Are Home Improvement Stores a Bubble?

Home improvement has been one of the biggest success stories in American retail. The two leading brands; Lowe’s (NYSE: LOW) and The Home Depot (NYSE: HD) have been blessed with growing revenues and soaring stock prices, but how long can that last.

Is improvement really a growth industry or is it a bubble? After all The Home Depot had 2,274 stores in February 2016, and Lowes and its subsidiaries were operating 2,365 locations in 2015. That adds up to 4,639 stores which raises the obvious question: how many stores can the market support.

The question is more relevant than ever in light of reports that claim America simply has too much retail space and too many stores. Some observers are even blaming the retail apocalypse on a glut of retail.

Lowes vs Home Depot which is better?

Obviously the best way to answer this question is to take a look at the two chains’ financial numbers to see if they are making money. If there really were too home improvement stores one of them should be losing money.

Here is what I found when I examined ycharts financial data for Lowe’s and Home Depot:

The Home Depot

• Revenues of $94.6 billion on January 31, 2017. Home Depot’s revenues grew by $6.07 billion in 2016, rising from $88.52 billion to $94.59 billion. That indicates the market is growing and there is a lot of room left for home improvement retailers.

 

• A net income of $7.957 billion.

 

• A profit margin of 7.85%.

 

• A free cash flow of $1.388 billion.

• Assets of $42.97 billion.

 

• Cash and short term investments of $2.538 billion.

 

• $9.783 billion in cash from operations.

 

• An enterprise value of $196.58 billion on April 13, 2017.

Home Depot is a very profitable company that generates a lot of float for a retailer. It is also bucking industry trends such as the revenue collapse at Sears (NASDAQ: SHLD) and Target (NYSE: TGT). That also indicates a very Amazon (NASDAQ: AMZN) resistant business model which is very good.

Lowe’s Companies

• Revenues of $65.02 billion. Lowe’s revenues rose by $5.95 billion in 2016; starting at $59.07 billion and finishing at $65.02 billion. That too indicates a growing market, and immunity to Amazon.

 

• A net income of $3.075 billion on January 31, 2017.

• A free cash flow of just $1 million on the same day.

 

• Cash and short term investments of $658 million.

 

• Assets of $34.41 billion at the end of the last quarter.

 

• $5.617 billion in cash from operations.

• An enterprise value of $84.54 billion on April 13, 2017

 

There are some worrying signs at Lowe’s including the low cash and short-term investments and the tiny free cash flow. That indicates a low operating margin which can lead to the death spiral.

Yet Lowe’s has some serious strengths; including a lot of cash and a good income. Despite the limited free cash flow there are few signs of bubbling here.

Quick and Dirty SWOT for Lowe’s and Home Depot

The best way to evaluate the home improvement giants and their future prospects is with a quick and dirty strengths, weaknesses, opportunities and threats or SWOT analysis. Here it goes:

Strengths

• Wide moat from high cost of entrance into the business.

• Popular brands with a great reputation.

 

• High level of cash and float for retailers.

 

• High-profit business that generates a lot of cash.

 

• A wide variety of products that cannot be sold online including lumber, large appliances, peat moss, lawn mowers, large plumbing fixtures etc.

• Large footprints of stores in United States and Canada.

 

Weaknesses

• Large footprint of stores leads to high maintenance and land ownership costs.

 

• Little presence in fast growing urban areas.

 

• Large stores will be hard to adapt to new products.

• Large inventory of merchandise that can depreciate leading to high costs.

 

• Costs of shipping, maintaining lots of stores.

 

• Large amount of merchandise on consignment which can eat up available cash flow.

 

• Seasonal business that is vulnerable to weather, economic downturns.

 

Opportunities

• Growing population of United States and Canada.

 

• Collapse or disappearance of traditional rivals such as hardware stores and Sear’s.

 

• Growth in home based entrepreneurship including the popularity of Airbnb hosting which promotes home improvement projects.

 

• Ecommerce opportunities particularly in sales to small business.

• New markets and revenue streams created by technology. One tremendous opportunity is delivery driven by Uber-type apps which replaces employees with lower cost contractors.

 

• Continued revenue growth.

 

• Decline in home ownership in U.S. leads to more rentals and more landlords that need supplies and tools for maintenance.

 

Threats

• The growing decline in home ownership, particularly among the young. The percentage of Americans that own a residence has fallen to 9% – the lowest level since 1965. Fewer homeowners will mean fewer home improvement projects and lawn mowers.

 

• Rising real estate prices that make home ownership unaffordable for many Americans.

 

• The shift in population from suburban to urban areas; which means fewer people will be living in houses that need maintenance and yard care.

• Aging population. This will mean more people who are physically incapable of engaging in home improvement and many seniors giving up their houses.

 

• Growing income inequality and wage stagnation will mean fewer people can afford home improvement products and new appliances.

 

• Increasing competition from deep discounters including Walmart (NYSE: WMT) and Amazon which can undercut prices.

• Possibility that Amazon or Walmart might introduce some sort of delivery service for hardware and building supplies that will compete directly with home improvement stores.

 

• Real estate bubbles that might burst and destroy property values. Fear of real estate bubbles keeps many people from buying property or from investing cash in homes they own.

 

All this means that the home improvement stores prospects are cloudy. The threats to their future exceed the opportunities.

Lowe’s and Home Depot are overpriced

My take is that there is no home improvement bubble, but both Lowe’s and Home Depot are overpriced.

Lowe’s was trading at $81.84 on April 17, 2017, and was scheduled to pay a dividend of 35¢ on April 24. There’s nothing in its financial numbers to support that. More importantly there are other retailers that offer similar dividends at a low price such as Best Buy (NYSE: BBY). Best Buy was trading at $48.41 a share on April 13, 2017, but it paid a dividend of 34¢ on March 20, nearly as a high as Lowe’s.

Home Depot was trading $147.25 a share on April 17, 2017, which was ridiculous. Nothing not even the 89¢ dividend paid out on March 7, 2017, justifies that. Particularly when there are retailers like Kroger (NYSE: KR) out there. Kroger was trading at $29.94 a share on April 17, 2017, yet it was scheduled to pay dividend of 12¢ on May 11, 2017.

My prediction is that both Lowe’s and Home Depot will continue to grow and make money for the foreseeable but their stock prices will collapse. The business and its prospects simply don’t justify the share prices. All it would take to send the home improvement giants’ stock into free fall is one quarter of falling revenues or foot traffic.

Stay away from home improvement for now because the sector is overpriced. Jump in when the stock prices return to reality.