Home Depot: Outperformance Likely to Continue

Investors in Dow component Home Depot (NYSE: HD  ) are likely to see continued outperformance in their investment. The largest home-improvement and construction retailer stands to keep benefiting from an improved housing sector that is driving sales. 

Housing fundamentals strong until at least 2016
Industry experts are predicting a continuous improvement in the housing market until at least 2016, when housing starts will reach an estimated annual pace of 1.5 million units. The most recent data, from Aug.16, showed annual starts of 896,000 units. All of this stands to benefit Home Depot, which is riding the wave of the housing recovery. In fact, the recovery was referred to 19 times during the company's most recent conference call.

Big-ticket items encouraging
During the company's second-quarter conference call (Aug. 20), management noted strong sales in big-ticket ($900-plus) items, which grew 15.5% in the quarter. Big-ticket items indicate a greater willingness on the part of the consumer to take on large projects and are traditionally bought on credit.

These trends are especially encouraging given that borrowing still remains constrained by the credit environment (with Home Depot credit card approval rates declining and hovering around 58%). This could suggest that any improvement in credit availability has the potential to drive big-ticket items up even further.

Focus on e-commerce demonstrates long-term vision
Investors should be encouraged by management's ongoing focus on e-commerce. The company continues to roll out a functionality called "MyInstall," which provides customer-specific installation information, tracking of products, and email notifications for appointments.

The company also recently rolled out the "ship to store" option, which allows customers to purchase an item online and have it waiting to pick up at their convenience. Management noted that 1 in 5 customers who pick up orders in-store also buy an additional item upon arrival.

Long-term commitment to shareholders
Home Depot's commitment to its share-buyback program remains in place as the company continues to return cash to shareholders.  On the conference call, management stated that the company repurchased $2.1 billion, or 25.4 million shares. Management expects to complete $6.5 billion of their $17 billion buyback authorization in 2013, with the remainder expected to be completed by the end of fiscal 2015.  The company is also targeting a dividend payout ratio of approximately 50%. Finally, management maintains a high return on invested capital, with a goal of reaching 24% by the end of fiscal 2015.  

Furthermore, with a leverage ratio of less than 1.8 times (below its 2.0 times target), Home Depot is well positioned to increase its debt given its limited cash needs. The company can borrow capital to support its ongoing buyback program or even return value to shareholders through a special dividend.

Everyone is gaining from the housing rebound
Home Depot's closest competitor, Lowe's (NYSE: LOW  ) , is also riding the housing recovery wave. A recent strong quarter helped Lowe's close the gap with Home Depot. The company announced a massive increase in net earnings, which grew 26% from a year ago, rising to $941 million on a 10.3% increase in sales.

Much like Home Depot, Lowe's executives credited better home-improvement demand. According to analysts at Citi, the company's 9.6% same-store sales growth (compared with 5.3% consensus) is a sign that Lowe's is closing the gap with the larger Home Depot.

Retail sales data from the U.S. Census Bureau released on Aug. 13 shows that year-over-year sales growth for building materials and garden-equipment retailers accelerated to 9.2% in the second quarter of 2013 from 2.2%. Lowe's is also gaining the same macroeconomic exposure and benefiting from a management team committed to increasing shareholder value.

Lowe's is also in the middle of a share repurchase plan and recently raised $2 billion in the bond market. The company plans to repurchase $5 billion of shares over the next two years.

Exclusive product offerings 
Given the fact that Lowe's has a price-match guarantee, Home Depot makes use of specialized exclusive consumer goods to attract customers by offering a different set of products. One of the products is a top-of-the-line, energy-efficient LED lightbulb manufactured by Cree  (NASDAQ: CREE  )

Cree recently announced the newest addition to its LED lightbulb product line, the Cree BR30 LED bulb, which is available exclusively at Home Depot. During a conference call, Cree executives estimated the number of lightbulbs in people's homes to be 5 billion. Partnering with Home Depot with exclusive shelf space allows the company to best profit from the growing trend of residential adoption.

According to a recent report by McKinsey, LED lightbulbs will see greater than 50% penetration by 2015. Cree's CEO, Charles Swoboda, said this during the company's fourth quarter 2013 conference call (Aug. 13):  "Our partnership with The Home Depot has demonstrated that great products at great prices, combined with a world-class retailer and a serious investment in marketing, can change both consumer behavior and the product category faster than many of the skeptics predicted."

Through exclusive agreements such as the one with Cree, Home Depot is able to differentiate itself against its competitors by offering exclusive top-brand names. Customers looking to purchase a Cree lightbulb (which has received top-notch reviews from leading blogs such as The Verge) can only do so at Home Depot.

Conclusion
Homebuilders have been among the weakest stocks in the entire market over the last few weeks, and investors will continue watching news very closely. The most recent economic data showed that existing home sales jumped 6.5% to an annual rate of approximately 5.4 million units. This number came in above analyst expectations and further raises the case that the housing market is in recovery mode.

Home Depot is well positioned in all aspects of its business to continue offering investors a return that greatly outperforms the S&P 500 and will likely continue doing so for years to come.

The retail space is in the midst of the biggest paradigm shift since mail order took off at the turn of last century. Only those most forward-looking and capable companies will survive, and they'll handsomely reward those investors who understand the landscape. You can read about the 3 Companies Ready to Rule Retail in The Motley Fool's special report. Uncovering these top picks is free today; just click here to read more.


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