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Improvement Coming to Home Improvement?

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August 28, 2008 – Comments (0) | RELATED TICKERS: HD , LOW

The latest existing home sales report from the National Association of Realtors showed an increase of 3.1% over the previous month with sales rising to about 5 million units a year annualized.  When the last twelve months of data is plotted, there’s a clear bottoming pattern being formed.  The report also shows home prices continuing to fall and the inventory of unsold homes increasing.  That’s bad news for sellers but good news for buyers since the increasing inventory should continue to put pressure on prices. 

The AP release listed on MSNBC.com includes this additional information, “Between 33 and 40 percent of sales activity is coming from foreclosures or other distressed properties, estimated Lawrence Yun, chief economist at the Realtors group.” 

If existing home sales have bottomed, it should be good news for home improvement retailers Home Depot (HD) and Lowes (LOW).  The high percentage of sales coming from foreclosures should also be a positive for their business.  I haven’t found any data to back this up, but it’s logical that on average a foreclosed home will need more repairs than an owner-to-owner purchase.  Granted, logic doesn’t necessarily apply to the stock market.

Both companies are profitable even in the current soft housing market.  Valuations are similar with both companies trading at about 15.5 times the next 12 months earnings.  Cramer did a head-to-head between HD and LOW on Wednesday’s Mad Money and concluded LOW was the better bargain primarily because of better growth prospects.  One key difference between the companies is the dividend.  HD yields about 3.3% vs about 1.4% for LOW.  Obviously, Lowe’s has a much lower payout ratio so more of its earnings are available to invest in expansion. 

If home sales have bottomed, LOW and HD sales traffic should start increasing, particularly with a high percentage of sales and housing inventory coming from foreclosures.  Both companies should benefit from easy same-store-sales comparisons going forward.  Analysts’ earnings estimates for both companies have been lowered over the past 90 days.  I think that’s a mistake.  Cramer based his opinion of the two stocks partly on his prediction that new home sales will start improving late next year.  I suspect many analysts are also considering new home sales for their models.  They may be overlooking stabilizing and improving existing home sales volume (not necessarily prices) providing a lift to home improvement centers. 

I believe LOW is a slightly better buy than HD based on better growth prospects and a lower debt ratio.  The higher dividend makes HD attractive to income investors and should provide more support to the share price if the thesis is wrong; the dividend is comfortably covered so there isn’t much chance of a cut.  If stabilizing home sales drive an increase in traffic, both companies should benefit. 

As with most stocks in this market, I don’t think there’s any big hurry to jump in to these two.  Moves in the housing market won’t be fast and there’s no harm in waiting for another home sales report or two to see if the bottoming trend is intact.  A ‘nibble now, add more later’ approach would also make sense. 

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