- Home Depot fails on some fundamental metrics over a 10 year period. Its debt has risen too fast leaving little equity on the balance sheet.
- The price to rent ratio continues to increase in the US. This is bearish as more Americans rent due to inflated home prices.
- Price to sales ratio is above historic averages. It will revert to its mean of 1.12 which will mean a drop in the share price.
Warren Buffet once said " Be fearful when others are greedy and greedy when others are fearful" and Home Depot (NYSE:HD) is certainly a stock that investors may be getting a bit ahead of themselves on with respect to being long the stock in spades. For example, its latest bumper quarter closed 2015 with revenue of $88.5 billion which was a 6.4% jump over 2014 and an EPS of $5.46 which was almost a 16% increase over 2014. Furthermore, operating margins rose to 12.1% in the fourth quarter which is really impressive considering this metric was under 10 for four straight years between 2008 and 2012.
When a retailer has higher margins coupled with higher traffic numbers in stores (as reported in the fourth quarter), analysts become more bullish as indicated by their $6.21 EPS estimate for 2016 which, if achieved, will be a 14% increase over 2015. The scheduled share buybacks will help with $5 billion being earmarked for 2016. Net income would probably only need around a 9 to 10% hike (to around $7.7 billion) for analyst EPS expectations to be met. Recent positive numbers and exciting growth prospects have resulted in the company hiking the dividend by 17% to $0.69 which was last paid out on the 8th of March. High double digit dividend hikes will always peak interest, especially in a yield environment investors are facing nowadays. However in this article, I would like to point out some areas where Home Depot may run into trouble. I wouldn't be going long now as a long term investor and here is why.
Firstly, even though Home Depot has had solid growth since 2012, I believe 3 to 4 years isn't long enough to justify going long this stock. Therefore, let's look at its most important fundamental metrics over the last 10 years to get a gauge on how the company responded through leaner times.
|Years Of Dividend Increases||7 Years - Pass|
|Free Cash Flow||$7.8 billion (10-Year Trend Is Up) - Pass (Very Important For Dividend Investors - Dividend Currently Is 2.14%)|
|Revenues||$88.52 billion (10-Year Trend Is Up) - Pass|
|Profit Margins||8% - (10-Year Trend Is Up) - Pass|
|Total Debt||$20.5 billion - Up from $1.7 billion in 2005 - Fail|
|Healthy balance sheet||Total assets = $42.55 billion (10-Year Trend Is Flat) - Pass|
|Resistant to recessions?||Sales still haven't reached 2007 levels and the dividend (although not cut) remained stagnant for 3 years. Share price also dropped by 40%+ in this time period. - Fail.|
Fundamental metrics over a large enough time-frame always highlight any potential problems a company may run into. The first metric where the company fails on is its debt which has spiked to $20.5 billion. Now debt does not need to necessarily decrease but if it is increasing, I believe that its ascent must not be much greater than sales, asset or earnings growth but unfortunately it is. Home Depot's equity has fallen from $26+ billion in 2006 to only $6.32 billion at the moment. This is the first red flag that longs should be mindful of. With long term debt currently standing at $17.91 billion, it is now more than twice the 2011 numbers despite returning billions to shareholders.
Bulls maintain that Home Depot is well diversified to withstand a recession in the US as 35% of its sales come from pro sales (new construction) and 65% of sales come from retail sales which are mainly customers undergoing improvements or maintenance on their homes. This means that bulls believe only 35% of Home Depot's core business is cyclical but I don't share the same point of view. Why? Although home improvement activity could increase in a recession, it is equity in one's home that is the defining factor whether a person spends money on his or her home. Furthermore, the price to rent ratio of housing in the US is currently 19.21 which means that the real estate market is still more suited to renters at the moment as the historic average is approximately 15. This ratio bottomed out in 2012 and has been rising ever since indicating that the market is still overvalued (see chart). This means that eventually house prices will have to fall or home ownership will fall in the US which are both bearish for Home Depot.
The retailers price to sales ratio is currently 1.9 but its 10 year average is 1.12. Analysts believe the company will do $93.82 billion in sales this year which if achieved would drive the market cap to over $178 billion. I like to look at sales for big retailers as margins can come under pressure in recessions which we saw with Home Depot in 2008. As we can see from the chart, the share price has vastly outperformed the p/s ratio (sales have not caught up with share price growth), leading to a significant rise in the PS ratio since 2014. I believe it is only a matter of time before this ratio comes back into sync.
To sum up, whereas many analysts have turned bullish on Home Depot stock since its recent earnings, I would advise caution for a number of reasons. The Home Depot stock is overvalued on a historical basis, more people in the US are starting to rent and margins will come tumbling down if a recession were to hit the US. Home Depot's goods are not essentials like Walmart (NYSE:WMT) and McDonalds (NYSE:MCD) which means it is not a recession-proof stock.