In the Land of Giants

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

The home improvement industry has been a two horse race for some time, as Home Depot (NYSE: HD) and Lowe’s (NYSE: LOW) have built national store bases and use similar operating strategies.  Often, their locations are within a stone’s throw of each other.  While Lowe’s stores are larger on average, 113,000 square feet versus 104,000 square feet, Home Depot’s stores are more productive, with FY2011 average sales per store of $31.3 million compared to $28.8 million for its competitor.  However, both chains offer roughly 40,000 items that meet a homeowner or contractor's needs, including products in the plumbing, hardware, lumber, and paint categories.  The corporate graveyard is filled with mom-and-pop building supply companies that couldn’t compete with the chains’ pricing power.  Even Sears, a venerable name in the tools category, has been unloading subsidiaries that compete directly in the hardware or lawn and garden categories.

A Long Uphill Climb

After contracting during the financial crisis, the home improvement industry has been bouncing back in line with rising real estate sales activity.  In October, new and existing home sales were reported at a seasonally adjusted level of 368,000 and 4.8 million, increases of 17.2% and 10.9%, respectively, over the prior year levels.  Prices have also been attempting a comeback, with the S&P/Case-Shiller Index reporting a 3.6% year-over-year gain in national home prices during the third quarter of 2012.  While both sales and prices remain far below their peak levels, government programs aimed at reducing housing supplies have had some success.  In October, the National Association of Realtors reported a 22% year-over-year decrease in inventories, based on the current level of home sales activity.

The higher level of new construction and existing home renovations have led to solid gains for the home improvement retailers.  Through the first nine months of FY2012, Home Depot reported sales and pretax income of $56.5 billion and $5.6 billion, increases of 3.9% and 15.2%, respectively, over the prior year period.  Comparable stores sales rose 3.9% and operating margins benefited from higher store productivity and cost efficiency programs.  Meanwhile, Lowe’s reported similar gains over the same period, with sales and pretax income of $39.5 billion and $2.7 billion, increases of 2.3% and 10.8%, respectively.  Investors have taken notice of the improvement, as stock prices for both companies have appreciated sharply over the past twelve months.

However, the premium P/E multiples that are built into both companies’ current stock prices may be unwarranted, given their growth opportunities.  Neither company has added significantly to their global base of stores lately, in fact Home Depot has closed stores in China that it acquired in a 2006 acquisition.  Instead, both companies are primarily using their strong operating cash flows to pay dividends and buy back shares.  While that policy is good for shareholder value, it indicates a lack of investment opportunities.

Jack Be Nimble, Jack Be Quick

Investors looking at the home improvement sector may want to look at an upstart that has been growing despite the industry’s travails.  Founded in a trucking company’s yard in 1993, Lumber Liquidators (NYSE: LL) has grown into the largest specialty retailer of hardwood flooring with 284 stores in the U.S. and Canada.  Over the past four fiscal years, the company generated a 68.2% increase in revenues by expanding its store base across the country and offering a wide assortment of flooring products at value prices.

We Have an App

Despite an obvious size disadvantage compared to the industry’s retailing giants, Lumber Liquidators competes by buying directly from mills and providing distinctive value, including a 100 year transferable warranty on its Bellawood premium products.  The company is also tech-savvy, with a new mobile app that allows prospective customers to search through 200 floor samples.  In its latest fiscal year, Lumber Liquidators reported revenues and operating income of $681.6 million and $42.4 million, increases of 9.9% and 0.7%, respectively, versus the prior year.  While its gross margins improved slightly, operating margins were negatively impacted by the costs of opening 40 new stores and upgrading its IT systems.

Looking Ahead

In FY2012, the company has raised its performance level, with increases in revenues and operating income of 18.8% and 86.2%, respectively, compared to the prior year period.  Lumber Liquidators has continued to open new stores at a fast pace and its existing locations have enjoyed greater productivity, with a 10.7% gain in same stores sales.  Given the government’s support for the housing market, the company should be well positioned to continue winning market share against its competitors, both large and small.  While investors should wait for a better entry point, Lumber Liquidators is a solid holding for a growth portfolio.

rghanley owns shares of Lumber Liquidators. The Motley Fool owns shares of Lumber Liquidators. Motley Fool newsletter services recommend The Home Depot, Lumber Liquidators, 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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