Can Home Improvement Retailers Help You Construct a Sturdier Portfolio?

The outlook is bright for home improvement products manufacturers and retailers according to a forecast from the Home Improvement Research Institute, or HIRI. The organization expects that the total home improvement market will grow at an average pace of 6.9% in 2014 and 2015. HIRI sees growth moderating to 5% and 4.5% in 2016 and 2017, respectively.

Today we look at flooring retailer Lumber Liquidators (NYSE: LL  ) and two giants in home improvement products retailing, The Home Depot (NYSE: HD  )  and Lowe's Companies (NYSE: LOW  ) .

A third quarter to remember
Lumber Liquidators is the largest specialty retailer of hardwood flooring in North America with over 300 locations. The company offers its customers more than 340 flooring varieties.

Lumber Liquidators reported that for the third quarter ending September 30, comparable-store net sales rose by an extraordinary 17.4% from the same quarter of 2012. The number of customers increased by almost 10% and the average sale to these customers was 6.9% higher. That's just the beginning of the favorable results:

Gross margin expanded by 370 basis points to 41.8%. Key factors behind the impressive gains were lower product costs, operational efficiencies, and increased sales of moldings and accessories.

Although selling, general, and administrative expenses as a percentage of sales rose 80 basis points -- due to an aggressive advertising strategy -- the sales and gross margin increases brought about a 290 basis point increase in operating margin for the quarter which reached 13.1% of sales.

Net income soared more than 50% from the year-ago quarter to $20.4 million.

Bringing home outstanding profit
Sometimes when a company is the largest in an industry, a position Home Depot has reached in home improvement retailing with over 2,200 locations, this position makes it more difficult for the company to grow revenue at the same pace as smaller competitors.

That was certainly not the case for Home Depot in the third quarter. Comparable-store sales rose 7.4% from the same quarter last year. In the U.S. -- Home Depot also has stores in Canada and Mexico -- sales did even better, up 8.2%.

The company said that the number of customer transactions increased 4% and the average transaction increased 3.2% to $56.27.  

Cost of sales as a percentage of sales declined 30 basis points year-over-year. Selling, general, and administrative expenses actually declined by 1% in dollar terms. The sales increase and across-the-board operational efficiency brought about a nearly 43% increase in net earnings to $1.35 billion.  

Keeping pace with its large competitor
Lowe's operates more than 1,800 stores in the U.S., Canada, and Mexico, which makes it smaller than Home Depot but still the second-largest home improvement retailer.

In the third quarter, Lowe's performance was similarly strong, with total sales up 7.3% from last year's third quarter and comparable store sales up 6.2%.

Gross margin improved by 26 basis points and selling, general, and administrative expenses as a percentage of sales declined by 47 basis points.

Just as with the other two companies, Lowe's sales gains and efficient operations -- what Lowe's CEO Robert A. Niblock termed "improved collaboration and execution" -- resulted in a splendid increase in net income, up 26% from the same quarter last year.

What we learned
HIRI forecasts only a modest increase in mortgage rates in 2014, which is good news for these retailers because homeowners often finance large home improvement projects and because relatively low rates can spur further recovery in the housing market. HIRI forecasts that the 30-year conventional mortgage rate will stand at 4.5% at the end of 2014. 

As Lowe's CEO said in the earnings release, "The home improvement industry is poised for persisting growth in the fourth quarter and further acceleration in 2014."

For its part, in December Lumber Liquidators released an extremely upbeat outlook for 2014, saying that comparable-store net sales will grow in the range of high single-to-low double-digits.

Lumber Liquidators views its industry niche -- retailing hardwood flooring -- as highly fragmented. The company has a significant price advantage over many of its smaller competitors because it purchases directly from lumber mills. A Lumber Liquidators banner ad that showed up on my computer screen recently made this bold statement about its prices: "up to 38% less than other flooring stores."   

This company's financial results reveal that it is not only fully taking advantage of the revitalized housing market and homeowners' renewed enthusiasm for upgrading their residences, it has also been able to significantly improve its operational efficiency which has brought more dollars to the bottom line.

The price advantage the company possesses certainly draws customers. Lumber Liquidators, like Lowe's and Home Depot, also recognizes the critical importance of having product experts in the store to help customers make the right decision. With 340 flooring choices, a consumer needs a great deal of information to make a confident purchase decision.

Lumber Liquidators' sales personnel are trained to identify which customers are knowledgeable DIYers and which are casual consumers who need more assistance.

Lumber Liquidators participated in the Credit Suisse Hardline Retail Roundup Conference in December. One of the interesting stats management presented was that average sale per customer has steadily risen over the last three years to $1,745. Even with its past growth, the company believes its market penetration of owner-occupied homes is less than 3%.

Aggressive is the best way to describe this company's strategy. It intends to increase its store count by 30 to 40 locations in 2014. If it ends up adding 35, that would translate into an 11% increase in store count in just one year.

The company intends to aggressively go after market share by boosting its advertising spend by 25% to 35%.

The bottom line
Each of these companies has delivered outstanding results. The question is, what stage of the housing recovery are we in? If you believe the recovery has longer to run, then each of these companies represents a sound choice for investors.

My favorite of the group is Lumber Liquidators because it offers fast-paced growth over an extended period of time. The company believes that it can increase its store count in the U.S. to 600 from its current base of just over 300.

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