The Best Value in Home Improvement
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
If there was any question as to which home improvement store is the better value, that question has been fairly emphatically answered. Home Depot (NYSE: HD) is the clear leader, and proved this by nearly every measure in their earnings report. While revenue growth left something to be desired, the company is using its prodigious free cash flow to buy back shares, which helps earnings now and in the future. Let's look at how the big orange money-making machine did, and see what investors should expect in the future.
Home Depot reported sales up 1.7% and comparable sales up 2.1%. While this doesn't sound like much of an achievement, their primary competitor, Lowe's (NYSE: LOW), reported sales down 2% and comparable sales down 0.4%. Both companies are struggling with an uncertain domestic economy, and customers in many cases have already done the majority of their buying for spring and summer outdoor home-improvement months.
A positive for this industry going forward should be the vast improvement that many homebuilders are seeing in their backlog. Just as one example, Lennar (NYSE: LEN) saw a 61% increase in their unit backlog in the company's most recent report. This homebuilder was not unique, as multiple companies in the industry have also reported significant double-digit growth in their homebuilding backlogs. With more new homes being built, contractors will likely utilize Home Depot and Lowe's as primary locations to obtain supplies. In addition, Home Depot should benefit even as the months turn cooler, as homeowners traditionally start to think of the interior home improvement projects in the fall and winter months. Since Home Depot is producing more average sales than Lowe's, the company should continue to outperform on a relative basis.
While Home Depot operates more stores (2,255 versus Lowe's at 1,745), it also sells more on average per store than their competitor. In the most recent quarter, Home Depot sold about $9.12 million per store versus $8.13 million per Lowe's store. This significant difference between the two competitors shows that customers are choosing Home Depot over Lowe's. In addition, this higher sales amount allows Home Depot to carry a higher gross margin of 34.16% versus 33.93% at Lowe's.
Where Home Depot really shines is the company's financial statements. In the last year, Home Depot has retired 4.1% of their diluted share count. In addition, though operating cash flow was down 5.04% over the first six months, the company managed to produce $3.7 billion worth of free cash flow. With Home Depot paying out about $880 million in dividends, this gives the company a free cash flow payout ratio of just 23.78%. This should give investors confidence that not only is the company's current yield well covered, but future dividend increases are nearly certain. Last but not least, the company is projecting full-year sales up 4.6%, with diluted EPS up 19%. With the company seemingly firing on all cylinders, what challenges stand in the way?
In the home improvement industry, traditional retailers such as Wal-Mart (NYSE: WMT) have begun to realize the profitability of expanding their home improvement selection. This has led Wal-Mart and other retailers to begin carrying a larger paint selection, as well as more tools, small hardware items, and other do-it-yourself necessities. The big difference between a retailer such as Wal-Mart and Home Depot is the type of customer making these purchases. Home Depot traditionally attracts not only the weekend warrior, but also the everyday contractor. In addition, most people when they think of home improvement think of Home Depot first.
While it's true that Amazon.com (NASDAQ: AMZN) offers thousands of home improvement items, realistically contractors don't think of Amazon when they need something for a job. This could change over time, but a contractor who realizes they need something in the middle of a job isn't likely to go online and order a part. They need the part now, and no matter how efficient home or business delivery gets, there is nothing as effective as going to the store immediately. This physical presence is a competitive advantage that Amazon can't compete with. Though delivery the next day or within two days might work for many people, contractors don't have time to wait.
By far the biggest challenge facing Home Depot is the slow recovery in the housing market. While new home building seems to be picking up, the unemployment rate is still relatively high and this hurts Home Depot's sales. What should investors do in the meantime?
The best course for now is to be patient and wait for the economy to recover. With Home Depot paying a respectable 2.05% yield, investors are getting paid to wait. While a 2% yield might not sound like much, the company's free cash flow payout ratio is very low and this yield should improve over time. If the company can turn in double-digit earnings growth when sales are slow, imagine what it can do when the economy recovers.
MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of Amazon.com. Motley Fool newsletter services recommend Amazon.com and The Home Depot. 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. If you have questions about this post or the Fool’s blog network, click here for information.