Home Depot Continues To Ride A Stop-Start Recovery

By Stephen D. Simpson, CFA | August 16, 2012 AAA

Investors seem to be pretty committed to the idea that a real recovery is underway in America's housing market. While earnings reports from companies like Armstrong World Industries (NYSE:AWI), Mohawk (NYSE:MHK), Masco (NYSE:MAS) and Stanley Black & Decker (NYSE:SWK) did not support an unequivocal bull argument, the stocks recovered pretty quickly.

What's more, leading home improvement retailer Home Depot (NYSE:HD) continues to report rebounding sales in a wide range of housing-related product categories. Although Home Depot shares seem ahead of themselves on valuation alone, momentum will likely stay with the stock until the beat-and-raise pattern is broken.

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Solid Financials for a Semisolid Recovery
Home Depot reported 2% sales growth for the second quarter, with same store sales growth of a little more than 2%. Although that represents a notable slowdown from last year's 4.3%, U.S. comps still grew 2.6%, despite an estimated full point of comp growth pulled into the first quarter by the warm weather. While traffic growth is still sub-1%, growth is growth.

Home Depot also logged better margins and profit growth this quarter. Gross margin improved slightly (about 17 basis points), while operating income rose 10% on a reported basis. Ongoing/continuing operating income and EBTIDA both grew around 9% for the quarter.

SEE: Understanding The Income Statement

Looking to Pull Even More Long-Term Growth Levers
Based on recent same-store sales trends, it looks as though Home Depot has been pulling share from rival Lowe's (NYSE:LOW). At the same time, Home Depot's recent analyst day highlighted many additional ways in which the company can improve its performance.

Management continues to talk about improving its customer service experience, but of course the question is how they can do so without reversing some of that operating margin improvement that the Street so covets. Of course, there's also no one-size-fits-all answer as to what represents an improved customer service experience - some people love self-service kiosks like those sold by NCR (NYSE:NCR), while others hate them; some want to be actively engaged by staff, others want to shop in peace.

Other measures are more straightforward. Home Depot wants to improve its merchandising and supply chain management; increasingly looking to shift slow-moving inventory off store shelves and to regional distribution points to fulfill online orders.

Home Depot does indeed offer a lot more SKUs online than in-store, but will shoppers think to go online and look, or will they come home from unsuccessfully finding an item at a Home Depot store and just order from Amazon (Nasdaq:AMZN) instead?

Likewise, I'm curious to see how companies like Whirlpool (NYSE:WHR), RPM (NYSE:RPM) and Stanley Black & Decker will fare through this process, as there is always a push-pull between what's good for the retailer and what's good for the manufacturer.

SEE: Earning Forecasts: A Primer

The Bottom Line
Home Depot longs have enjoyed a really good year with this stock. At this point, it looks like the Street is already baking in a solid improvement in the U.S. housing market, but so long as the company continues to exceed expectations, valuation isn't going to be a top-of-mind worry. So while the stock does seem a little pricey now, I wouldn't be in a rush to sell. Investors may want to think about protecting some of their gains (whether with options, stop-losses or the like), but I wouldn't jump off a winning horse until it shows some sign of tiring.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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