3 Hardliners to Buy Ahead of Earnings Season

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

Earnings season has not ended and in fact some industries have not ‘inaugurated’ their earnings season as yet. Hardline retailers are one of them. As the norm has been, most of the hardliners are expected to announce their earnings next week. Housing and autos have been the hottest topics discussed among the market circles in recent days. Let’s have a look at earning previews of some of the players in the industry:

Housing on the boom – Which names to buy?

In a recently published note, Credit Suisse called Home Depot (NYSE: HD) and Lowe’s Cos (NYSE: LOW) Spiderman stocks. Both names now encompass great expectations. Home Depot needs an ~8% comp to satisfy investors with Lowe's a point or two below. (Comp is a buzz word that refers to a retail firm's comparable same-store sales. Comps compare the degree of revenue growth/decline that a firm's stores achieve relative to their sales in previous years. Sales numbers from stores that have been operating for more than a full year are used in the comparison)

Based on strong housing data and equally solid supplier data, comps for both companies are expected to meet expectations. Importantly, this sector remains best positioned to see multiple years of strong comps as spending on housing remains well below historical levels.

Talking about company-wise performance, Home Depot has moved up ~5% since bottoming post Q1, yet with estimates moving higher, the multiple is little changed. Q2 earnings could exceed the Street consensus by a penny or two, living up to the stock's intra-quarter move. The Street’s consensus comp estimate is 6.7% but market (investors) expectations are closer to 8%, which implies a flat two-year number. With later breaking summer weather in certain regions, which should have created some demand spill-over from Q1 into Q2, a flat two-year comp seems achievable. Gross margin expansion of 20 bps is expected which will be consistent with Q1. On an 8% comp, Selling General & Admin leverage would be meaningful and expense dollar growth at 40% of comps implies 3.2% growth. Even without the full benefit of expense leverage with an 8% comp, EPS would be $1.22, coming in above consensus. Looking forward, Q3 top-line compares are still relatively easy, meaning Home Depot could be set up well to do mid-single digit comps again. But Q4 becomes more difficult on both top-line and EPS compares.

25% year-to-date run for this stock

The stock is up 17% since pre-Q1 and its multiple has expanded by 1.5 turns. Despite that outperformance, Lowe’s is still expected to deliver, helped by a strong start to the quarter. The company exited April running at 10% comps, which implies they started off the quarter running around 9%. Even if the quarter started a little weaker, around 8%, and they saw a moderation thereafter, comps should still be north of 6%. Credit Suisse believes that the market expectations are for ~6.5%. While comps will likely be the focus, it is also an important quarter for gross margins. The Street is modeling +30 bps, which is achievable but the key is demonstrating that margins are moving in the right direction, supporting the notion that Lowe’s is starting to benefit from recent investments. Over the past few quarters, expenses have been managed well (down 2% on average) and as sales gain momentum, better leverage could lead to earnings power significantly higher than Street estimates.

A super name to buy out of housing and auto

Past housing and auto dealers, there are a number of special situations that the Street likes. Ulta Salon Cosmetics & Fragrance (NASDAQ: ULTA) is a prime example of such a case. Ulta remains one of the favorite long term growth stories, combining double digit square footage growth with a very high return and disruptive concept. The stock has been a strong performer in the past quarter thereby raising expectations, but based on the channel checks it is widely believed that they can deliver.

The company is expected to announce its earnings on Sep 9. With respect to Q2, sales and earnings estimates are at the high end of the range for ULTA (4%-6% comps, $0.64-$0.67 EPS), but there are a couple of pennies of upside. As for sales, there were concerns in the early part of the quarter that beauty industry sales were choppy. But those concerns were put to rest when Sephora gave an upbeat assessment of the US market. In addition, as shown below, the leading indicator points to comps over 7%, which are above the 4%-6% guidance range.

A combination of healthy mature store comps, solid contribution from immature stores, and additional Lancôme and Clinique boutiques are driving that strength. Gross margin is also expected to show upside. Gross margins are expected to be up following Ulta's Q1 setbacks, but the magnitude is underappreciated. The model calls for 50 - 60 bps of expansion. With similar SG&A leverage to Q1 (it should be better given stronger comps), EPS could reach $0.70.

Final word

It is clear that companies tied to housing and auto sector will display strong results this season. Both Home Depot and Lowe’s are recommended as buys given strong industry dynamics and cost-cutting initiatives. However, once we leave these two sectors (auto and housing), we are left with very investible options. Ulta is one of them given its strong channel of growth.

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