Will Home Improvement Retail Continue to Heat Up?

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

The recovery of the housing market has also positively affected home- improvement companies including Home Depot (NYSE: HD) and Restoration Hardware (NYSE: RH). Will the demand for housing continue to rise? Will home-improvement companies continue to benefit from the housing recovery? Let’s examine these issues in detail.

Will growth in the housing market reach a halt?

The housing market continues to show signs of growth: the number of new homes sold (opens pdf) during the first five months of the year was 2.3 million compared to 1.8 million in the first five months of 2012 – a 28.7% increase. The median sales price was roughly 10% higher in May compared to the price in May 2012.

These indicators suggest the demand for new dwellings hasn’t diminished. But this may change in the near future.

The recent added capital restrictions that the Fed imposed on banks regarding their equity ratio may eventually lead some banks to provide fewer loans to meet the new requirements. Another factor is the Fed’s next move regarding its asset-purchase program. The Fed might start tapering its current asset-purchase program in which it purchases $40 billion of mortgage-backed securities and $45 billion of long-term securities on a monthly basis.

If the Fed slows down the asset-purchase program, long-terms rates are likely to rise. This, in turn, will drag down the demand for mortgages and thus lower the demand for housing. Moreover, some data suggests a slowdown in the housing market’s recovery. According to a recent report, housing starts (opens pdf) declined by 9.9% in June compared to May. If this trend persists, it could suggest the housing market will start to cool down in the near future, which, in turn, may curb the growth in home-improvement retail. In the meantime, home-improvement retail sales continue to rise.

Home improvement sales are slowly rising

According to a recent retail sales report (opens pdf), in the first six months of the year the furniture and home-furniture store sales slightly increased by 2.3% compared to first six months of 2012; sales of building material and garden equipment and supplies dealers rose at a faster pace at 5.3%. Total retail sales rose by 3.7% during this time frame.

Based on the above, home-improvement and renovation sales haven’t increased at a much higher pace than the entire retail market. If leading home-improvement retailers have done better than their market average in terms of growth in sales, then they could be an investment worth considering. Let’s see how several companies in this industry have done in recent months.

Growth in revenue continues

During the recent quarter ending at the beginning of May, Home Depot's net sales rose by 7.4%. Moreover, in the past six months (up to May), net sales grew by 10.5%, which is much higher than the growth in sales in the home-improvement market. The rise in net sales didn’t diminish the company’s operating profit margin that slightly rose from 10% to 11% in the recent quarter.

Restoration Hardware has outperformed Home Depot not only in the stock market but also in terms of revenue growth:  During the first quarter of fiscal year of 2013, the company’s net sales spiked by 38.3%. This is among the factors responsible for the sharp rise in Restoration Hardware's shares in 2013 – the stock rose by 100.6% during the year (year-to- date).

The company projects its net revenue will be between nearly $1.5 billion and slightly more than $1.5 billion in fiscal year of 2013. This represents 25% growth in revenue, which is roughly the same as last year’s growth rate in revenue. The company also expects its net income to be between $56 million and $58 million.

Based on the first-quarter report, the company may not reach its target annual net income. Moreover, even though this company is sharply progressing, its profit margin is razor thin compared to other home- improvement retailers such as Home Depot.

Unlike Home Depot and Restoration Hardware, Lowe's (NYSE: LOW) isn’t showing growth in sales: In the recent quarter, Lowe’s net revenue slipped by 0.5%. Despite this drop in sales, the company’s operating profit margin rose slightly from 6% to 7%.

Based on the above, both Home Depot and Restoration Hardware were able to exceed the growth in home-improvement retail sales. This high growth is likely to proceed in the near future as the housing market continues to post sharp growth. But looking further into the future, the recent drop in housing starts might suggest a shift in the housing market; if this becomes a downward trend, home-improvement companies will see this change in the coming years.

In the mean time, Restoration Hardware still has room for growth and its low debt- to-equity ratio, which currently stands at 0.2, suggests the company could raise debt if needed. In comparison, Home Depot and Lowe’s have much higher debt-to-equity ratios of 0.8 and 0.7, respectively.

Despite the high growth in Restoration Hardware's revenue, the company has yet been able to translate this high growth into profits. Therefore, Home Depot and Lowe’s, unlike Restoration Hardware, are capable of offering dividend payments, which currently result in an annual dividend yield of 1.9% and 1.6%, respectively. 

The Foolish bottom line

The high growth of Restoration Hardware is partly due to the recovery of the housing market. Home Depot is also showing strong growth in revenue. But looking forward, the housing market could start showing a slowdown in its recovery, which will curb these companies’ rally. Further, the low profit margin of Restoration Hardware compared to Home Depot makes it a less preferable investment for those who wish to cash in on this high-growth industry.

Therefore, for the near future, I think Home Depot might offer relatively high growth in revenue compared to the industry and a reasonable profit margin that translates into dividends.

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Lior Cohen has no position in any stocks mentioned. The Motley Fool recommends Home Depot and Lowe's. 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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