Rising home equity levels could help stoke pent-up demand for these two stocks
Home Depot Chief Financial Officer Richard McPhail couldn’t ignore a difficult reality on the retailer’s most recent earnings call: higher interest rates are forcing customers to shy away from big projects. “You have this odd irony of every sound bite you read, … ‘they’re coming down soon,'” McPhail said, referring to the expectation of lower interest rates ahead, as he talked with investors on an earnings call on May 14. ” Our customers tell us, ‘Hey, with that in mind, with that on the horizon, we’re just going to wait,’ and so that’s really the most important dynamic from an income perspective.” Lowe’s echoed this sentiment when it reported first-quarter results on May 21. Despite beating analyst estimates, the retailer is seeing signs that shoppers are avoiding bigger projects, especially ones that require them to hire a contractor. “Uncertainty around interest rate cuts, stubborn inflationary pressures, and a consumer still showing a preference towards spending on discretionary services and experiences continue to weigh on the DIY home improvement demand,” Lowe’s Chief Executive Marvin Ellison told investors. Home Depot said it saw a 6.5% decline in sales tickets above $1,000 in the first quarter from the same period a year ago, and more discretionary projects are being delayed. At Lowe’s, tickets of $500 or more fell 7.6% year over year. Both companies are seeing customers tackle do-it-yourself projects that are much smaller in scope. How long this trend will last is unclear, though it’s clear a lot will depend on the direction of interest rates. Even though the Federal Reserve has signaled the possibility of interest rate cuts this year, the market anticipates it won’t happen for several months as inflation has remained elevated . That will keep the pressure on the stocks of both Lowe’s and Home Depot, analysts say. Still, some see an opportunity for patient investors when the Fed begins easing monetary policy and consumers exercise some pent-up demand. HD LOW YTD mountain Both Home Depot and Lowe’s are underperforming the broader market this year. “We still believe near-term (6-12 month) upside in shares may be limited, given valuation and ‘higher for longer’ interest rate dynamics,” KeyBanc analyst Bradley Thomas said in a research note Tuesday, reiterating shares at a sector weight. “But [we] see LOW as a long-term beneficiary once muted housing conditions recover.” Both stocks are underperforming the broader market. Shares of Lowe’s have fallen more than 2% this year, while Home Depot is down more than 5%. The S & P 500, meanwhile, has climbed more than 11%. Projects on hold “I think project demand is material to both Home Depot demand and Lowe’s,” Evercore ISI consumer & retail analyst Greg Melich told CNBC in an interview. “The balance of all of this suggests that Home Depot’s [same-store sales growth] will still be negative in the third quarter, but they’ll be less negative .” This dynamic isn’t surprising given a high interest rate environment that has pressured consumers. The average rate on credit cards, for example, has reached an all-time high this year. But it’s not all bad. Homeowners are sitting on more equity in their homes than they had prior to the pandemic, according to a May 8 report from real estate data firm ATTOM. That may make homeowners feel wealthier and more confident to use that cushion to trade up to a bigger home or borrow against it when rates drop to fund projects like a new deck or an updated bathroom. From the fourth quarter of 2023 to the first quarter of this year, the so-called equity rich share of mortgages increased in 23 states, albeit by less than one percentage point, the firm said. Homeowner equity levels remain elevated compared with the pre-pandemic period. Higher levels of home equity, combined with a desire to tackle deferred projects, could be a plus for Home Depot and Lowe’s once rates move lower. “Elevated interest rates are causing customers to defer their large discretionary projects,” UBS analyst Michael Lasser said. “This means that a recovery should be robust as interest rates move lower.” The analyst maintains a buy rating the stock, but lowered his price target to $400 per share from $411 following Home Depot’s earnings . Lasser’s forecast implies 23% upside ahead. For the time being, Melich said, consumers have been forced to only take on repairs that are absolutely necessary. Some are “trading down,” or looking for cheaper alternatives in terms of materials and overall project scope, he said. “Life happens, and households form,” Melich said. “At a certain point, [people] will have to accept that that’s the price [and] that’s the rate.” One surprising element of Home Depot’s first-quarter results was that there remained strong consumer engagement with products despite the trading down on bigger projects, Melich said. That is a factor that could bode well for Home Depot over the long run, and Melich sees an opportunity for investors to buy the stock “at a market multiple on depressed earnings.” His $390 per share base case implies 20% upside from Friday’s $325.10 close. Wolfe Research analyst Greg Badishkanian also expects that homeowners will update their homes when rates fall, which supports his outperform rating on Home Depot and $401 per share price target. Badishkanian’s forecast amounts to more than 23% upside moving forward. “Existing home sales also continue to be a material headwind to remodel activity as long as interest rates remain relatively high,” Badishkanian said. Counting on the pros For those busted pipes and leaky roofs, homeowners are likely turning to professional contractors, and that part of the business has been a top focus for both retailers. Home Depot leads Lowe’s in the pro category, with roughly half of its business coming from professionals, compared with 20% to 25% for Lowe’s. LOW YTD mountain Lowe’s shares year to date Home Depot is leaning into this segment with the planned acquisition of specialty distributor SRS , its biggest move yet to capture a larger share of what Home Depot Chief Executive Edward Decker says is a $250 billion market. Still, Lowe’s efforts to grab market share among pros seem to be gaining traction. The first quarter revealed slight gains in its pro segment that helped offset the troubling losses from DIY business. KeyBanc’s Thomas said this positive inflection came as Home Depot saw its pro same-store sales skew negative. Under Ellison, Lowe’s also has been working to improve customer engagement and e-commerce. “Beyond private brands, management expects to continue to build out Pro initiatives, while undertaking several new Pro-related actions, such as the conversion of LOW’s Pro card holders into the Company’s new Pro loyalty and credit program and the launch of new online tools that allow Pros to build and update online quotes from anywhere,” Thomas said. Analysts surveyed by FactSet on average predict Lowe’s shares could climb about 17% from Friday’s close. “While the near term is still challenging to read, we remain confident in the medium to long-term outlook for our industry as our core demand drivers are all supportive of growth,” Lowe’s Ellison recently said.
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