Pay attention to stocks that get no respect
Depressed by the weak real estate market, Lowe's and especially Home Depot look like long-term bargains.
(Money Magazine) -- Home prices are falling, and economists are worried about a possible drop-off in consumer spending. So it's hardly surprising that the stocks of home improvement retailers are particularly depressed.
Shares of Home Depot and Lowe's, the two leading do-it-yourself retail chains, once carried a big premium over the typical blue chip. Now they trade at a discount to the S&P 500.
These two stocks today are classic examples of contrarian investments - businesses with long records of success that have fallen thoroughly out of favor with shareholders.
Before the real estate bubble burst, Home Depot's earnings were expected to increase at a 13 percent compound annual rate, and Lowe's growth was projected at 17 percent. Now both chains will be lucky to squeeze out single-digit earnings gains in 2007.
There's more to bargain hunting, of course, than loading up on stocks simply because they're down. You want to be reasonably sure that the businesses still have the potential for superior earnings and sales growth once conditions turn favorable again. It's equally important to gauge how long the bad times are likely to last. And even then, you have to be prepared to be patient.
Bad today, good tomorrow
Both companies reported disappointing results for the most recent quarter. While profits were up and total sales growth looked okay, the number that told the whole sad story was same-store sales, the results at outlets open more than a year.
Those figures were dismal: Lowe's was down 4 percent vs. a year earlier, and Home Depot was down 5 percent. The two stocks won't be able to sustain an advance until those numbers are heading back up again. And that won't happen until the housing market starts to improve.
The majority of economists think the bad times will last a couple more quarters. But the real estate market could well be weak beyond 2007.
Fortunately, both chains still have great long-term growth potential once the environment does turn favorable. They follow a successful formula of opening a significant number of new outlets each year, squeezing more sales out of existing stores and enhancing profit margins by fine-tuning the mix of products they sell.
Add in some small price increases to keep up with inflation, and earnings can grow faster than 12 percent a year.
Home Depot over Lowe's
But Home Depot has bigger current problems, and it's a good deal cheaper as a result. In fact, the company is attracting interest from bargain-hunting private equity funds.
Home Depot has managed to prop up sales figures by acquiring three companies that sell to professional contractors. The catch is, those sales are less profitable than ones in the core retail business.
In addition, CEO Robert Nardelli has antagonized shareholders by taking an enormous pay package at a time when the stock is declining.
But Home Depot's basic strategy still looks solid. With more than 2,100 stores, the chain continues to open new outlets and upgrade existing ones.
Although the pace of growth is down from recent years, retail square footage increased more than 6 percent over the past four quarters. Those increases haven't shown up in profits yet, but when business improves, they will.
In addition, Home Depot has boosted the dividend twice in the past year. Spare cash has also gone into repurchasing stock. Since 2002 the company has bought up 16 percent of its outstanding shares.
All of that sounds great. Buyers will still have to wait out the bad times, though, and CEO Nardelli has warned that earnings will be down for the current quarter. To be on the safe side, you can wait to buy until results are out, but there's always the risk that the stock will begin to rally as soon as there's any sign of improvement.
At $38, Home Depot (Charts) trades at just 12.8 times estimated results for 2007. And because of the two recent dividend increases, the shares pay 2.4 percent. That low P/E and above-average yield should give the shares support against further sharp declines.
And if you're looking to add a good stock at a good price to a long-term portfolio, it's often better to be a little early than a little late.
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