Home improvement stocks have been one of the shining lights in retail over the past five years, up 32.3% compared to 12.9% for the S&P 500.
Investors who heavily weighted their portfolios with either Home Depot Inc (HD) or Lowe’s Companies, Inc. (LOW) have done well. So well, in fact, that neither HD stock or LOW stock has had an annual decline in its stock price since 2008.
The question on every investors’ mind at this point is whether the good times can continue. As long as housing prices continue to appreciate, homeowners are going to want to invest in their homes. Add to this a not-so-good May jobs report keeping interest rates in check and you’ve got the gas to run the engine.
So, yes, the good times can continue. Now it’s just a matter of deciding which is the better buy. A year ago, most investors would have offered up HD, but the tide appears to be turning. Is it enough for me to recommend Lowe’s over Home Depot?
Read on and I’ll tell you.
HD Stock Is Good
Home Depot’s first quarter saw revenue growth of 9% to $22.8 billion, with same-store sales up 6.5% globally and 7.4% in the U.S. A strong showing indeed.
On the bottom line, its first-quarter earnings were $1.8 billion, 12.5% higher than in the same quarter a year earlier. On a per-share basis, Q1 2016 earnings were up 19% year-over-year. The 650 basis point differential is due to $8.2 billion in share repurchases over the past 12 months and $1.2 billion in the first quarter alone.
In addition to the buybacks, HD paid out $862 million in the quarter, allocating 57% of its $3.6 billion to shareholders.
Not only did Home Depot deliver solid first-quarter results, it also raised its fiscal 2016 guidance. It now expects revenues to increase by 6.3% for the entire year with same-store sales growth of 4.9%. In addition, it sees earnings per share growing by 15% in 2016 to $6.27. How many retailers can say they raised guidance for 2016? Not many.
While the good news from Atlanta keeps coming, investors seem willing to overlook warning signs that not everything is perfect at the world’s largest home improvement retailer.
When Home Depot stock started on its impressive eight-year run back in 2008, long-term debt represented 26% of its total assets; today that’s 47%. Back then you paid 50 cents for every dollar of revenue; today, investors are prepared to pay $1.90 for every dollar of revenue despite the fact its leverage has doubled. That’s fine while interest rates are low but not so good when they move higher.
Yes, you can argue that in 2008 the price-to-sales ratio of the S&P 500 was 0.9 and now it’s 1.9, so investors are paying more for everything (low interest rates mean no choice but equities) and not just Home Depot, but that doesn’t make it right. Essentially, HD investors have gone from paying 44% less than the S&P 500 per dollar of revenue to paying the same amount as the index.
Is the upside potential after eight consecutive years of growth worth exposing yourself to this kind of specific company risk? Probably, but it’s something to keep in mind should interest rates change.
LOW Stock Is Better
Mad Money host Jim Cramer loves Lowe’s.
“While I like both stocks, I have to respect the changing of the guard and tell you that I prefer Lowe’s right here. That said, if Home Depot gets clocked back to the low $120s, we may need to recalibrate,” Cramer recently said about Lowe’s.
I’m not saying you should buy LOW stock over HD stock because he changed his mind about which is the better buy, but it certainly should make you think. You might not be a fan of Cramer’s, but he does know a thing or two about stocks.
Specifically, Cramer likes three things about Lowe’s in comparison to Home Depot: First, it’s doing a better job on top-line growth; second, it’s doing a better job on bottom-line growth; and, third, LOW stock is cheaper to own at the moment. More growth for less. What’s not to like.
Lowe’s same-store U.S. sales grew 7.5% in Q1 — an all-important 10 basis points better than HD, the first domestic beat since Q2 2010. That’s 22 quarters for those counting. Overall, its same-store sales growth of 7.3% beat Home Depot by 80 basis points, only the second time in 27 quarters it has been able to pull off this feat.
Considering analysts were expecting 4% same-store sales growth from Lowe’s, the company’s performance suggests it’s doing a good job luring the non-expert home improvement customer into its stores. If it continues like this, investors can expect the same thing to happen in future quarters.
Lowe’s gross margins shrank by 43 basis points in the first quarter compared to Q1 2015. Don’t take the head fake. Lowe’s did a great job on the bottom-line in Q1, cutting SG&A expenses by almost a full two percentage points, and in so doing increased its operating margin to 9.4% from 7.8% in the same quarter a year earlier. That’s an extra $257 million in pre-tax profits.
Cha-Ching.
As Cramer points out, Lowe’s stock’s valuation is far less than HD at the moment. On a price-to-sales basis, it’s almost 40% cheaper. When it comes to cash flow, Lowe’s multiple is 13; HD’s is 17. Investors are paying 31% more for the same dollar of cash flow. Considering Lowe’s is matching HD in terms of growth, this hardly seems like a justifiable premium. The market is clearly mispricing Lowe’s stock relative to HD.
Bottom Line
One thing missing from most of the business media’s attention regarding these two stocks is Canada. Few in the U.S. seem to be talking about Lowe’s $2.4 billion acquisition of Rona which creates a C$6 billion business in Canada and a major competitor to Home Depot in the $45 billion home improvement market.
Lowe’s couldn’t pull off the Rona acquisition in 2012, but now that it has, the duopoly created in Canada is even more significant than back home in the U.S.
I’m not sure investors in the U.S. realize how important this transaction is to Lowe’s ability to compete in Canada. Prior to owning Rona, it was playing catch-up with Home Depot. While integration isn’t going to be easy given Rona’s mix-and-match store size, ultimately, the removal of Rona from the equation is definitely addition by subtraction.
All things considered, I don’t see how you can favor HD stock over LOW stock — especially if you believe in growth at a reasonable price.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.
