By Amy Tsao The past few months haven't been kind to retailers. The Standard & Poor's Retail Index has declined 2.5% so far this summer. Home-improvement retailing has been no exception. It's contending with the tail end of a mortgage-refinancing boom and doubts over whether housing demand and consumer spending will hold up as interest rates keep rising and oil prices hold at sky-high levels.
However, the giants of the business -- Lowe's (LOW) and Home Depot (HD) -- haven't been hurt too badly. This summer, Lowe's stock has fallen 7%, to $47, while Home Depot shares are down 2%, to $33. Both are trading just above their 52-week lows.
Most analysts expected the companies to match consensus earnings expectations and deliver relatively upbeat views of the future when they report second-quarter earnings. On Aug. 16, Wilkesboro (N.C.)-based Lowe's reported earnings per share or 89 cents, 2 cents short of analysts' consensus forecast, but within the range the company had promised previously, says SG Cowen analyst Joe Feldman. Atlanta-based Home Depot on Aug. 17 beat the consensus expectation of 64 cents earnings per share, reporting 71 cents a share in the quarter.
ROBUST TURNOVER. Don't expect any fading of the optimism for the rest of 2004. "Even though it's going to be challenging, neither will take down earnings targets for the second half," Feldman predicts. He recommends both stocks and figures they can outdo the overall stock market by 15% to 20% over the next year. (Feldman doesn't own the stocks, and his firm has no banking relationship with either company.)
As the Federal Reserve continues its tightening cycle, rising interest rates will take some zip out of the last two years' home-buying pace and mortgage-refinancing fever. While the housing market loses velocity, however, home-improvement retailers' fundamentals could keep them chugging along.
For one, housing turnover -- existing and new home sales combined -- has been robust in recent months. That bodes well for the retailers, since they typically see solid demand in the six months to nine months after strong housing-sector gains, says Feldman. Home sales were strong for the first half of 2004. "The numbers have been bumpy, and the growth rate overall has moderated a bit, but levels are still strong," adds Feldman. "That gives Home Depot and Lowe's support at least through the rest of the year."
ALREADY SPOOKED. Moreover, rising rates aren't the scary prospect some might think. "The reality is that the impact isn't what [Wall] Street perceives it will be," says Donald Trott, a retail analyst at Jefferies. If mortgage rates shot up 2 percentage points that would spell big trouble for home-improvement retailers, but rates are expected to crawl higher. "Being spooked by rising rates has already happened," Trott says. (Jefferies doesn't have investment banking relationships with either Lowe's or Home Depot.)
Of the two, Lowe's is likely the more appealing investment opportunity in the near term. Over the last two years, it has overtaken Home Depot as one of retailing's hottest growth stories, even though the latter has far more stores. At the start of Home Depot's fiscal year on Feb. 1, it had 790 outlets in the country's 25 largest metropolitan markets, while Lowe's had just 290.
"There is a very high visibility of ongoing attractive expansion opportunities at Lowe's," says Trott. Earnings growth for the next two years will be about 20%, due, in large part, to the store growth Lowe's has in its sights. Trott owns shares in both names and has a buy rating on Lowe's stock, figuring the price can rise to $58 in the next six months.
THIRD-QUARTER WATCH. Home Depot isn't growing nearly as fast, but it's likely to hold its own over the long term, says Trott. Efforts at sprucing up aging stores and implementing new technology systems are starting to pay off. Home Depot is also getting higher profit margins as it bolsters appliance sales. That business should be solid going forward, notes Charlie Georgas, analyst at Marquis Investment Research, since it's less sensitive to interest rates.
"Home Depot stock is a good value right now," Georgas says, adding that the share price could rise by as much as 4 cents on Aug. 17 if the company tops consensus earnings expectations, as he predicts it will. (Marquis Investment Research doesn't perform investment banking, and Georgas doesn't own either Lowe's or Home Depot stock.)
Neither retailer astonished investors with home-run earnings in the second quarter, and going forward both will likely have a hard time besting impressive sales and earnings reported in the second half of 2003. Last year, Lowe's had a 12.4% increase in same-store sales in the third quarter, while Home Depot posted a strong 7.8% gain. But expectations have fallen low enough that it didn't take too much to get the Street excited as the retailers reported quarterly earnings this week. Investors reacted positively as the companies gave better-than-anticipated outlooks for the rest of the year.
While the housing sector might not be on the tear that it was, home-improvement retailers aren't going to fade any time soon -- and both Lowe's and Home Depot are seen as attractive long-term investments. Tsao is a reporter for BusinessWeek Online in New York