in debt and $813 million in cash.
Next, given the declines since last fall, these stocks already look cheap. Morningstar, for example, has "fair value" estimates for Home Depot and Lowe's at $44 and $62 or 18% and 16% below where they recently traded. Morningstar's "fair value" means this is where the stock should trade now, based on expected earnings and cash flow. They are not 12-month price targets.
Here's another way to look at it. Home Depot and Lowe's trade below the price earnings multiple of the S&P 500. Yet they are expected to grow two to three times as fast as the stocks in that index over the next three years. That gap should be closed by gains in the shares of the two home center retail chains, says Evergreen Investments' Cowperthwaite.
"If these companies continue to deliver healthy earnings growth, ultimately the stock prices will respond," Cowperthwaite says. "We have a case of very healthy earnings growth and very reasonable valuations. I think that is a good combination for stocks outperforming."
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