December 1, 2022

Home improvement giants Lowe’s (LOW)  and Home Depot (HD) have benefited significantly in recent years from several trends, including low interest rates, stimulus checks spent on home goods, remodeling for home offices, and a hot housing market. Until now, they have been clear pandemic winners. Cracks, however, in these stocks’ stories are starting to emerge.

Just Friday, the well-followed retail analyst Chuck Grom from Gordon Haskett downgraded LOW and HD, citing various trend reversals. Although the stocks have pulled back this year with the market, headwinds will likely impact their businesses, resulting in lower share prices.

The Gordon Haskett analyst is worried about four challenges for Lowe’s and Home Depot:

  • First, the rapid rise in mortgage rates “is very likely to create havoc on housing affordability in the coming months.” While he’s still optimistic about the post-Covid structural benefits of the home being used for multiple purposes, he sees uncertainty ahead.
  • Second, store traffic trends have weakened year-to-date across the group. While there’s still a debate about the cause — perhaps from a cold weather pattern — a post-Covid normalization of spending less time on home projects is plausible. Moreover, a pull-forward in demand has been playing out in the guidance of other home décor retailers.
  • Third, Grom is concerned that cost inflation will lead to a fewer purchases or trading down. Other retailers that have recently reported earnings have noted soft sales. The benefits of the massive home equity increases that have helped sustain demand is likely to reverse course.
  • Lastly, the high margins enjoyed during the pandemic from a lack of markdowns will likely revert to normalized levels. Several other retailers, including Wayfair (W) and the Gap (GPS) , have warned that they are oversupplied with excess inventory, and are faced with increased labor and shipping costs. At the same time, Restoration Hardware (RH) announced that demand for home furnishings has dropped.

There’s still a lot to like about these retailers. In a 74-page report, UBS sees the glass as half full for Lowe’s and Home Depot. The report notes that with mortgage rates spiking, there will be a lack of incentive to move houses, which will motivate homeowners to invest in current homes. They see continued, although modest, revenue increases through 2024, relying on demand from household formation and the $12 trillion in housing gains since 2019. However, the analyst cautions that higher interest rates and demand pull-forward are risks to the industry.

LOW and HD can be considered a play on climate change as the intensity and frequency of natural disasters increase. Indeed, the United States had a record $145 billion in losses due to natural disasters in 2021, $85 billion of that covered by insurance.

Lowe’s and Home Depot have been among the strongest retailers, producing reliable earnings and then plowing cash flow into dividends and buybacks. Yet, given a market concerned about the business sustainability of pandemic winners, home improvement retailers seem vulnerable and caution is warranted into upcoming earnings.

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https://realmoney.thestreet.com/investing/stocks/home-depot-loew-s-investors-should-check-for-cracks-in-the-foundation-15995328