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The Ugly Housing Report - Should You Sell?

Thursday - 5/23/2013, 4:10pm  ET

If the past five years have taught us anything, it is the importance of the housing market to the global economy. A strengthening housing market has also been widely regarded as a major indicator of a growing economy. However, last week's new-housing starts report was a bit of a shock to the markets. 

New housing starts fell in April to an 853,000 annual rate, below analysts expectations of 945,000. This represents a 16.5% drop. There was some positive news in the report, as new building permits issued rose 14.3% from a month earlier, signaling that builders are preparing for more construction projects.

The three stocks below rely heavily on the housing market to drive business. The future of the housing market will dictate business growth and may already be represented in the stocks' valuation.

The market leaders are richly valued

Home Depot is the leading home-improvement retailer in the US and is credited with creating the business model. The chain was founded in 1978 and now operates 2,257 stores across North America. 

Results from the company's most recent fiscal year show that 70.6% of revenue comes from the product groups: plumbing, electrical and kitchen, building materials, lumber, and mill-work, and painting and flooring.  The housing market is clearly a driver of these product groups.

Lowe's is the biggest competitor of Home Depot and operates in the same home-improvement retail space. The company was founded in 1946 and currently operates 1,754 stores across North America. Much like Home Depot, approximately 68% of revenue comes from segments closely tied to housing.

Both companies released quarterly earnings within a day of this writing, and the results were mixed. Home Depot reported strong results, with revenue increasing by 4.3% and net earnings increasing by $200 million for the quarter. 

Lowe's report was not as strong, as same-store sales dropped 0.7% and revenue was flat, below analyst expectations. EPS came in at $0.49, above the prior year EPS of $0.44, but below analyst expectations of $0.51. This was the second quarter in the past four such periods where Lowe's saw a decline in sales or profits.  

While Lowe's blamed "cooler than normal temperatures and greater precipitation" for the poor results, Home Depot's comments were more telling: "We continue to see benefits from a recovering housing market that drove a stronger-than-expected start to the year for our business," according to a press release.

Home Depot currently trades at a P/E of 25.9 versus a five-year average P/E of 18.3, while Lowe's trades at a P/E of 25.7 versus a five-year average of 17.5.  It would appear that both companies are pricing in strong future growth.

The specialty player flying high

Lumber Liquidators operates as a specialty retailer of hardwood flooring and hardwood flooring enhancements and accessories. The chain was started in 1994 and has 290 retail locations across North America. The company is clearly reliant on the housing market to drive its business. However, it is important to note that less than 10% of the company's revenue comes from new home construction. Lumber Liquidators primarily serves the home-improvement market.

Lumber Liquidators' stock has been on a tear as of late and trades at $89.80 versus a 52-week low of $26.52.  The current P/E is 45.5 versus a five-year average of 24.9.

However, the company's product sales mix has been moving toward lower revenue/margin products. The company sells solid and engineered hardwoods, laminates, and bamboo, cork and resilient flooring options. Solid hardwoods are the highest-revenue and margin product, and remain the majority of sales. 

The problem is that hardwood sales have not kept up with overall sales growth. In 2012, they represented 47% of sales versus 50% of sales in 2011 and 54% of sales in 2010.  If the shift in product mix continues this way, it will impose a strain on margins.  

Foolish opinion

It remains to be seen if the housing report released last week was just a hiccup or a turning point for housing. As Home Depot stated, its success was driven by the housing recovery. If housing slows down, so should Home Depot's strong growth.

Lowe's has been having ongoing financial issues at a time when its main competitor is enjoying great success. Lumber Liquidators is pricing in an enormous amount of growth, but margins could begin to slip as the product mix continues to move to less profitable products. At current valuation levels, these stocks seem to price in all potential growth opportunities. 

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