The U.S. and Canadian housing markets are at very different places in their cycles. The U.S. housing market has finally started recovering from the plunge in prices caused by the subprime mortgage crisis of 2007, while Canada’s market, which held up well in the past few years, is now weakening.
This means different prospects for Home Depot Inc. of Marietta, Ga., and Lowe’s Cos. Inc. of Mooresville N.C., on the one hand, and Boucherville, Que.-based Rona Inc. on the other hand. Share prices for Home Depot and Lowe’s already have moved up in anticipation of their expected good earnings growth during the next four to five years; Rona’s shares are at a low.
Nevertheless, all three companies are worth considering for a client’s portfolio. Home Depot and Lowe’s have a combined stranglehold on the U.S. home-improvement retail market. The sector has consolidated more than most, says Charles Burbeck, head of global equities with Barclays Bank PLC’s wealth-management division in London, because Americans like to get their home-improvement supplies from big-box stores at which they can choose from every colour and shade of paint and can find virtually every tool they might need.
As for Rona, it could be a good turnaround story despite the weakening housing market in Canada. The chain has been struggling and changes are underway. CEO Robert Dutton has stepped down and Toronto-based Invesco Canada Ltd., which owns about 10% of Rona’s shares, is requesting a meeting of shareholders “for the purpose of removing Rona’s current board of directors and electing new directors in their place.”
Lowe’s made an unsuccessful bid for Rona earlier this year, which could be resurrected. Both Lowe’s and Home Depot are major players in the Canadian market as well — along with privately owned Home Hardware Stores Ltd. of St. Jacob’s, Ont.
Here’s a look at the three public companies in more detail:
> Home Depot Inc. is not only bigger than Lowe’s, with annual revenue of more than US$70 billion (vs about US$50 billion for Lowe’s), it’s a great deal more profitable. Burbeck says Home Depot’s return on equity is around 24% (vs 11.5%), and its operating margin is 9.5% (vs 6.5%).
Home Depot responded to the credit crisis and collapse of the U.S. housing market, Burbeck says, by stopping square-footage growth and focusing on efficiency and margins. The firm centralized buying, which had previously been done autonomously by individual stores. This not only increased efficiency but allowed the company to take advantage of its huge buying power. Adds Burbeck: “Home Depot went from being very inefficient to very efficient.”
Ryan Amerman, portfolio manager with Atlanta-based Invesco Ltd. in Houston, is equally impressed: “This is a management team that realizes that it’s in a mature industry and that what’s needed is to improve margins and return to shareholders rather than continuing to grow.”
Both Amerman and Burbeck add that Home Depot is excellent at returning shareholder value through dividends and share buybacks.
The financial results for the third quarter (Q3) of fiscal 2013, ended Oct. 28, underline both the uptick in home renovation activity and the company’s particular success in taking advantage of it, Burbeck says. Sales are up, with customers coming in more often and spending more, while the use of promotions is lower.
A report from New York-based UBS Securities LLC has a “buy” rating on Home Depot’s stock and says the firm “should be a core holding for a multi-year time horizon, as we believe it will maintain its recent record of strong execution and will generate significant earnings momentum as the housing cycle unfolds.”
UBS’s 12-month price target for Home Depot is US$70; the report says the price could rise to US$80 in a couple of years if Home Depot’s operating margin approaches 13%. The 1.5 billion outstanding shares closed at US$62.12 on Nov. 16.
A report from J.P. Morgan Securities LLC in New York also views the stock as a core holding and recommends “overweighting” it, with a 12-month price target of US$67.
Home Depot’s net income for the nine months ended Oct. 28 was US$3.5 billion on revenue of US$56.5 billion, vs net income of US$3.1 billion on revenue of US$54.4 billion in the corresponding period a year prior.
> Lowe’s Cos. Inc. had been on a strong growth path until 2007, but found it more difficult to adjust to weak demand in the wake of the U.S. housing market’s collapse. As a result, Lowe’s hasn’t matched Home Depot in efficiency gains in the past few years.
However, this means Lowe’s has more room than Home Depot to improve margins and earnings, Burbeck says.
Robin Dietrich, an analyst with Edward Jones & Co. in St. Louis, agrees. Not only is Lowe’s valuation more attractive, she says, but the firm also is investing in technology to improve inventory control and pricing and, thus, margins and earnings. A major initiative is the repositioning of products and pricing.
A UBS report has a “buy” rating on Lowe’s stock, saying the results for fiscal Q3 2013, ended Oct. 28, suggest that execution is improving and that the firm is “well positioned to generate accelerating earnings momentum.”
An earlier UBS report had noted that if Lowe’s returns to its 2002-06 average sales of US$292 per square foot as well as operating margin of 10.4%, the firm could have earnings per share of more than US$4.40, vs UBS’s estimate of US$1.67 for fiscal 2013, ending Jan. 31, 2013. The recent report’s 12-month price target is US$36 a share. Lowe’s 1.3 billion shares closed at US$31.98 on Nov. 16.
A J.P. Morgan report rates the stock at “neutral,” even though it has the same 12-month target price as the UBS report.
One question mark is whether the change in management at Rona will lead Lowe’s to make another bid for the Rona. A UBS report issued Sept. 17, when the first bid failed, notes that without Rona, Lowe’s may be too small to be competitive in Canada and suggested it leave that market.
Net income for the nine months ended Oct. 28 was US$1.7 billion on revenue of US$39.5 billion, vs net earnings of US$1.5 billion on revenue of US$38.6 billion in the corresponding period a year earlier.
> Rona Inc. is a company that analysts aren’t enthusiastic about at the moment. That’s partly because of the anticipated sluggishness in Canada’s housing market, but also because Rona’s results are weaker than the economic fundamentals justify.
Reports from Canaccord Gen-uity Corp. and Desjardins Financial Group’s and Royal Bank of Canada’s (RBC) capital markets divisions, all of which are based in Toronto, lowered the 12-month price targets following the release of Rona’s Q3 results on Nov. 7. Desjardins and RBC also downgraded the rating to “hold” or “sector perform” while Canaccord confirmed its “hold” rating. The target price is $11 for Desjardins and RBC and $10.75 for Canaccord. Rona’s 122.3 million shares closed at $9.45 on Nov. 16.
Analysts are discouraged by the slow pace of restructuring, which involves closure of big-box stores and the opening of smaller ones.
The Desjardins report says that Rona’s results are so poor that the report has lowered the probability of another bid from Lowe’s to 33% from 60%. That’s not encouraging, according to the report: “Lowe’s and Rona need to combine forces to solve their individual challenges.”
Net income in the nine months ended Sept. 30 — excluding restructuring expenses and the cost of fighting the Lowe’s takeover bid — was $71.7 million on revenue of $3.7 billion. This compares with net earnings of $75.2 million on revenue of $3.6 billion in the corresponding period the year prior. IE