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The housing market in the US is beginning to show signs of recovery as the prices have started rising. This prospective recovery has reintroduced investors' interest to the housing industry. Most importantly, the complementary segments of the industry are also expected to profit and the stock prices are likely to improve. In this scenario, a key opportunity would be to identify a homebuilding services company with strong financial standing which is most likely to benefit from the industry's recovery.

Recovery in Housing Market and Homebuilding Services Companies

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Source: Reuters

The chart above shows the performance of Case Schiller Index which shows the moving average of home prices since 2000. We can clearly see the effect of the financial meltdown in FY08; however, it appears that the housing industry has hit the bottom in FY12 and is on its way to a recovery. The most important sign of recovery is that the US pending home sales index is showing a rapid increase as more customers are planning to buy previously owned homes. At the same time, a report by Freddie Mac suggests that the prices are rising but the level of activity, specifically in the more affected areas, is still low. Therefore, there is enough room for a gradual and, more importantly, sustainable growth in the market due to expected improvement in demand. As these markets begin to project growth, stock prices of homebuilding services companies have also started to show an upswing.

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Source: Bloomberg

The above chart shows the stock performance of Home Depot (HD) and Lowe's Cos. (LOW) as compared with the S&P 500 index. The homebuilding products of these companies have developed a strong demand due to the overall recovery of the housing industry. We can see how the companies' stock prices started to demonstrate substantial improvement in late FY11. The housing prices had not started to recover by that time but as markets are forward looking, the effect is clearly visible.

Comparative Financial Performance

Considering the financial performance of these homebuilding services companies, we see that on average, there is no substantial boost in the results to reflect the upward price movement shown in the previous chart. This further supports our claim of housing recovery's impact on stock prices of homebuilding services companies.

Data Source: Morningstar

The table above shows the basic income statement metrics of the two companies in FY11 and FY12. Lowe's performance over these two years shows a mild improvement. Home Depot, on the other hand, shows remarkable step forward with a 6.4% increase in revenues, 16.8% rise in net income and a 21.1% improvement in earnings per share. Following these results, the market share of Home Depot in homebuilding services has improved to 19% as compared to 16% of Lowe's. Referring to the stock price chart, we can see why Home Depot's stock has outperformed its competitors over the last one year period.

Business Strength and Investor Considerations

The superior financial performance of Home Depot is not limited to the previous two years. The company has consistently outperformed its competitors over several years and has projected strong growth prospects.

Data Source: Morningstar

The table illustrates key performance metrics of Home Depot, its major competitor and the respective industry. The table also shows a breakdown of ROE of the two companies according to the three part DuPont methodology. Home Depot has projected outstanding net income growth of 19.5% over the past three years as compared to the industry's corresponding figure of only 1.9%. The operating margin of the company is also stronger than its competitors and the industry average. Most importantly, the DuPont analysis shows that the company's impressive performance is not entirely supported by an extensive leverage. In fact, the company is operating at an optimum level of financial risk with current debt to equity ratio of 0.61. Therefore, the company is producing a staggering 25.42% ROE through strong profit margins.

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Source: YCharts

The chart above presents the dividends of Home Depot and Lowe's. The company has also addressed investor considerations through stock repurchases and the chart clearly shows that the company's financial performance makes it capable of improving dividends whereas its major competitor is unable to do so.

Conclusion

Keeping in view the environment in the housing market and the strong financial structure and performance of Home Depot, a buy recommendation is proposed. This is because the recovery in the market, which is yet to attain its full swing, will improve the demand for homebuilding products. Moreover, Home Depot has the strong position in the industry and is set to attain sizable gains from the recovery in the market. On the back of improved demand and the largest market share, Home Depot will further its outstanding financial performance which is likely to result in profits for investors in the form of stock price appreciation and improved dividends.

Source: Home Depot: Well Positioned To Grow