The prospect of rising interest rates might be spooking investors right now, but it isn't fazing home-improvement retailers such as
, or a host of analysts who cover these stocks.
While there's little doubt that higher rates and soaring oil prices will have some impact on sales this year, concerns about a huge slowdown in spending at do-it-yourself stores has probably been exaggerated. That could make the pair attractive to dismayed retail investors who've been burned in the heretofore undiscriminating sector selloff.
"We believe interest rate concerns are overblown at this stage in the cycle," said Bill Sims, an analyst at Smith Barney.
Both Lowe's and Home Depot have fallen this year, as investors have worried about the impact rising rates would have on housing activity. Lowe's is down more than 7%, while Home Depot is off 2%.
When mortgage rates rise, home sales tend to slow down, and demand for new fixtures, fittings and furniture can drop off. The wave of refinancing that put cash into consumers' pockets over the past two years is also expected to slow down as mortgages go up.
Still, many experts say housing activity should remain at historically high levels this year. They argue that home sales have been strong recently because of favorable demographics, not just low rates. Immigration into the U.S. remains solid, driving demand for homes. Meanwhile, young people are buying houses at an earlier age, and baby boomers are purchasing second homes at a rapid clip, thanks to favorable tax laws.
Even if mortgage rates were to rise by 100 basis points this year to an average of 7%, Lowe's Chief Executive Robert Tillman said that would still be the third-lowest average annual rate in the last 37 years, which is "hardly prohibitive to home ownership and home-improvement spending."
David Lereah, chief economist for the National Association of Realtors, agrees, saying that 2004 should be the second-best year on record for home sales. He forecasts 6 million existing-home sales and 1.07 million new-home sales this year. For 2005, he predicts only a slight slowing, and all of these homes will need to be furnished.
If these estimates prove too optimistic, however, analysts say this wouldn't have a huge impact on the bottom line of home-improvement retailers, because these retailers derive a good portion of their sales from consumers who simply want to maintain their existing homes and make repairs.
"Maybe as much as 60% of sales in the industry are maintenance sales," said Joseph Feldman, an analyst at SG Cowen. "If something breaks, you have to fix it."
What's more, Feldman noted that a rising rate environment signals an improving economy and a better job market, which should give consumers more discretionary income. He expects both Lowe's and Home Depot to appreciate between 15% and 20% over the next year.
Smith Barney's Sims agrees that both stocks are attractive right now. Historically, he said, Home Depot and Lowe's have fallen an average of 14% and 19%, respectively, in the one to three months prior to the first rate hike, but they outperformed over the subsequent six months.
A study by Merrill Lynch analyst Danielle Fox reached the same conclusion. "History suggests that current volatility ... is typical, and should be followed by a period of relative outperformance once the
moves," she wrote in a recent note.
On a conference call Tuesday, Home Depot CFO Carol Tome said she has found no correlation between interest rates and the firm's sales results.
Of course, some investors think things are different this time. The Federal Reserve has held rates at a 45-year low for an extended period of time, and investors are now more indebted than they have been in the past. Even a small rate hike could have severe ramifications, they argue.
"I guess you could say ...
the housing industry benefited inordinately this time from low rates relative to the past," said Eric Bosshard, an analyst at FTN Midwest Research.
Still, he believes rising interest rates will have more of an impact in 2005 than in 2004.
Nathan Lewis, an analyst at Jackson Securities, said his biggest concern right now isn't interest rates but sky-high energy prices. "We believe that even if rates go up 50 basis points, rates are low historically, which will allow the consumer to purchase Lowe's and Home Depot's goods," he said. "But if the price of oil continues to rise, we may have a problem with the economy as well."
Nevertheless, analysts say that if a company is fundamentally sound, it will hold up regardless of the interest rate cycle. Both Home Depot and Lowe's reported very strong sales and earnings in the first quarter and raised their estimates for the full year.
Merrill's Fox said Lowe's is "one of the few retailers that is clearly a better company than in the past, with more visible growth." She noted that the stock is trading close to trough levels and said its forward price-to-earnings ratio is well below the 10-year average on both an absolute and relative basis.
As for Home Depot, the company's recent push into the contractor market is a long-term positive, and Fox thinks the company is poised for further market-share gains. The stock also trades at trough levels, and "we see limited downside risk from current levels."
"They look a little cheap right now," agreed Tom Goetzinger, an analyst at Morningstar.
He expects Home Depot and Lowe's to grow sales by 11% and 17%, respectively, this year. Home Depot and Lowe's trade at 16 times and 18 times forward earnings, respectively. "They've probably sold off a little too much, based on the interest rate fears," he said.
Merrill Lynch has, or intends to seek, a banking relationship with Lowe's and Home Depot. Smith Barney has provided non-investment-banking services to Home Depot and makes a market in both stocks. SG Cowen, Jackson Securities and Morningstar have no banking relationships with the firms mentioned.