The housing market seems to have bottomed, as new housing construction, sales, and prices start to recover from the depressed levels of the earlier years. With this in focus, total home improvement product market sales are expected to rebound, averaging about 5% per year between 2012 and 2016, according to the 2012 IHS Global Insight/HIRI Home Improvement Products Market Forecast. This bodes well for the two dominant market players in the U.S. home improvement industry, Home Depot (HD) and Lowe's Companies (LOW). Both companies are dividend plays that pay yields higher than the yield on the 10-year Treasury bond. Lowe's, a dividend aristocrat, pays a higher dividend yield and, historically, has had higher dividend growth rates than Home Depot; however, is it a better dividend play for the next five years?
History says that Home Depot has outperformed Lowe's over the very long-term horizon. Moreover, specifically, the company's stock has beat Lowe's on a five- and ten-year basis in terms of total returns, notwithstanding the prolonged periods during the past decade in which Lowe's stock fared better. A decade ago, Home Depot had a dividend yield of 0.7%, while Lowe's paid a yield of 0.2%. Even though Lowe's grew its dividends at an average annual rate of 32% per year over the past decade, while Home Depot boosted dividends at an average rate of 18.6%, Home Depot produced higher total returns, averaging 9.2% per year over the past decade compared to 5.1% annually for Lowe's. On the other hand, over the past five years, Lowe's continued to bolster its dividend at an average annual rate that exceeded Home Depot's by 14.5 percentage points; however, Home Depot's returns still beat Lowe's performance. Home Depot returned 10.2% per year, while Lowe's performed flat for the period. It is obvious that stronger capital growth drove Home Depot's total returns relative to those of Lowe's.
The companies' EPS growth is telling. While EPS of both Home Depot and Lowe's contracted over the past five years, Home Depot's EPS fared much better. Lowe's EPS shrank at an average rate of 6.3% per year over the past five years, while Home Depot's EPS contracted at an average rate of 0.6% per year. Despite its EPS contraction, Lowe's still continued to boost its dividends at double-digit rates annually. In terms of valuation, both companies' average P/Es over the past five years stood at about 16x trailing earnings. Home Depot is currently trading at a significant premium to this average, while Lowe's is positioned right around the average.
Going forward, assuming constant stock prices and dividend growth at average rates from the past five years, Lowe's could be a better dividend play. Based on the current stock price and a forecast dividend growth of nearly 20% per year, its yield on cost in five years would be 6.5%. At the same time, Home Depot's yield on cost would equal 2.9%, assuming that dividends grow on average by 5.2% per year for the next five years. Still, it should be noted that based on the last implemented dividend hikes of 16% for Home Depot last year and 14% for Lowe's this year, both stocks would have equivalent yields on cost of 4.9% in five years. Both companies have low dividend payout ratios, with Home Depot's at 44% and Lowe's at 42%.
However, capital gains do matter, and there, the picture about the future winner is not so clear. Home Depot seems to have better prospects than Lowe's. Home Depot's same-store sales are running ahead of those at Lowe's. The former has seen a better inventory turnover and higher margins due to its numerous distribution centers and more aggressive sales. In principle, Home Depot seems to be priced at a premium due to its better fundamentals and higher return on invested capital (ROIC) compared to Lowe's, even though analysts expect Lowe's to achieve a higher EPS growth over the next five years. Home Depot has a ROIC of 14.3% versus 7.9% for Lowe's. Elevated stock prices will likely be sustained at these levels given the improvement in the housing market. In addition, stock prices will be supported by both companies' efforts to boost their stock repurchase programs. Lowe's is planning to boost its leverage around 30% to free more funds for stock buybacks and Home Depot is raising its share repurchase plan by $500 million to $4 billion for this year alone.
Some investors are bullish about the future prospects of these home improvement industry players. Andreas Halvorsen at Viking Global initiated a large $135 million position in Home Depot in the first quarter of 2012. Also bullish about the stock are billionaires Ken Griffin and Cliff Asness. On the other hand, fund manager Edgar Wachenheim (Greenhaven Associates-see its top picks) had nearly $390 million invested in Lowe's Companies at the end of the first quarter of 2012. During the same quarter, value manager Jean-Marie Eveillard (First Eagle Investment Management-check out the fund's largest holdings) established a new, $132 million position in the stock.