Home Depot Inc's Reward Doesn't Justify The Risk

  • Home Depot continues to defy all logic. Recently it produced an exceptional set of earnings which will drive the stock higher.
  • However, many investors are buying into its guidance and fundamentals but forgetting its valuation and inherent risks.
  • Issues such as impending interest rate hike could adversely affect the housing market in the US. It is not a diversified company.

Many investors and analysts alike have continued their bullish stance on Home Depot Inc. (Home Depot (NYSE:HD) after the company delivered a solid set of first quarter earnings. Furthermore, housing starts surprisingly jumped in April which only added fuel to the bullishness already surrounding this stock. Moreover, analysts are now stating that the slight dip following the earnings release was due to a comment made by the management on the call that was construed wrongly. Guidance was raised by management but the stock sold off because US store comps fell from 11.8% in February to 4.6% in April. The reasoning behind the bullish call is that the company wouldn't have raised its guidance unless it felt that this downtrend had stopped. In the near term, Home Depot will be aided by a rising stock market (which has probably bottomed on 05-19-2016) but, in my opinion, there are just too many risks to consider going long this stock at the moment.

Also Read: Home Depot Stock Is A Risk At Current Price

Firstly, the company is definitely bucking the retail trend as sales growth of 9% and overall same-store sales of 6.5% are definitely indicative numbers of a rising market. Furthermore, the company is on track to earn $6.30 in earnings in 2016 which would be just under 20% earnings growth from its previous year. These are stellar numbers for a retailer and the bulls are stating growth will continue for years citing its strong brand, housing demographics and underlying strength in the US economy. However, Home Depot's sales multiple is now at 1.9 and its earnings multiple is 24.1 which are well above the company's 10-year averages. Is it worth investing in a stock trading at a sales multiple almost double of its 10-year average? (1.12 is the company's 10 year average). Study the company's price to sales ratio as it is a much more accurate valuation metric than the earnings multiple which would be much higher but for incessant buybacks.

Secondly, investors swarm to companies similar to Home Depot because of its strong cash flows, share buybacks & dividend plus sales and revenue growth. In fact over the last 5 years, Home Depot has grown its sales from $67 billion in 2011 to a trailing twelve month average of over $88 billion. Operating margins have grown from 8.6% to over 13% which is one of the main reasons why this company spun off almost $8 billion in free cash flow last year. However, this substantial growth has come at a cost to its balance sheet of which few are talking about. Long-term debt has gone from $8.7 billion in 2011 to almost $21 billion at the end of the last quarter. On top of this, equity in the company has shrunk from $18.8 billion to presently $6.3 billion. This means the debt to equity ratio has gone from 0.46 to 3.31 which is a huge negative in my view if present market conditions were to change. Every bull talks about Home Depot's incessant buybacks but never mentions where the funds are coming from.

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In terms of diversification, Home Depot has around 180 stores in Canada and a further 60 in Mexico. The rest of its almost 2,300 warehouse-style stores are in the US. Home Depot has done very well in recent years due to low interest rates, a strong US economy and a strong US dollar. Capital has been flowing heavily into the US in recent years precisely because the Fed has kept asset prices purposely elevated. What if this all changed? What is the dollar sold off and capital left US shores? When home owners have equity in their homes, home improvement activities become the norm which is why earnings estimates continue to grow for Home Depot "at the moment".

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However, with an interest rate hike in the US on the table (for June), many homeowners mortgages are going to be shelling out more every month on their mortgages. The stock is stretched too high above its 200 week moving average for me to get interested at these levels. We will either have consolidation for a significant period of time or the stock will fall. Swinging from the fence up here just doesn't make any sense in my view.

To sum up, I would be cautious while investing in Home Depot around these levels. Yes, it delivered an excellent first quarter but its sales multiple is far too high at these levels. Furthermore, I don't see much diversification (despite going into maintenance and repair) against a US down turn. Finally, its balance sheet has definitely been affected by the company's insistence on reducing the float in a low-interest rate environment.

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  • I do not have any business relationship with the companies mentioned in this post.
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Comments on this article and HD stock

user profile picture
atxmtnb1k3r
bullish
The company is taking advantage of its online presence and dominating with appliances. They also have great revenue from their Husky line which has low overhead. If Husky became its own brand, it would still be a top 500 company. Raising interest rates may slow home buyers but it will also keep people in their old homes which will need some sweat equity. I also know they do very will with contractors and have a great relationship with their contractor customers.
1 reply
user profile picture
Individual-Trader
neutral
Yea it all depends on the housing market. If equity were to subside in second hand homes, customers would be slower to refurbish and reform. Also don't like how debt has gone a lot higher in recent years. Would a value investor buy up here?
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