Home Depot Stock Continues To Rise, But So Does The Downside Risk

  • There isn't healthy end-user demand in the US housing market. Prices rise despite muted house sales isn't sustainable.
  • The share price is inflated by all of these stock buybacks. P/E ratio is far too high, near historic multiples for the stock.
  • E-commerce companies will continue to threaten Home Depot. Online companies don't have the fixed costs that Home Depot has.

Home Depot (NYSE:HD) reported stellar third quarter results on the 17th of November. In reaction, Home Depot stock has rallied 10%+ to $134 a share since then. Revenue grew by 6.4% last quarter compared to the same quarter in 2014 and US comp sales grew by a whopping 7.3% which demonstrates the present robustness of the US economy. Furthermore the growth reported in the US mainly came from more traffic in the company's stores which has led many to believe that the retailer could easily accelerate its store openings so it could capitalize on strong consumer demand. Net income which has risen meaningfully this year as a result of higher operating margins and share buybacks is predicted to come in just under $7 billion this year which is terrific for a retailer based off a predicted $86.7 billion in revenues for fiscal 2015. However despite the momentum this stock clearly has, I would caution investors against being long at this stage. Home improvement spending is directly associated with economic strength, the job market, interest rates and the housing market. Furthermore this stock is a direct play on the US where it has approximately 90% of its stores (the other 10% are in Canada and Mexico). Ultimately stock selection should be based on whether present momentum can endure long term which I'm not so sure it can. Let's discuss.

Firstly the fundamentals of Home Depot may be sound, but the fundamentals of the US housing market in my opinion continues to be weak despite what we hear in the main stream media. Take a look at the chart below which compares new home sales in the US (red) against the median sale price of new homes.

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As you can see from the chart, the US is still building far less houses nowadays that it did 15 years ago, which means there have to be less buyers in the market irrespective of what the media says. However prices continue to rise. Furthermore, banks are far more stringent in their lending practices compared to 2006, which means housing is far less affordable in the US that it was 10 years ago. I believe low interest rates and quantitative easing which has put money into the hands of the few have fueled house price growth in the US. If we had healthy end-user demand, the chart above wouldn't have such a divergence. Watch average house prices compared to growth in new home sales. If prices continue to diverge, we may be entering a bubble in housing which would be bearish for Home Depot as existing home sales are also diverging from average house prices.

Secondly when you look at the company's balance sheet, it is evident that long term debt is growing at a faster clip than revenue. Long term debt is projected to come in at $16.87 billion this year compared to $14.7 billion last year. The company has embarked on a share buyback plan which is boosting EPS but investors need to consider the impact rising interest rates would have on the real estate market and the management of its debt load. Home Depot's dividend has shot up from $0.29 a share in 2012 to a current $0.59 a share. Dividend growth investors have definitely been attracted to this stock, not so much for the present yield which is 1.79% but for the rate at which it is growing. Personally I just feel the company wont be able to keep hiking the dividends at this rate. Just look at its valuation metrics, all of which state that Home Depot stock is expensive on a historic basis. Its price to earnings, price to book, price to sales and price to cash ratios have never been higher over the last 10 years. Furthermore its rising debt levels has spiked its debt to equity ratio to 2.34 in its recent quarter which again is multiple times higher than its average over the last 10 years. If the bottom line starts to slide in an environment of rising interest rates, this stock could start to slide pretty aggressively to the downside.

Finally, and although many analysts believe that this stock is Amazon (NASDAQ:AMZN) proof, I still see huge risk from the online channels, especially if economic growth was to deteriorate from here. At the end of the day, Home Depot is just a retailer that buys from manufacturers, and the "weight" and the "complexity" of the items it sells have meant that online retailers in general have kept away from this space up to now. Over time, I see this trend changing especially for categories that have been commoditized. 5% of Home Depot's business is now coming from its online channel which could easily double to 10% withing a few years. Nevertheless I just feel that online retailers are going to be attracted to this space, not just because of the revenues it generates but also because of the high value items the industry sells. More fulfillment centers and pick up points every year means e-commerce is going to continue to become really efficient in the years to come and I don't think companies like Home Depot will be able to evade this threat.

To sum up, Home Depot may be on the rampage at the moment but its valuation metrics are too high and its debt to equity metric is way up on years gone by. Furthermore if interest rates were to rise, managing this debt would be more difficult which would over time affect EPS and dividend growth levels. E-commerce will become more of a threat in the future especially for products that can be sold in bulk. This stock is a pure play on the US economy and personally I feel there is more risk to the downside than anything else.

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  • I do not hold any positions in the stocks mentioned in this post and don't intend to initiate a position in the next 72 hours
  • I am not an investment advisor, and my opinion should not be treated as investment advice.
  • I am not being compensated for this post (except possibly by Amigobulls).
  • I do not have any business relationship with the companies mentioned in this post.
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