Home Depot, Lowe's for Portfolio Improvement

Home Depot (HD) and Lowe's (LOW) dominate the building materials/home improvement segment with approximate sales of $65 billion and $48 billion respectively. EPS peaked for each of them in fiscal 2006 (ended Jan. 2007) as the housing market crested. Since then earnings have come down from $2.79 to an estimated $1.42 for HD’s FY 2009 and from $1.99 to this year’s $1.23 FY 2009 estimate for LOW.

The share prices have done exactly what you would have expected. HD touched $43.90 and LOW hit $35.70 briefly in early 2007 before dropping to $23.61 for Home Depot and $19.22 for Lowe’s as of last week’s close.

Why am I writing about these then? We seem to be nearing the bottom of the cycle. Analyst estimates for FY 2010 look for 10% – 13% growth off this year’s depressed levels. Costs have been cut, inventories pared down and the stage appears set for a resurgence over the next few years.

Morningstar rates both companies at 5-stars, their highest category. They see ‘fair value’ of $35 for HD and $36 for LOW. Both companies are fiscally sound. Value Line rates HD as ‘A++’ and LOW as ‘A+’ for financial strength. Each one pays a sustainable dividend. Current yields are now 3.81% for Home Depot and 1.87% for Lowe’s. Payout ratios are 63% and 29% on FY 2009 estimates.

With obvious headwinds that appear to be fully reflected in the share prices, the question becomes, “When will these dogs come alive again?” Rather than try to answer that I’d rather make good returns even if these high-quality issues just ‘hang around’ current levels.

I don’t see much downside anymore so I’m willing to play as detailed below…

If Home Depot shares merely remain above $23 on February 19, 2010:

The $23 calls will be exercised.

You will sell your shares for $23,000.

The $23 puts will expire worthless.

You will likely have collected $450 in dividends.

You will have no further option obligations.

You will hold no shares and $23,450 cash.

That represents a best-case scenario net profit of $5,540 / $17,910 = 30.9% achieved in less than eight months, on shares which did not need to go up.

What’s the risk?

If Home Depot shares finish below $23 on February 19, 2010:

The $23 calls will expire worthless.

The $23 puts will be exercised.

You will be forced to purchase an additional 1000 shares of HD.

You will need to lay out another $23,000 cash.

You will likely have collected $450 in dividends.

You will end up with 2000 shares of HD and $450 cash.

You will have no further option obligations.

What’s the break-even on the whole trade?

On the first 1000 shares it’s their $23.61 purchase price less the $3.00 /share call premium = $20.61 /share.

On the ‘put’ shares it’s the $23 strike price less the $2.70 /share put premium = $20.30 /share.

Your net break-even would be $20.46 /share (excluding dividends) or $20.24 /share including dividends.

Home Depot shares could fall by up to $3.37 /share or (-14.2%) without causing a loss on this trade.

If Lowe’s shares rise by 4.1% or more to above $20 by January 15, 2010:

The $20 calls will be exercised.

You will sell your shares for $20,000.

The $20 puts will expire worthless.

You will likely have collected $180 in dividends.

You will have no further option obligations.

You will hold no shares and $20,180 cash.

That represents a best-case scenario net profit of $5,660 / $14,520 = 38.9% achieved in less than seven months, on shares which only needed to rise by 4.1%.

What’s the risk?

If LOW shares finish below $20 on January 15, 2010:

The $20 calls will expire worthless.

The $20 puts will be exercised.

You will be forced to purchase an additional 1000 shares of LOW.

You will need to lay out another $20,000 cash.

You will likely have collected $180 in dividends.

You will end up with 2000 shares of LOW and $180 cash.

You will have no further option obligations.

What’s the break-even on the whole trade?

On the first 1000 shares it’s their $19.22 purchase price less the $1.85 /share call premium = $17.32 /share.

On the ‘put’ shares it’s the $20 strike price less the $2.85 /share put premium = $17.15 /share.

Your net break-even would be $17.24 /share (excluding dividends) or $17.15 / share including dividends.

Lowe’s shares could fall by up to $2.07 /share or (-10.7%) without causing a loss on this trade.

Disclosure: Author is long HD and LOW shares and short their options.

Comments

[jay fredric...:]

Why not just buy shares in both and have hope that people will start to spend on fixing up their homes again. People are only going to save for so long before they'll have to spend on new tools, paint etc. Buy and hold these 2 for a 40% gain in less than 2 years.

Jun 29 11:01 AM

[U Dontknow ...:]

I'd rather have the 31% and 39% gains from today
just through Jan-Feb 2010.

Jun 29 01:21 PM

[Ted Hurlbut:]

My suspicion is that these companies may lag the recovery is retail stocks. The housing market is clearly going to be a drag on any recovery, and I suspect thsat will dampen sales at these companies somewhat.

Jul 01 02:51 PM

[igggy:]

Paul, I like your ideas but I think you are over-estimating the gains while underestimating the risks. The problem is the potentially naked puts. You have to have enough cash to buy the shares if the market tanks. As a result, in the case of HD for example your cash outlay is 20K higher and the actual return is much lower: 5,660/34,520 = 16%

I suppose you could sell your shares to cover the puts but that wouldn't be enough (since the stock will be down) and the worst case return would also be lower.

Do correct me if I am wrong.

Jul 01 07:02 PM

[U Dontknow ...:]

You only incur the extra cash outlay IF the puts get exercised.

In the 'best-case' examples above this could not take place as the share prices at expiration would make the put exercise unprofitable for the holders of the options.

Even if the puts do get exercised, an immediate liquidation of the shares held would result in profits as long as the share price at that time was above the 'break-even' price in my calculations.

It is impossible to calculate a specific ROI for these trades IN ADVANCE as you can't know whether the puts would be used or not. That is why i clearly identify the 'best-case' and 'break-even' so that you can evaluate the potential returns based on where you think the shares will be from inception through expiration date.

I've been doing these trades for 31 years with excellent results.

Jul 02 07:35 AM

[Paul Price:]

Today's Businessweek magazine's 'Inside Wall Street' column said to buy HD and LOW at $27.21 and $22.81 respectively.

Too bad they waited for them to move up $3 - $4 /share each before jumping on the bandwagon.

Aug 14 11:56 PM