Are Home-Improvement Stocks at Risk?

Home-improvement companies have done very well. Masco , Home Depot , and Lowe's have all seen their stock price rise between 25% and 34% over the past year, but those gains could now be at risk. Reduced buying from residential-property investors could portend weakening home sales, which would likely depress housing-related stocks, including home- improvement names. Is such a faltering in the housing market possible? I think it is. Here's why.

The precarious role of the short-term investor
The investor's role in housing's resurgence has been largely ignored, but it appears to be a significant force. All-cash sales, the short-term investor's hallmark, made up a staggering 32% of home purchases in November, according to the National Association of Realtors. While the long-term consequence of an investor- driven housing rally is unknown, history suggests market dynamics can change suddenly when numerous property purchases are made for quick financial gain.

Private equity has been the noticeable investor in residential property. The Blackstone Group has purchased more than 41,000 homes in the last couple of years. Turning them into rental properties, the financial firm has become the nation's largest single-family home landlord. Blackstone is not the only participant. It's been reported that a lone hedge fund acquired about 9% of available residences in an Ohio town. In Atlanta, a current investing hot spot, investors including Blackstone, American Homes 4 Rent, and Colony Capital purchased almost one-in-three properties sold in September.

Though the buyers have emphasized their long-term intent, signs of waning home-ownership enthusiasm may already be emerging. The recently introduced home-rental asset backed security, or ABS, may be an indication of how these financially focused investors might be eyeing the exit. This creative debt instrument allocates home-rental revenues to the ABS buyer in a way that allows the large-scale institutional homeowner to quickly monetize their properties.

While Blackstone initiated the market by selling the first single-family rental ABS in October, others are quickly following. Colony American Homes, owner of more than 15,000 properties, expects its first sale shortly, and American Homes 4 Rent, a REIT with more than 20,000 rentals, is preparing an imminent offering. While investors will likely continue to buy homes, the rapid securitization of relatively recent purchases suggests that some instability in future housing demand is probable.

A vulnerable products company
One company at risk in a turbulent housing market would be Masco. A leading maker of home-improvement products, Masco has taken full advantage of housing's 2013 turnaround. In its most recent quarter, company sales increased 12% year over year due to strength in North American new home construction and increased repair and remodel activity. All of the company's divisions saw gains. Cabinet and related product sales rose 21%. Sales of plumbing products and installation service revenue also expanded thanks to the rise in the number of new homes and a boom in remodeling.

Masco's outstanding performance has garnered great investor enthusiasm. With expected revenue of around $8.2 billion and cash earnings, basically net income plus non-cash charges such as depreciation and amortization adjusted for expected capital expenditures, of around $331 million, the company's shares trade at a very optimistic 24 times cash earnings; a valuation level that appears vulnerable to any hiccups in housing's recovery.

A highly priced big-box store operator
Home Depot, the world's largest home-improvement retailer, could also suffer in a weakening home sales environment. While the store operator reported a stellar recent quarter, with year-over-year sales increasing 7.4% and adjusted earnings per share soaring 28.4%, Frank Blake, Home Depot CEO, attributed much of the result to "continuing improvement in the housing market."

Housing's expansion spurred increased demand in the company's appliance business, and strength in maintenance and repair products helped propel the comp-store sales gains. Increased professional contractor sales, which boosted average sales per customer by 2.8%, contributed to the earnings growth.

Home Depot investors appear to be expecting continued good times, with shares trading at around 19 times expected profits of $5.9 billion derived from revenue of $79.1 billion. The stock, possibly over extended, appears noticeably above its "good times" mid-2000's multiple average of around 14 times cash earnings based on 2005 results of $6.2 billion in cash earnings and revenue of $81.5 billion.

An exuberant management team
Lowe's also reported outstanding results in its latest quarter. The world's second- largest home-improvement retailer saw earnings jump 26% and total sales increase 7.3% from the prior year. Business was especially good in hot real estate markets like Florida, California, and Arizona where professional installation and repair services contributed heavily.

Management appears quite sanguine on the future. They believe that, despite a decline in home affordability, the home-improvement industry is poised for further growth in 2014, citing stronger job growth and benefits from the housing recovery as key drivers.

Lowe's shareholders look just as optimistic. With sales anticipated at around $53.6 billion and cash earnings of $3 billion, the stock appears to be valued near 17 times cash earnings. Not too high compared to its historic 2005 average of around 15 times cash earnings of $3.2 billion on sales of $43.2 billion, if home sales remain robust.

Summary
Home-improvement companies like Masco, Home Depot, and Lowe's have seen their share prices rally over the past year, pretty much on the back of a housing recovery driven in large part by residential-property investors. But if, as some indicators suggest, these investors slow down their spending, housing-related stocks may face tougher times. Home-improvement names, given their enthusiastic valuations, especially so. Investors may want to monitor real estate markets attentively. Any sign of weakness might advocate for a quick change in home-improvement-related stock holdings.

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The article Are Home-Improvement Stocks at Risk? originally appeared on Fool.com.

Bob Chandler has a short position in Masco Corporation. The Motley Fool recommends Home Depot. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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