Rising mortgage rates and house prices are starting to hurt affordability for home buyers. Although both still remain favorable relative to their historical averages, optimistic housing data is losing momentum. Housing starts rose at an 896,000 annual rate in July, the slowest so far this year. Whereas in July new home sales dropped 13.4% MoM, existing home sales beat expectations, surging 6.5% in July and 1.7% in August. Let's have a look at how this data could affect three closely related shares in the home improvement industry.
Fastenal (FAST 0.43%) has a vast geographic presence around the globe providing industrial and construction supplies, such as fasteners and other general-purpose maintenance, repair, and operations items. Fastenal owns nearly 2,700 stores, mostly located in the US. Other stores, representing 11% of sales, are located in North and Central America, Asia, and Europe
Fasteners are financially insignificant, yet essential for production continuity, so customers are practically insensitive to price. Considering that Fastenal is the dominant player in the fastener business, its pricing power is substantial. However, the industry is highly fragmented, with low customer switching costs and huge growth potential in the business. Hence, new entrants are quite likely to appear. Despite this situation, Fastenal has been able to differentiate itself from its peers by focusing on fasteners and store size across the US, which helps support its wide economic moat.
In order to increase profitability, the company has implemented FAST Solutions. FAST is a revolutionary distribution system that consists on installing vending machines at the client's location. These vending machines inform the customer what they are using and how they are using these products, aiding in controlling inventory and administrative costs while reducing product consumption. Currently, these vending machines account for more than 30% of the company's sales.
On the other hand, cannibalization is a concern. As the company opens new stores and introduces its vending machines, which ultimately compete with older stores, the risk increases. Trading at about 33.9 times earnings, 25% above the industry average of 27.6x, I would wait on Fastenal shares at the time.
Housing recovery to drive positive surprise trend
Lowe's (LOW 0.73%) offers a wide range of products and services for home decoration, maintenance, repair, remodeling, and property maintenance. Lowe's is the second-largest home-improvement retailer in the world, after Home Depot (HD 1.61%).
Both in stores and online, the company continues to develop brand strategies and acquisitions. Most recently, the company launched a new tag line, "Never Stop Improving," and acquired ATG Stores. These initiatives should provide the company with a competitive advantage over its peers, as they allow customers to easily go ahead with remodeling projects using an online retailing platform, while receiving better customer service. By targeting new audiences, Lowe's ameliorates its position to benefit from the housing market recovery.
Another big move for Lowe's is the recent agreement to buy the majority of the assets of Orchard Supply Hardware Stores, a local hardware store operator. This will bring significant opportunities for the company to increase its square-footage in the very attractive California market.
Lowe's main strength comes from its logistics system, which allows the company to make large-scale purchases at a discount. By consolidating its purchasing power, the company holds a low-cost position that supports its wide economic moat: by passing along a portion of these savings in the form of lower prices Lowe's inspires customer loyalty.
However, I would hold on Lowe's stock as it operates in a cyclical retail environment. The US economy is still under recovery. Therefore, consumer spending (particularly on remodeling projects) will likely remain under pressure until the housing market unquestionably stabilizes. Trading at 24 times forward earnings, 4% above the industry average, this stock seems a little overvalued in relation to the uncertainties that surround the industry.
Aggressively restructured to improve efficiency
As the world's largest home-improvement retailer, Home Depot spent the last four years battling economic headwinds, updating its distribution network and focusing on its orange box stores. The company´s scale generates significant bargaining power with vendors when it comes to products, advertising, and rent, which is the foundation of their wide economic moat.
As a leading player in the highly competitive home improvement industry, the company has made it operations simpler and more customer-friendly. These changes should drive positive operating results when a comprehensive housing recovery arrives. Yet, in the meantime, the company depends on consumers' willingness to spend money in their homes, and on professional contractors' expectations and decisions to invest in building new homes.
Currently, the mixed housing data has led to uneven quarterly results. Customers remain sensitive to macroeconomic factors, including an increase in fuel and energy costs, credit availability, unemployment levels, and high household debt levels. Home Depot shares are currently trading at 22.6 times its earnings, quite close to the industry average. This suggests that the market has fully priced in the current housing market trends, thus making an attractive entry point unavailable.
In conclusion
With the global economic environment still not fully recovered, all three stocks are expected to deliver returns close to their market benchmark. Fastenal is hurt by soft fastener sales and weakness in construction, while Lowe's and Home Depot face moderate sales due to deteriorated labor and housing markets.
