Has Optimism Been Guiding Home Depot And Lowe’s To Glory?

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Since the recession, stocks of home improvement giants, Home Depot (NYSE:HD) and Lowe’s (NYSE:LOW), have registered phenomenal growth. Even now, analysts continue to upgrade the stocks citing a recovering U.S. economy and housing markets, coupled with strong business fundamentals as reasons. However, questions arise as to how much of this growth is a consequence of investors getting in on anticipating a recovery in the U.S. housing markets, and how much is actually a consequence of a growing business. Could it be that these stocks come plummeting down as soon as investors start losing faith in the U.S. recovery? Here’s evidence of why positive expectations might be driving these stocks, more than any other factor.

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Source: NASDAQ

Let’s start by looking at macroeconomic statistics and the performance of these stocks in response to that. There is no doubt that the U.S. economy has achieved strong growth since the recession. However, there have been quarters when the U.S. economy faced weakness. Furthermore, existing home sales, a key metric for home improvement spending, has displayed considerable volatility. Even then, the stock prices of the retailers have continued to soar. In this situation, one can attribute the development to forward looking positive sentiments, where investors automatically assume that the U.S. economy or housing markets will bounce back after a weaker quarter. Moreover, what is interesting is the movement in the stock prices of the two names against the S&P 500 index. While all three names were moving together until about 2011, the two big retail stocks started beating the index going forward to achieve growth rates of over 200% as opposed to about 95% in the index. This, to a large extent, could show the positivity surrounding the stocks, where investor sentiments and expectations of a housing market recovery have fueled the growth.

GDP

Source: Statista

Next, let’s look at how Home Depot and Lowe’s have performed from a business point of view. Since 2009, both retailers have seen single-digit increases in revenues in the 3-6% range. Margins have remained more or less flat for Lowe’s, while Home Depot has managed to achieve modest increases in margins. It might be slightly questionable as to whether these numbers can fully explain the phenomenal growth these stocks have shown. However, what has actually been working in Home Depot and Lowe’s favor the past few years, has been a solid double digit growth in EPS numbers. Even going forward, the retailers expect EPS to continue growing at this rate, even as sales undergo a 4-4.5% increase. The problem here though is that the majority of the EPS growth has been guided by share repurchases, which have reduced  the outstanding share count. In this case, announcements of major buybacks such as that at Home Depot could have generated the excitement to give the share price a push. While these buybacks have been successful in boosting EPS, it may just be questionable as to how much of this growth has actually come from a fundamental value increase.

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Lastly, there was the issue of a data breach at Home Depot that left close to 56 million credit and debit card details exposed. When a similar event struck America’s second largest discount retailer, Target, the stock price declined almost 14% within the next few months. However, Home Depot came out relatively unscathed. In fact, in the few months right after the data breach last year, the stock continued to increase by almost 8%. It may be surprising that Home Depot faced little or no impact although the magnitude of the data breach at the store was larger than that at Target. In this case, it may just be that investor’s optimistic outlook on U.S. macroeconomic fundamentals could be exerting a strong influence. (Or that data breaches have become perceived as a more common and unavoidable event.)

Now, if it is true that Home Depot and Lowe’s have, for the most part, been growing against positive expectations, it may just dissipate when investors start sensing signs of weakness in the economy. In the last quarter the U.S. economy failed to grow as expected, but instead contracted 0.2% according to Commerce Department estimates. The deceleration occurred as a consequence of an appreciating dollar choking of exports, labor disputes on the West coast adversely impacting trade, declining oil prices leading to lower investments in the sector, and harsh winter weather choking off consumer spending. [1] While GDP growth has historically remained slower in Q1, economists fear that this slowdown may be harder to recover from for the U.S. economy. Even as port disputes and harsh weather conditions subside, factors such as the dollar strength and declining oil prices could continue to weigh on growth prospects. Slower wage growth has also continued to remain a serious problem, which could have a negative impact on home improvement spending. In this case, the anticipation of lower spending on home improvement could threaten prospects for the stocks. What is further of worry is a hike in interest rates, which could stall the anticipated growth in the housing markets by bringing up mortgage rates. But will this mean it’ll be downhill for Home Depot and Lowe’s as soon as investors catch on — maybe not in a very extreme sense.

While there is a possibility of less enthusiasm around the stocks, in the sense that the stocks may not be able to sustain the kind of growth that they have enjoyed so far, one cannot completely disregard Home Depot and Lowe’s achievements. Both retailers have delivered in terms of revenues, and could continue doing so against higher Pro customer penetration and a booming online business. Furthermore, in spite of a relatively slack start to the year, and some uncertainty regarding the future, the full year forecasts for the U.S. economy continue to remain upbeat, with GDP projected to grow at about 3% and unemployment projected to reach 5.5%. In addition, key drivers such as existing home sales and new home sales are also expected to witness notable gains in 2015, at 6.4% and 33%, respectively, against low interest rates, stability in the job market, and improving consumer confidence. [2] If the U.S. economy and housing markets do end up achieving these numbers, it could translate into higher home improvement spending, with some time lag. In this case, these stocks could see better days, at least in the short to medium run.

We have a price estimate of $120 for Home Depot’s stock, which is above the current market price.

Our complete analysis for Home Depot’s stock

See our complete analysis of Lowe’s here

We have a $78 Trefis price estimate for Lowe’s stock, which is above the market price.

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Notes:
  1. The Slowdown In The American Economy []
  2. U.S. Economic Outlook: April 2015 []