Midyear Checkup: Home Improvement Retail

Now that we're into July, it's a good time to check up on how the year is shaping up for retailers. Spring has sprung. The major early season holidays are over. We're into the dog days of summer when retailers typically clear out early-season merchandise and get prepared for fall and the holidays -- where the real action is.

Today we'll look at home-improvement retailers. This group in general had been a consistent performer for several years, on the dual trends of increasing home ownership and busy two-income families creating a quiet sanctuary at home (also known as "cocooning"). A year ago, the bottom fell out of that idea with the collapse of sub-prime lending.

I think of this retail subsector as containing two groups of companies. First, there are the big-box players Home Depot (NYSE:HD) and Lowe's (NYSE:LOW), which help you fix up your home. Then you have sellers of stuff to go in the home, like Bed Bath & Beyond (NASDAQ:BBBY) and Williams-Sonoma (NYSE:WSM). Although the products they sell are different, the stocks tend to track similar patterns.

The big picture
All of these companies have jumped off the monthly sales reporting bandwagon, so we only see results at the end of each quarter. Despite this limitation, I think the chart below does a pretty good job of showing the big picture year to date.

First-quarter results

All four companies have seen their stock price fall since the beginning of February, while the S&P500 has notched a 6.4% gain for the same time period. Only Bed Bath & Beyond has reported positive comparable-store sales and earnings growth. All these stocks currently sport trailing-12-month P/E multiples at or below the S&P500 average of 18.

What's going on here? Aren't stock prices a leading indicator? If so, shouldn't investors be looking beyond the sub-prime meltdown and snapping up these shares at what appear to be historically attractive prices? I think the market is telling us that credit markets will be choppy for longer than originally thought. The most recent sales and earnings release for home builder Toll Brothers (NYSE:TOL) showed six-month sales down about 20%, signed contracts down 25%, and cancellation rates improving slightly but still nearly three times historical averages. These numbers don't bode well for housing demand in the near term.

Home Depot
The big news for Home Depot so far this year is the announcement of the sale of its wholesale supply business to a private equity group led by Bain Capital. Home Depot intends to use the $10.5 billion proceeds from the sale, along with a $12 billion debt issuance, to repurchase up to $22.5 billion of its shares "as soon as practicable." This huge share-repurchase program is the likely reason HD's shares are only down 2% since February.

The sale represents two significant strategic shifts for Home Depot. First, it means the company will refocus its attention exclusively on the retail side of the home improvement business. In addition, the company reiterated guidelines for how it intends to manage capital allocation in the future. The guidelines made it crystal clear that growth-related capital investments must compete effectively with share repurchases. In other words, capital will go where it yields the highest return for shareholders. This is not unlike the direction Wal-Mart (NYSE:WMT) is taking, by dialing back growth in supercenters to improve overall returns on capital.

Lowe's
Nothing so dramatic is happening at Lowe's, a company that has traditionally kept its focus tightly on the retail side of the business. The first quarter was pretty rough, but Lowe's has the advantage of more domestic expansion opportunities than Home Depot's more mature store base.

The company appears to be battening down the hatches to weather the credit crunch, believing it will come out stronger when the housing market returns to form. Lowe's announced in its first-quarter earnings release that it continues to gain market share and expects improved sales results in the back half of 2007. The company also added $3 billion to its share-repurchase program and upped the dividend 60%.

Bed Bath & Beyond
Bed Bath surprised the markets a month ago when it issued an earnings warning for the first time in its 15-year history as a public company. As the only company in this group with positive comp sales and earnings for the first quarter, you would think things aren't so bad. But investors had become so attuned to Bed Bath & Beyond delivering mid-single-digit comps and double-digit earnings growth, the news was a shock.

In the end, first-quarter results weren't so bad. Margins were down 70 basis points, but expenses were tightly controlled and inventories ended the quarter in line (unlike many other retailers that experienced soft sales). The company also announced the signing of its first lease on a store in Canada, where Linens 'n Things has had a wide-open playing field for several years. Canada could represent a solid growth market for Bed Bath over the next five years. The stock is down the most of this group (4% for the year) and is trading at a multiple that investors would have jumped at two years ago.

Williams-Sonoma
The question the market is wrestling with on WSM is whether the company is just feeling the effects of a housing slowdown, or whether the Pottery Barn brand could be losing its luster. For several years, the brand was knocking the cover off the ball but has now experienced negative comp sales for four quarters. Inventories are creeping higher, and margins are eroding.

Wall Street analysts are on the fence, with the majority rating the stock a hold. The CAPS community views the stock more favorably, with nearly 90% of players expecting Williams-Sonoma to outperform the market. This stock commands the highest P/E multiple in the group.

Summary
While the year hasn't been kind so far to the retail sector as a whole, these are four exceptionally well-managed companies. I view Home Depot, Lowe's, and Bed Bath & Beyond as solid value plays. I'm more concerned about Williams-Sonoma, preferring to wait for evidence of resurgence in the Pottery Barn brand. It's quite possible that all these stocks could be in for a tough back half of the year. But as Warren Buffett is fond of saying, "You pay a high price for a cheery consensus in the market."

For more news on home improvement companies, check out:

• Foolish Forecast: Lowe's Looks for Improvement
• This Stock Is Cheap -- Or Is It?
• Dueling Fools: Bed Bath & Beyond

Home Depot, Wal-Mart, and Bed Bath & Beyond are all Motley Fool Inside Value recommendations. Bed Bath & Beyond is also a Stock Advisor selection. For access to either market-beating newsletter, simply click on those aforementioned links for your free 30-day trial subscription.