Betting on Housing Market Recovery

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

Low interest rates and the Fed's efforts to curtail unemployment all point to a likely housing recovery. Ben Bernanke disclosed in September that the Fed continues to purchase mortgage-backed securities that will put downward pressure on mortgage rates--thus increasing refinancing at lower rates and boosting overall demand for housing. Housing prices are also starting to build up, indicating an increase in demand. Hurricane Sandy is further boosting new-housing and repair demand on the East coast. Bloomberg reports that construction in the US is growing at the fastest rate in four years. With all these indicators pointing to an improving housing sector, needless to say, now may be the right time to bet on it. 

One housing market company destined to win in this recovery is Home Depot (NYSE: HD), the largest home-improvement retailer in the world. Home Depot reported its third quarter earnings the day before yesterday. The retailer reported Q3 EPS of $0.74, which beat analyst forecasts by $0.04, and revenue of $18.1B, which beat forecasts by $150M. The stock closed at $63.38 the same day, close to its 52 week high which is the highest the stock has reached in over a decade.

Home Depot's CEO, Frank Blake, yesterday reaffirmed that housing is now becoming “an asset rather than a negative.”According to Home Depot's CFO, Carol Tome, housing turnover this year is about 4.5 million units on an annualized basis which is impacting the company's comparables about 50 basis points this year.

Q3 Highlights

  • Adjusted diluted EPS of $0.74 is an increase of 23.3% from last year.
  • Reported GAAP diluted EPS was $0.63, reflecting the $0.11 impact of charges associated with China store closures.
  • Reported GAAP income was $947 million, compared to $934 million (60 cents per share) a year earlier.
  • Adjusted operating expenses as a percent of sales decreased by 93 basis points to 24.2%
  • Interest and other expenses were $150 million, a slight decrease from same quarter last year.
  • This quarter, 2 new stores were opened in Mexico and 7 stores were closed in China for an ending store count of 2,250.
  • Total sales per square foot were $307, up 4.6% from last year.
  • $10.2 million of outstanding shares worth $700 million were repurchased in the third quarter.
  • ROIC (Return on Invested Capital) was 16.1%, 200 basis points higher than last year's third quarter.

Hurricane Benefits

In the latest earnings call, Home Depot's management remained conservative regarding any benefits from Hurricane Sandy. In the last week of the third quarter, the company did experience around a $70 million increase in sales that included batteries, flashlights, generators and extension cords--as customers geared up to face the hurricane. However, management sees the overall impact from Sandy to be similar to that of Irene. Altogether, the company benefitted $360 million in sales from Hurricane Irene last year--$230M in Q3 and $130M in Q4, and estimates sales benefit from Sandy to hover around the same total of $360M. But I don't see them coming any time soon.

Of its total 40 markets, only 7 delivered negative comparables, all primarily in the hurricane-hit Northeast. The company's Southern division was the strongest for the quarter. The Northern division mostly suffered because of the overlap from Hurricane Irene last year with Hurricane Sandy this year. Home-owners in the region are still in a state of panic. The company is headed into the winter quarters now which are usually the weakest quarters of the year. Cold weather hampers rebuilding and repair efforts. I believe the company will start realizing the benefits by the end of next year's first quarter.

Competition

After Home Depot, Lowe’s (NYSE: LOW) is the second largest home improvement retailer in the world. Another smaller industry player is Fastenal (NASDAQ: FAST). Amongst the three competitors, Fastenal boasts the best financials. It has the highest ROE (return on equity) and ROA (return on assets), zero debt to equity, highest profit margins, and a higher EPS growth rate and dividend yield than Home Depot and Lowe's. Home Depot has the second best financials but among the three it is the best buy-and-hold candidate for value investors as it has a strong history of dividends.

<table> <tbody> <tr> <td> </td> <td>Mkt Cap</td> <td>Dividend Yield</td> <td>Forward P/E</td> <td>Beta</td> <td>Store Count</td> </tr> <tr> <td>Home Depot</td> <td> $93.5B</td> <td>1.83%</td> <td>21.06</td> <td>0.72</td> <td>2,250</td> </tr> <tr> <td>Lowe's</td> <td>$36.86B</td> <td>2%</td> <td>19.26</td> <td>0.8</td> <td>1,745</td> </tr> <tr> <td>Fastenal</td> <td>$12B</td> <td>2.03%</td> <td>29.15</td> <td>0.81</td> <td>2,650</td> </tr> </tbody> </table>

 

<img src="http://media.ycharts.com/charts/e792461024ff63715fa4de1bd3fa852e.png" />

HD Dividend data by YCharts

Home Depot has never cut dividends over the past decade and has consistently increased them. Fastenal, on the other hand, had volatile dividend payments in the past. Home Depot also has very sturdy free cash flows to finance future dividend growth.

What Lies Beyond Q3

Home Depot's management has upped their guidance for the year. Adjusted EPS (excluding China's store-closure impact of $0.11 and including share buybacks) is expected to rise 23% to $3.03 versus consensus of $2.97. Revenues are forecasted to rise 5.2% to $74.1B vs. consensus of $73.8B. Managements plans to repurchase $700 million of outstanding shares in the fourth quarter, bringing the total share repurchases to $4 billion for the year.

Making the Call

The company has beaten analyst forecasts in seven out of the past eight quarters, with the one exception being this year’s Q1 when results came in line with forecasts. It has a higher forward P/E than Lowe's but better financials too. However, the stock is still over-valued when compared to the industry average forward P/E of 18. The retailer's forward P/E of 21.06 gives it a fair value of $63.81 for an adjusted EPS of $3.03, and a fair value of $61.50 for an unadjusted EPS of $2.92. This is range in which the stock is currently trading. I believe that if you're looking for a profitable long position in HD, wait for a dip below $56.


PalwashaS has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend The Home Depot and Lowe's Companies. 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.

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