2 Retail Stocks To Avoid, 1 To Buy
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
After rallying by around 50% over the last 12 months, Home Depot (NYSE: HD) and Lowe's (NYSE: LOW) may need a reality check at this point. Both stocks have become expensive and do not provide enough reward to justify making an investment. With the housing market still uncertain and limited growth in free cash flow, downside outweighs upside.
Pros & Cons to a Home Depot Investment
There are, however, reasons to be positive on Home Depot. The Canadian division, which represents less than a tenth of the business, is positioned to gain market share and improve margins as domestic supply chains are copied. This geographical market is largely dependent on housing permits and consumer confidence. Fortunately, it already offers strong margins from merchandise mix that is, according to BMO Capital Markets, 15% more productive per square foot. Management expects same-store sales to increase by the low single digits this year; total sales will be up around 4.6%. At the same time, $4 billion worth of share repurchases will add upwards of 5 basis points to EPS growth this year.
Should GDP growth get any worse, management is likely to cut expectations. In the past, management has placed greater emphasis on macro growth over housing trends. Currently, the company anticipates to grow roughly in-line with GDP for the next two years and then to possibly exceed it by upwards of 4%. Never in the past has the company exceeded macro trends by this amount, so it is fairly optimistic.
Many analysts have made a note about weather - arguing that warmer conditions have resulted in sales transitioning to lower-margin items, like air conditioners and refrigerators. Regional differences have narrowed, so I do not believe that weather conditions are not a meaningful consideration for long-term value investors.
Compared to Lowe's, Home Depot's growth has been consistently stronger over the last 4 quarters. This outperformance has been driven by an attractive product layout that encourages transaction, restructuring management to improve the merchandise mix, and the brand name value in placing special orders. Even still, the multiples are very elevated at north of 20x past earnings.
Buy Wal-Mart Over Lowe's
Lowe's has actually been losing market share to Home Depot. This has been recognized by the market given the drastic double-digit outperformance of Home Depot over the last 12 months. The top-line still shrunk 2% y-o-y as unusually warm weather cut into sales. Free cash flow has fallen from $2.9 billion for the TTM ending 2Q11 to $600 million less this last quarter. The home improvement store is still at a decade high valuation gap against Home Depot and likely to see multiples catch up. The problem is that the bar has been set very high.
Wal-Mart (NYSE: WMT) has seen same-store sales growth trend towards negative territory in 2010 and 2011. It is still one of the safer stocks and has delivered, all in all, consistent earnings growth. 8.6% annual EPS growth is forecasted over the next 5 years, and I believe that this sets the bar low for "surprise" returns. Accordingly, I expect Wal-Mart to provide greater risk/reward than Lowe's, which is forecasted for 15.7% annual EPS growth over the next 5 years. This forecast implies that the company will be worth $68.70 by 2016 at a 15x multiple. But with much lower volatility at a beta of 0.3 and a proven brand, Wal-Mart is a safer bet, especially in the context of a weakening economy.
TakeoverAnalyst 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. 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.