- Home Depot’s fortunes depend heavily on the economy and the housing market.
- Home Depot resides in a position of market leadership.
- Home Depot takes on long-term debt to buy back shares.
Home improvement retailer Home Depot (NYSE:HD) and its shareholders enjoy the fruits of an expanding economy. Over the past five years the company’s stock increased 299% versus 70% for the S&P 500 (see chart below). However, long-term investors should consider the following issues before investing. Let’s examine.
Market leader in the publicly traded universe
Home Depot possesses more ubiquity than its publicly traded rival, Lowes (NYSE:LOW). Home Depot operates 2,273 locations versus 1,845 for Lowe’s. Home Depot rules the North American retail discretionary sector with a 10% market share versus 7% for Lowe’s. This kind of market leadership gives Home Depot greater economies of scale, ensuring that it can profitably offer lower prices to its customers.
An expanding economy and a robust housing market contributed to expansion in Home Depot’s fundamentals. Over the past five years, its revenue, net income and free cash flow increased 26%, 138% and 64%, respectively. So far this year, Home Depot performed well with its year-to-date revenue, net income and free cash flow expanding, 5%, 12% and 20%, respectively.
Organic growth contributed heavily to Home Depot’s fundamentals in FY 2015. More customers returned to spend an increasing amount of money for their homes. Comparable store sales increased 5.1% so far this year versus 4.6% the same time last year. The company’s year-to-date customer transactions increased 3.8% year-over-year. Interestingly, customers are increasingly buying from Home Depot’s website. Online sales comprised 5% of year-to-date total sales versus 4.3% the same time last year.
The acquisition of maintenance, repair and operations (MRO) company Interline Brands also contributed to Home Depot’s top line so far this year. Home Depot wants to expand its presence in the MRO market. Keeping costs under control, as well as gains from the sale of Home Depot’s last remaining stake in HD Supply (NASDAQ:HDS), boosted Home Depot’s year-to-date net income. Increased net income filtered down to free cash flow.
Going in for debt
One of the downsides to consider regarding Home Depot is the increasing amount of long-term debt on its balance sheet. One of the reasons the company does this is to repurchase shares instead of investing in the business. Home Depot increased long-term debt 5.6% since the end of FY 2014. Long-term debt equates to 234% of stockholder’s equity so far this year compared to 181% at the end of FY 2014. However, operating income still adequately covers interest expense. Home Depot’s year-to-date operating income exceeded interest expense by 13.6 times.
Still, plenty of cash
Home Depot holds plenty of cash on its balance sheet. In the most recent quarter, the company held $3 billion in cash, equating to 40% of shrunken stockholder’s equity (due in part to its stock buyback program). The cash balance represents a 76% increase since the start of the year.
Home Depot pays a solid dividend. In FY 2014, the company paid out a reasonable 37% of its free cash flow in dividends. So far this year Home Depot paid out 36% of its free cash in dividends. Currently, the company pays its shareholders $2.36 per share per year, translating into a yield of 1.8%.
Valuation highest in five years
Home Depot’s P/E ratio clocks in at 25, which is the same as Lowe’s (see chart below). This compares to the P/E of 19 for the S&P 500, according to Morningstar. These numbers come close to being the highest in five years. Like a number of companies I’ve researched, it’s overvalued in a pricey market.
Home Depot stock will continue to do well as long as the economy and the housing market keep expanding. Home Depot’s debt appetite won’t be too harmful as long as interest rates remain low. Investors may want to sell Home Depot stock if the spread between operating income and interest expense gets too narrow. The company’s valuation resides a little in the higher range; however, investors may want to take a small position in the company while adding more during corrections.