This is not the best of times to be in retail in general, or home-related retail in particular, but it may be the moment for investors to look at hardware store stocks.
Let's look at the hardware big boxes, where there is plenty of room for improvement in the market. Just in mid-November, Home Depot CEO Frank Blake was telling analysts: "Inventories remain high, pricing is under pressure and credit is still difficult."
That pretty much sums it all up for hardware stores. All the plastic, copper, and lumber you need for pipes, wiring, and two-by-fours is having commodity price pressures. And that means margin pressure. At the same time, the hardware chains are having to invest in improving store facilities after taking costs out to balance their books earlier in the recession.
Neither Home Depot (NYSE: HD ) nor Lowe's (NYSE: LOW ) is baking a housing recovery into its 2012 estimates, so if housing were to surprise even slightly on the upside, the effect on their stocks could be noticeable.
Housing: still in the doghouse
The biggest snag for home center chains has been simply that the housing slump has lasted longer than expected, leaving them no room for error. At first, they cut costs and moved focus from selling to construction pros to pushing moderately priced stuff such as paint and flooring to DIY homeowners fixing the homes they couldn't sell.
But by the end of 2011, they had made real structural changes, closing stores and investing in technology to make store operations more efficient. That meant higher capital expense at a time when inventory costs were also under pressure.
In Lowe's case, it added a fair amount of expenses as part of its latest restructuring, which included overhauling inventory and closing stores. The latest move was buying online retailer ATG at the end of the year. Like many retailers, Lowe's needed a handle on e-commerce and decided to buy instead of build.
However, there is good news as well. COO Robert Hull indicated Lowe's is expected to crank out about $2.1 billion in free cash flow during the next fiscal year. Lowe's managers also said they've laid out a five-year plan to get them to 2015 with no expectation of a "frothy housing market."
Lowe's is where Home Depot was a couple of years ago, trying to fix stores and boost sales, and its stock has been driven down by those issues, which gives it a bit more upside potential. Fool Austin Smith likes Lowe's over Home Depot as a better shareholder value for buying back far more of its shares.
And Home Depot has burned through quite a bit of upside potential already. It was one of the best performers in the Dow in 2011, as The Fool pointed out recently. It hit its 52-week high recently, and as fellow Fool Dan Caplinger mentioned, it's expensive and investing in it requires faith in the housing recovery, so the short-term upside is slim.
But Home Depot has been paying dividends regularly and accelerated its share repurchase plan last year. If you're a value investor, there are worse places to be in retail than a sector leader who pays regular dividends.
It's up to you whether you want to back the favorite or the scrappy upstart. But keep in mind, the U.S. is not Japan -- retail is not facing a lost decade. Housing and consumer spending will pick up, because Americans are shoppers and homeowners by nature. Saturday morning at the hardware store is not a ritual in danger of extinction.
So if you are hoping for a real retail recovery, invest in Home Depot, Lowe's, or even Orchard Supply Hardware -- these days, it beats putting your money on stocks of clothing chains or bookstores -- but keep a long horizon.
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