Home Depot Is Still Looking Good

The world's biggest home-improvement retailer, Home Depot (HD 1.50%), recently reported quarterly results that were well above market expectations. Its closest competitor, Lowe's (LOW 2.29%), also posted strong results as these two stocks continue their rally on the back of a housing recovery. The latest new home sales data was disappointing, but the long-term outlook remains positive.

Quarterly results

Home Depot's net sales increased  by 9.5% year-over-year to $22.5 billion, while net earnings rose 17.2% to approximately $1.8 billion, or $1.24 per share. The company managed to beat both revenue and EPS estimates by $780 million and $0.03 per share, respectively . Comparable-store sales were extremely strong--the year-over-year increase was 10.7%, as opposed to analysts' estimates calling for a gain of 7% to 8% .

Home Depot's CEO Frank Blake has attributed an uptick in consumer sales, as opposed to the more traditional professional-contractor sales, as one of the reasons behind Home Depot's better-than-expected performance .

While the housing recovery has played its part, Home Depot's management has also done an excellent job in terms of cost discipline. Net sales rose 9.5%, but the selling, general and administrative expenses increased by just 5.6% to $4.3 billion. As a result, Home Depot's net profit margin improved by 52 basis points from the corresponding quarter last year to slightly less than 8.0%. 

Home Depot increased its FY 2013 EPS and revenue growth guidance from $3.52 per share on 2.8% growth to $3.60 per share on 4.5% growth. On the other hand, the markets are expecting EPS of $3.65 per share. 

Meanwhile, Lowe's recorded a 10.3% increase in sales to $15.7 billion, while net earnings rose 26% to $941 million, or $0.88 per share. Lowe's same-store sales have trailed Home Depot's with growth of 9.6%. Like its bigger rival, Lowe's has also outperformed the market's consensus estimates. The company similarly raised its annual guidance, and now expects 5% sales growth with EPS of $2.10. 

Future outlook:  New housing data

There are risks associated with high unemployment numbers and increasing mortgage rates, which could slow the housing sector's recovery. By mid-August, the rate on a 30-year fixed loan reached nearly 4.7%, one of the highest levels in two years . The increase in borrowing costs can have an adverse impact on home resales.

But analysts believe if that happens, then both Home Depot and Lowe's will be better positioned than home builders, such as Toll Brothers or PulteGroup . This is because Home Depot and Lowe's primarily serve the home-improvement sector, not the home-construction sector, which could be the biggest casualty of a housing slowdown.

The latest new single-family-home sales data for July displayed a 13.4% drop , which was considerably worse than market's expectations of a 2% to 3% decline . However, the National Association of Realtors has pointed out that sales of existing homes in July increased by 6% sequentially and 17% year-over-year . This indicates that although the increase in rates had a negative impact on new homes, the housing market continues to improve overall.

The increase in existing home sales will create more business opportunities for Home Depot and Lowe's in the coming quarters. For home-improvement retailers, the year-over-year comparisons will become difficult in the next two quarters because last year's results received a boost due to some extraordinary weather conditions .

Challenging retail environment

While the housing recovery is doing wonders for Home Depot and Lowe's (both are trading at more than 20 times their current year's earnings estimates), it has created a challenging business environment for retailers. This was evident in the recent lackluster results of some of the leading retailers, such as Macy's and Wal-Mart (WMT 0.33%). Consumer spending seems to have shifted in favor of housing expenditures as opposed to other discretionary purchases.

Unlike Home Depot and Lowe's, Wal-Mart cut its profit forecast by $0.10 per share. Although the U.S economy has been showing signs of improvement, the decrease in government expenditure, a two-percentage-point increase in payroll taxes and rising fuel costs have created a tough business environment for the world's leading brick-and-mortar retailer. Exchange-rate fluctuations will also have a "significant" negative impact on its sales in the coming quarter. Accordingly, sales growth expectations have now been cut from 6% to just 3% .

The retail environment looks challenging in both international and domestic markets (the company is expecting a considerable loss in Canada this year ); therefore investors should be cautious before putting their money in Wal-Mart.

Performance summary

I believe that both Home Depot and Lowe's are currently the best stocks to buy on the housing recovery. Home Depot and Lowe's have been up 21.8% and 34.3% this year, respectively, easily outperforming Wal-Mart, which is up 8.6%, and the S&P 500 ETF (SPY), which is up 19% . 

However, at these price levels, Home Depot looks more attractive than Lowe's. Home Depot declined by 2% in the week ending Aug. 23. I believe this could be a nice entry point for investors. Home Depot is slightly cheaper than Lowe's, as it is trading at lower multiples of trailing, current year and next year's earnings estimates, as shown in the table below. Home Depot also gives a better yield of 2.1% and generates a much higher return on equity of 27.5%. 

Source: Yahoo! Finance

My Foolish take

With an impressive track record and expected improvements in the future, both Home Depot and Lowe's are ripe for investment – although Home Depot looks more attractive. The increase in mortgage rates will have an adverse impact on new home sales. I believe, however, that due to positive job numbers and increasing home prices, the housing sector will continue to improve, albeit at a slower rate.