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Home Depot is no fixer-upper
Record home sales have left the home-improvement giants awash in profits and fully valued. Theres little upside left, especially as rates rise.
By Robert Walberg
Like Lowe's, Home Depot nailed its quarterly earnings on Tuesday, posting year-over-year sales and earnings growth of 11.7% and 14.2%, respectively.
Home Depot (HD, news, msgs) also upped its earnings guidance for the full year, forecasting growth as high as 17%, thanks to strong same-store sales, improved margins and a jump in the average amount customers spend at its stores.
But despite both companies' impressive results, investors are skeptical. And they should be. The reason is simple: Interest rates are on the rise. Though rate hikes have yet to adversely affect the housing sector, Wall Street is convinced that its only a matter of time.
As the housing market cools off, so will demand for the appliances, light fixtures, cabinets and the like that these companies sell.
The home-sale link
Interestingly enough, Home Depots stock was trading modestly lower despite its strong earnings report. Some analysts might brush it off as nothing more than the normal trading pattern of buying the rumor and selling the fact. The problem with that theory is that there wasn't much of a run-up -- a month ago, the stock was trading at about the same place it is today. The more likely explanation for the stocks soft performance stems from the weaker-than-expected housing starts data for July.
The Commerce Department noted that July housing starts fell by 0.1% to a seasonally adjusted annual rate of 2.042 million. Wall Street was expecting a gain of 1.4%. It wasn't a big miss, considering the upward adjustment to the prior months data, but the reaction shows how sensitive investors are to any sign of weakness in the home-construction industry.
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And they have every reason to be nervous. The Federal Reserve has clearly indicated that its not done raising interest rates, and while past increases havent taken a toll on the housing sector, its largely because the Fed had a long way to go to reverse the course of easy money, and it chose to do so only gradually.
The end of easy money
However, real rates (the federal funds rate minus the core inflation rate) are now approaching levels that traditionally lead to a slowing in the economy. Add two more rate hikes of 25 basis points, and real rates will be at the 2% threshold. Naturally, a slowdown in consumer spending could cause the home-improvement stocks to come up a bit short of their boosted guidance.
Bulls point to the recent past and dismiss rate fears, noting that the market has been crying wolf on this subject for the better part of two years. Certainly theres been no evidence to date of a sustained slowdown in the housing sector. To the contrary, the group continues to enjoy tremendous demand. And the good times might continue for another six months.
But successful investors are always looking ahead, and when you add rising real rates to the adverse effect on consumer spending of record high oil prices, the risk of owning the home-improvement stocks is getting higher -- especially now that they are trading near their 52-week highs. Home Depot trades at 15.5 times estimated 2006 earnings, and Lowes (LOW, news, msgs) is at 20 times next year's targets. Those aren't outrageous levels -- not if they can continue growing earnings by 14% or more.
Rising inventories, rising anxiety
However, the stocks -- up an average of 28% over the past year -- arent cheap. Investors should also take note that inventories grew faster than sales in the last quarter at both Lowe's and Home Depot. It may be as simple as the companies ramping up inventories in anticipation of a strong holiday season. And based on last quarters strength, who can blame either company?
Nevertheless, its often a sign of trouble when inventories rise faster than sales. And considering the potential adverse effect of rising rates and record high gasoline prices, its particularly worrisome right now.
So while Wall Street analysts may applaud the home-improvement sector for a job well done -- and will almost certainly raise their ratings on the stocks -- I see trouble ahead and suggest that investors consider taking a hacksaw to their home-improvement holdings.
At the time of publication, Robert Walberg did not own or control shares of companies mentioned in this column.
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