The curious case of home improvement retail in the U.S.

Specialty home improvement retailing refers to the distribution of building materials, tools, lawn and garden products, decorations, etc., catering to both professionals (such as residential contractors) and do-it-yourself (DIY) enthusiasts. This sector represents a significant segment of the U.S. economy with an estimated market size of USD 1 trillion. Of this, USD 525 billion is attributed to the professional segment and USD 475 billion to the DIY segment. The U.S. home improvement retail market is projected to grow by a low single-digit percentage over the long term. The market is primarily dominated by two giants: Home Depot and Lowe’s, with 2023 sales of USD 153 billion and USD 86 billion, respectively. The key differentiator between the two lies in their customer base. While only a quarter of Lowe’s sales come from professional clients, Home Depot attributes slightly over half of its sales to this demographic.

On March 28, Home Depot announced its intention to acquire SRS Distribution for over USD 18 billion in cash, a valuation of a substantial 16.1 times SRS Distribution's 2023 EBITDA before synergies. SRS Distribution caters to roofing, landscaping, and swimming pool contractors. The acquisition is expected to contribute an additional USD 10 billion to Home Depot’s sales. But what prompts such a substantial transaction? One possible motivator could be the stagnant growth in the DIY market. Although Home Depot does not report sales by market segment, its total sales declined by 3.2% on a comparable store basis in 2023, with a further 1% decline anticipated for 2024. In contrast, Lowe’s — which relies more heavily on the DIY market — saw an 11% decrease in sales last year and anticipates an additional 2-3% decline on a like-for-like basis in 2024.

Why is Home Depot focusing on the professional segment? It already holds around half of the U.S. DIY market share, indicating greater opportunities for expansion within the professional sector. However, market dynamics, rather than market share alone, are decisive. The DIY segment is largely driven by existing home sales, which typically involve renovations, whereas the professional segment is propelled by new construction. A closer examination is warranted to understand why the new construction sector of the housing market is performing better and appears more promising in the near term compared to the existing homes sector."

 

The conundrum of higher interest rates and a strong housing market

At first glance, it seems perplexing that housing prices remain resilient in the face of steep hikes in interest rates over the past two to three years, following an extended period of exceptionally low rates. Currently, a 30-year fixed mortgage carries a 7% interest rate in the U.S., a stark increase from the rate less than half this level a couple of years prior. Theoretically, such a significant shift in rates should have sent housing prices sharply downward, yet in reality, they have hardly budged.

 

US mortgage rates evolution since 1971

Source: Econopolis, LSEG Datastream

Upon closer examination, there are indeed compelling reasons for the housing prices to remain robust. The U.S. housing market is currently grappling with a structural shortage estimated at approximately 3 million homes. Moreover, vacancy rates within the housing inventory have plummeted to the lowest levels recorded since such statistics began to be tracked in the 1970s. While the affordability of homes is historically low, the formation of new households continues unabated, and the U.S. population is still on an upward trajectory. These factors collectively fuel the demand for housing. Concurrently, the past decade has witnessed a trend of underconstruction. As a consequence of these dynamics, homebuilders are flourishing; they face no challenges in selling the homes they complete, eliminating the necessity to offer discounts to buyers.

 

US residential housing permits

 

Source: Econopolis, LSEG Datastream

 

Additionally, the scarcity of new construction is only part of the equation; it's the sale of existing homes that truly exemplifies the crux of the issue. The U.S. economy remains robust, characterized by near-record-low unemployment rates. Consequently, there is a small fraction of homeowners under financial pressure to sell their properties. Post-financial crisis, banks have become increasingly cautious when issuing mortgages, which has led to a decline in mortgage delinquencies. This fiscal prudence has, in turn, resulted in low foreclosure rates, meaning there are fewer instances of forced home sales.

Another factor contributing to the limited supply is that many current homeowners are reluctant to put their properties on the market. And it's hard to blame them, as selling would typically mean relinquishing a low-interest rate mortgage secured on a home purchased years earlier. Given that mortgages in the U.S. often come with a fixed interest rate, these homeowners would then have to take on a new mortgage at a significantly higher rate should they choose to buy another property.

 

Evolution US existing home sales since 2000

 

Source: Econopolis, LSEG Datastream

 

Good or bad news?

The impact of current market conditions on home improvement specialty retailers is indeed nuanced and varies across different market segments. For the professional segment, the prognosis seems favorable. Home Depot’s strategic move to acquire SRS Distribution is a calculated gamble on the resurgence of new construction in the upcoming years, a scenario well-supported by the existing demand-supply dynamics.

Conversely, the DIY segment might not see such a positive trajectory. Its surge during the COVID-19 pandemic, when lockdowns prompted many to embark on home improvement projects, has subsided. For a rebound in the DIY market, a resurgence in existing home sales would be instrumental. However, unless there is a decrease in mortgage rates, a swift recovery seems unlikely.

A potential silver lining for the DIY market could be the aging U.S. housing stock, with the median age of owner-occupied homes at 40 years. Should homeowners decide to remain in their current homes rather than move, there may be an uptick in renovation projects. As homeowners face the need to maintain and update their aging properties, this could provide a boost to the DIY segment of the home improvement market.

 

In the end it’s all about the housing market

The condition of the housing market is not only crucial to the economy but also significantly impacts the home improvement specialty sector. Therefore, if you have insights into the direction of the housing market, you might also have an indication of the future trajectory for companies such as Home Depot and Lowe’s.