Summer Home Improvements Will Bode Well for These 2 Stocks

Joseph is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Back in May, real estate website operator Zillow (NASDAQ: Z) raised its revenue forecast for the year. The company also saw a big boost in subscriptions, with revenue from its marketplace business (which includes not only subscriptions by agents but also advertising by mortgage lenders) jumping 87% to $31 million. The marketplace business attributed three-fourths of the company's revenue in 2012, so seeing it jump significantly was a good sign. 

At the same time, Home Depot (NYSE: HD) was also firing on all cylinders, with the housing recovery contributing to the company's 18% increase in net income for the first quarter. Besides topping earnings estimates, the planet's largest home improvement store also raised its full-year outlook for both revenue and earnings, anticipating that the good times would keep rolling in. 

Will the good times continue?

But then came the Fed announcing that the tapering of QE may come a little sooner than expected. The threat of the Goldilocks economy evaporating and taking QE with it caused a drop in stock prices and fears that the housing recovery would go south because of increasing rates.

While some think low rates will disappear and destroy the prospect of housing sustaining its positive momentum, others think that higher rates won't slow a resilient housing recovery.

While the argument (or noise) continues as to whether the Fed will allow rates to rise, and/or if rates will or will not kill the housing recovery, Zillow has one thing to say. According to a recent Zillow Digs Summer Home Improvement Trend and Spending Survey, 60% of homeowners plan to make a home improvement or addition this summer. 

The home improvement trend...

Homeowners improving their places this summer should benefit Home Depot, as well as its competitor and second-largest home improvement store, Lowe's (NYSE: LOW).

Unlike Home Depot, when Lowe's last reported earnings in late May it failed to meet expectations, with earnings increasing by only 3%. Besides suffering from a lack of presence in the lucrative California market, the company also blamed the rainy weather, with CEO Robert Niblock saying

“Temperatures were cooler and precipitation greater than normal for much of the quarter resulting in a delayed spring selling season.” 

Lowe's needs to bump up its earnings, and a trend in home improvement may benefit the company even more than it would Home Depot-- at least in the eyes of analysts. Under-penetration of the California market may still pose a problem, however. Luckily for Lowe's, it may have a solution to this problem.

If you can't beat them, buy out a competitor to better compete with them...

While Lowe's lagged significantly behind Home Depot last quarter, it is now looking to patch up its weaknesses by acquiring the majority of Orchard Supply Hardware Stores. An acquisition would be very lucrative for Lowe's, as explained by the company's CEO, who stated

“Strategically, the acquisition will provide us with immediate access to Orchard’s high density, prime locations in attractive markets in California, where Lowe’s is currently under-penetrated, and will enable us to participate more fully in California’s economic recovery.”

Last quarter's California issue? Instantly resolved if everything goes to plan. And that's not all. The acquisition would also allow Lowe's to sell Craftsman and Kenmore products. According to the Los Angeles Times, under the current acquisition agreement Orchard Supply Hardware stores would continue operating its stores as a standalone business while also retaining its management team and employees.

Lowe's is set to serve as a "Stalking Horse Bidder" and will make its offer at the auction that will occur after Orchard files for Chapter 11 bankruptcy. While other buyers can top Lowe's current price tag if they offer a minimum of $12 million more than Lowe's offer, worst case scenario Lowe's gets a 3% break-up fee. With the exception of only two stores, all of Orchard's 91 store locations are located in California. This is why the buyout by Lowe's makes great sense for both companies.

If Lowe's $205 million offer does become reality, the company should easily be able to pull the acquisition off without suffering any immediate negative financial repercussions, especially when considering that it has about $1.2 billion in cash on its books.

Valuations

 P/E Forward P/EDividend (Yield)Market Cap (Billions)
HD 23.43 17.33 $1.56 (2.10%) $107.84
LOW 22.64 15.63 $0.72 (1.80%) $42.41

Data provided by Yahoo! Finance 06/23/2013

While the much-smaller Lowe's is cheaper than Home Depot, it also offers investors less in the dividend department. Looking closer, It also appears that paying more for Home Depot is paying more for a good reason:

Home Depot's earnings growth looks impressive, especially when compared to that of Lowe's, which managed to grow revenue more than its larger competitor but not capitalize from it as efficiently.

The bottom line

While the argument over the effects of tapering on housing will likely continue, existing homeowners spicing up their homes may be a realistic positive trend to expect that will benefit home-improvement stores. With 37% of homeowners deciding to find their home-improvement designs online, Zillow will also benefit as its Zillow Digs is the third most common online source with a growing presence.

While Zillow as a newer company is currently rather light on earnings, heavy revenue growth is a good sign for the future of a fast grower that is still establishing itself. Zillow's display advertising revenue was up over 27% in the most recent quarter, with an encouraging 55% of total revenue coming from mobile devices. Zillow is still in the process of establishing its moat as the premier online real estate website, and huge jumps in revenue and market share mean more staying power when earnings finally begin rolling in. An investor that is patient enough to wait for these future earnings may be rewarded nicely, as Zillow may become quite a play on housing.

According to the company, 93 homes were viewed each second on mobile devices during its first quarter-- a whopping 63% increase year-over-year. Zillow is clearly heading toward its goal not only as the go-to site for those looking to find a home, improve their home, or just find real estate-based information, but it is also seamlessly growing its business in the lucrative mobile market as well.

Home Depot has already been capitalizing quite nicely from a recovery in housing, coming close to tripling sales of big-ticket items (anything over $900) and merchandise over its last three consecutive quarters. Despite only adding around 12 new stores since 2008, the company has managed to increase earnings by over 35%, largely because of its ability to improve its operating margins and lower store costs. Many of the big-ticket items the company has been selling are a direct result of people improving their homes, according to Brian Gilmartin, portfolio manager at Trinity Asset Management, cited in reports. 

The trend predicted by Zillow of a continual increase in the number of home improvement projects by homeowners throughout the summer should also help to continue to increase Home Depot's earnings.

While Home Depot currently looks like the clear winner of the two home improvement stores, if Lowe's can absorb Orchard and get its foot inside of the California market, then the tide might turn and the smaller company may be poised for big growth. Some $205 million paid out of a $1.2 billion cash pile shouldn't put a drag on the company's short-term financial health to invest in long-term growth, either. Orchard is a game changer for Lowe's.

Invest in Lowe's for its potential growth and increased earnings potential resulting from an acquisition of Orchard, or pick Home Depot for an established and safer bet to ride the summer uptick in home improvement.

 

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Joseph Harry has no position in any stocks mentioned. The Motley Fool recommends Home Depot, Lowe's, and Zillow. The Motley Fool owns shares of Zillow. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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