Rona: Why Investors Should Stay Away

The investment thesis for Rona (TSX:RON) is predicated largely on the Canadian housing market.  When Canadians are buying houses, they are also renovating and investing in their homes more.  This has been the driver for home improvement retailers such as Rona, Home Depot (NYSE:HD), and Lowes (NYSE:LOW).  With the Canadian housing market showing mixed signals, and fears of continued mortgage rate hikes, the macro environment is not looking good for Rona.

Further to this, and just as concerning, is the fact that Rona has been struggling to effectively compete with Home Depot, and therefore losing market share.  While Rona has been struggling to increase sales (in 2012, sales were up a mere 1.8%), Home Depot and Lowe’s had sales increases of 6.2% and 4.6% respectively in 2012.

Same store sales numbers paint a picture that is just as bleak.  In 2012, Rona’s same store sales were flat, and in the first quarter of 2013, same store sales decreased by 0.8%.  This compares to a more than 5% increase in same store sales at Home Depot.  Lowe’s saw an increase in same store sales of 10% in April after falling 10% in March, so it looks like things are improving there.

And to top it off, the recent announcement that Rona plans to close 11 stores is further evidence that it’s struggling to compete against the two U.S. giants.

The Canadian Housing Market

The most recent housing market data has sent mixed signals.   While data from May and June was better than expected, the CMHC is forecasting that housing starts will decrease 15% and existing home sales will be down 2.2% in 2013.  The Bank of Canada has bolstered this forecast by indicating new construction will decline as the market addresses previous overbuilding.

Another headwind is the fact that mortgage rates have been on the rise. There is much debate as to whether rates will go higher, but the fact remains that Scotia, TD and Royal Bank have all raised mortgage rates recently. Royal Bank has lifted its 5 year fixed rate 3 times since June. It now stands at 3.69% versus 3.09% before the increases began.  This is still a very attractive rate, however, the trend is unnerving.

Rising mortgage rates, already sky-high house prices, and a high debt load for the average consumer combine to indicate the risk for the housing market is to the downside.  This backdrop does not bode well for those in the home improvement industry.

Is there hope for Rona?

Rona is effectively being squashed by the competition and the market itself is potentially about to shrink.  Is there any hope that this tide will turn?  In a nutshell, it doesn’t look good.  Rona’s earnings over the last 6 quarters have come in below expectations.  A bad sign which should leave investors with little confidence in earnings estimates going forward.  A downward bias on this company is warranted.

Just as concerning, is the fact that Rona is not well positioned for the future.  Quebec is Rona’s primary market and the housing market in that province is particularly weak.

Peer Analysis

To make matters worse, Rona’s current valuation doesn’t really reflect this dire outlook.  As illustrated in the table below, EPS growth of 49% (!!!) is being forecasted for this company in 2014.  An astounding figure given the headwinds that exist.  Though Rona’s fwd P/E multiple may look good relative to its U.S. peers, it’s based on a seemingly unrealistic forecasted rate of earnings growth.

The Foolish Bottom Line

Faced with a potentially eroding market, loss in market share, and ambitious expectations, I believe that there is no compelling reason to own this stock.

Rona’s business model is potentially unsustainable, making for one tough investment thesis, regardless of price.  Rather than struggling with a company like Rona, why not invest in one of the best business models in the world?  To learn about 3 such models, simply click here now and download our special FREE report “3 U.S. Stocks That Every Canadian Should Own”.

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Fool contributor Karen Thomas doesn’t own shares in any of the companies mentioned at this time.  The Motley Fool doesn’t own shares in any of the companies mentioned.