By Kris Rosemann
Though there are many way to slice and dice the numbers, total employment continues to grow, helping consumers’ personal income levels, and gas prices have significantly reduced everyday expenses for the average American. Home improvement retail is benefiting materially, from our perspective, and we point to a number of trends that are driving Americans to spend more on their homes, “Is the Time Right to Invest in Home Improvement (Aug 2015).” Though many subdivisions across the country remain unfinished, “What’s the Deal with US Housing? (May 2015),” we’re even started to see life out of the builders in some previously abandoned areas.
Things are looking up…
Home Depot (HD) and Lowe’s (LOW) embraced the late-arriving winter last year, which came on the back of the warmest autumn in the lower 48 states since record-keeping began in 1895. Homeowners were able to continue with their outdoor projects far longer than they may have normally, but there were other, perhaps more significant contributors to demand for home improvement products. Positive signs prevailed in a variety of housing data metrics, including home price appreciation, housing turnover, and household formation data. Homeowners continue to invest in their homes, whether a recently-purchased house, a house they are preparing to sell, or tailoring a living space to a newly-formed household.
Home Depot grew sales in its fiscal fourth quarter, ended January 31, by 9.5% on a year-over-year basis to $21 billion. Comparable store sales jumped 7.1% as total comparable transactions advanced 5% and comparable average ticket price increased 2% from the year-ago period. Big-ticket purchases, tickets of $900 or more, leapt nearly 12% in the quarter. Demand for items such as appliances, roofing, and special-order kitchens remain high thanks to the desire of consumers to continue investing in their homes.
Lowe’s also reported solid top-line growth in its fiscal fourth quarter, ended January 29. Net sales increased 5.6% on a year-over-year basis to $13.2 billion, and comparable store sales advanced 5.2%. Comparable transactions grew 3.6%, and the comparable average ticket gained 1.6% from the year-ago period. Every one of the firm’s product categories delivered positive comparable store sales in the quarter, showing a reasonable balance between outdoor and indoor projects taking place despite the quarter falling mostly in the winter season.
Home Depot’s bottom line fared just as well, if not better than its top line in its fiscal fourth quarter. Operating income leapt more than 16% to $2.5 billion, and earnings per diluted share advanced more than 11% to $1.17 thanks to the operating margin expanding ~70 basis points and sales per square foot increasing nearly 7%. The company’s online business increased its efficiency in the quarter as well, and it grew 25% over the fourth quarter of the previous fiscal year. Also, 40% of all online purchases are of the pick-up-in-store variety, further improving the efficiency with which Home Depot is able to generate revenue.
Lowe’s performance on the bottom line wasn’t as strong as Home Depot’s on a GAAP basis, as the firm realized a non-cash impairment charge of $530 million related to its decision to exit its joint venture in Australia, where its opinion of the long-term opportunity has waned. However, after adding back this impairment charge, pre-tax earnings increased more than 20%, and its pre-tax earnings margin improved ~70 basis points. Earnings per diluted share on an adjusted basis jumped more than 28% to $0.59 in the quarter as well.
Looking ahead to the firms’ fiscal 2016, the home improvement market is anticipated to remain strong. Nearly all of the factors that led to strong growth in the most recently ended quarter are expected to remain for the near term, and lower market interest rates as evidenced by recent movements in the yield curve could provide an added boost. The upward wage pressure being felt by most of the retail sector has crept its way into home improvement, but Home Depot and Lowe’s are growing and executing well enough that it has not played a meaningful role yet.
Home Depot expects full fiscal 2016 sales to grow between 5.1%-6% with comparable store sales growth of 3.7%-4.5%. Comparable store sales growth is likely to be loaded in the back half of the fiscal year due to the continued integration of recent acquisition Interline–its new maintenance, repair, and operations (MRO) offering–which will have its anniversary in August. Earnings per diluted share are expected to grow by 12%-13% after share repurchases to a range of $6.12-$6.18 in the full fiscal year as well. Lowe’s is expecting strength similar to Home Depot’s for its fiscal 2016. Comparable store sales growth of 4% and the opening of 45 new stores are expected to drive net sales growth of 6% in the fiscal year. Operating margin improvement is expected to continue, and earnings per diluted share are expected to leap more than 21% to ~$4.00.
Despite expectations for solid growth, underlying fundamental strength continuing to drive the home improvement retail industry, and optimistic dividend potential, shares of neither Home Depot nor Lowe’s are enticing at the moment. Both have been overvalued for some time and continue to trade well above our fair value estimates of $103 and $58, respectively. The biggest problem we have with shares of each is that investors tend to forget that home-improvement demand is cyclical, and when the market weakens, sales and earnings come under tremendous pressure. We saw what happened during the Financial Crisis, and while we’re not expecting anything as severe to happen again, even something of modest severity could provide a far better entry point for existing investors than today.
The housing cycle is just that, a cycle, and when the dark days come (and they will), share prices will become much more palatable for new money.
Related ticker symbols: LL, XHB, ITB