The End of the Bull Run in Home Improvement Stocks?

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

Home improvement investors have seen fantastic returns over the last years. Month after month, shareholder returns have relentlessly gone up. The question now turns to whether the market has overreacted. While buying in to momentum is, in my view, a winning strategy in the long-run, you shouldn't risk investing in a company where reasonable momentum in the future doesn't even justify the current valuation. So, below, I review three home improvement retailers and see whether or not they are worth an investment.

Almost A $100 Billion Dollar Company, Home Depot may be at its Peak

Over the last twelve months, Home Depot (NYSE: HD) has gained 63% in value, and it's now a $93.6 billion company. Does it merit this price tag? When you consider that McDonald's is only worth $84.5 billion despite greater international exposure, a larger economic moat, and a more shareholder-friendly capital allocation policy, it becomes clear that the market has overreacted to home improvement momentum. With the housing market still uncertain (but the bulls nevertheless proclaiming it is an inevitable recovery) and stubbornly low consumer confidence, Home Depot shouldn't expect to outperform much longer.The stock now trades at a respective 22.2x and 18.3x past and forward earnings. 

On the positive side, ROA has recovered sharply from the 2009 and, at 10.3%, it is above the 7.6% 5-year average. During the third quarter, performance was also higher-than-expected as average ticket prices rose 2.9% y-o-y and net profit grew 1.4%. EPS of $0.74 was ahead of consensus by 4 cents, and full year guidance was increased. EBIT growth of 18% also heads the pack, and it is particularly noteworthy that same store sales has grown 4.3% while Lowe's has seen same store sales decline 0.4%. Fixes made post Sandy should also help to drive a heightened return from easy comparisons.

But I believe the company's growth curve ahead has been overhyped. Even if the firm manages to grow EPS by 14% annually over the next half decade, the stock would only be worth $75.60 at a 15x multiple. In present terms, this translates to a $47 per share value--implying that the stock is around 25% overvalued. Accordingly, I recommend looking elsewhere.

Lowe's, Lumber Liquidator Both Too Expensive

Unfortunately, Lowe's (NYSE: LOW) is not the place to look. ROE has fallen from a high of 12.5% and plateaued around 5.2% for the last two and a half years. Free cash flow has also held steady over the last two and a half years at around $2.3 billion, which represents only a 6.3% yield. The PEG ratio now stands at 1.4x, and it is quite risky to invest now after shares have soared 45.9% from the 52-week low despite worse-than-expected EPS in the second quarter (miss of 7.1%).

Fundamentally, I also see problems for the home improvement retailer. Comps have, as I mentioned earlier, been weak. To drive earnings improvement, Lowe's has been more dependent than Home Depot in cutting costs--a strategy that, admittedly, it has been successful in. Since January 2010, SG&A expenses has fallen 450 bps as a percent of revenue to 22%. Even still, competitive pressures are starting to weigh in, and this is evident in how gross margins have eroded from a 78.6% 5-year average to 74% today.

Then what is a good alternative to Home Depot? Lumber Liquidators (NYSE: LL) is, again, not the solution. The stock has been on a relentless rise--even among home improvement retailers! It is up a terrific 253% from the 52-week low, and has excellent liquidity to drive further growth opportunities. The current ratio stands at 3.3x, and there is no debt on the balance sheet.

Despite the momentum and despite the clean balance sheet, I am not confident that Lumber Liquidators will outperform. Analysts expect EPS to grow 17.1% annually over the next 5 years, but it has only yielded a rate of 10.5% over the past 5 years. At a multiple of 36.3x past earnings, it will be very hard for Lumber Liquidators to generate enough growth to even justify its current valuation. Stifel Nicolaus, perhaps bearing this in mind, recently downgraded the stock from a "hold" to a "sell."

TakeoverAnalyst has no positions in the stocks mentioned above. 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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