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I like to check out the macro data and look for divergences between the macro numbers and stock prices for opportunities, and also to see if the macro environment stirs any changes in analyst expectations. 

In the details of Monday’s June retail sales report, there was a sign of slower sequential sales in the building material, garden supply and supplies dealers category.  The sales results come at an important time as both Home Depot (HD - Analyst Report), Zacks Rank #2, and Lowes (LOW - Analyst Report), Zacks Rank #3, are flirting with their May highs.   

Year over year sales are healthy:

Category sales declined 2.2% from May, but spending in the sector remains vibrant relative to last year rising 9.4% and lapping a 6.5% y/y gain in 2012.  Home Depot and Lowes have tracked the direction of the Commerce Department’s building material sales data both on the basis of level and looking at the 3-month average of the year over year rate of change.

Analysts show disagreement:

It will probably take another month of soft sales numbers to shake earnings estimates at these home improvement retailers. 

Estimate revisions for the July quarter have displayed a healthy level of disagreement on Home Depot. There have been six upward revisions and seven downward revisions in the past sixty days, although estimate revisions have moved strongly higher for the fiscal years 2014 and 2015.  There may be unease over the July quarter, but there is confidence longer term.

There has been a level of disagreement over the outlook for Lowe’s July quarter earnings, but it has been much less dramatic than for Home Depot.  There were two downward revisions and five upward revisions in the past 60 days for the July quarter.  However, there is more disagreement in the fiscal year 2014 and 2015 outlook for Lowes.  There have been three upward revisions and six downward revisions for FY 2014, and three upward revisions and seven downward revisions for FY 2015.

On the earnings surprise front, Home Depot is more bullish than Lowes:

It should be noted that Home Depot has a stronger track record of posting upside earnings surprises.   In the last 10 quarters, it has surprised to the upside nine times with a match the exception.  Lowes has surprised to the upside seven out its last ten quarterly reports, with the other three shortfalls.

Valuations reflect an outlook for healthy earnings and sales growth:

Home Depot and Lowes are priced for continued sales growth and may not be able to afford signs of a setback in sales without generating some profit taking.  Both stocks are priced with a low 20’s PE ratio based on the outlook for expected FY 2014 EPS.  The table displays the current estimated PE ratios against the historic trailing PE ratios.

Why does Home Depot have a higher PE ratio?

HD may be trading at a higher PE multiple because it has been more successful in generating earnings growth and expanding its gross margin.  Over the past five years, Home Depot has posted a compounded growth rate of 17.5%, while Lowe’s has badly lagged with a compounded growth rate of just 2.6%.  

Lowe’s gross margin has been relatively flat since 2008, while Home Depot’s has displayed steady improvement. Home Depot’s gross margin has risen from 33.6% in FY 2008 to 34.6% in FY 2013.  In contrast, Lowe’s gross margin was 34.2% in FY 2008 and 34.3% in FY 2013.

PEG ratios suggest a rich valuation:

The graphic displays the PEG Ratio which illustrates the PE ratio over the growth rate in earnings.  Notice that both companies are trading at ratios which are on the higher end of the range when the financial crisis period is stripped out.

Bottom line:

Home improvement retailers are priced for growth, but the growth rate in building material sales are trending higher despite the pause in June.  Given rich valuations, the stocks will need to see strong execution and continued sales momentum to maintain their uptrends. 

Today’s six-point jump in the July NAHB Survey to 57 is surprising given the rise in mortgage rates and surge in June.  It leaves me a bit stunned, but indicates that housing continues to be a leading sector of the economy. 

The results will likely support enthusiasm for Lowes and Home Depot in spite of rich valuation. The track record of earnings surprise, gross margin expansion and earnings growth also confirms the outlook for Home Depot is stronger than that for Lowes, consistent with the Zacks Rank for each company. 

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