Home Depot: Fully Valued After Recent Rally

MIAMI, FL - MAY 17:  A Home Depot store is seen on May 17, 2016 in Miami, Florida. Home Depot  raised its yearly outlook after first quarter sales figures showed the home improvement retailer had a net profit of $1.8 billion, or $1.44 share, compared with $1.58 billion, or $1.21 a share, a year ago.  (Photo by Joe Raedle/Getty Images)

Home Depot (HD)  time and again has proved itself one of the world’s best retail companies.

And while in recent years the stock has hit rough patches due to fears associated with the e-commerce craze and its ability to adapt to a new retail environment, today the shares are sitting near all-time highs.

This confidence from the market is great for existing shareholders. But a recent rally in the shares, to around $212 currently, means that much of the margin of safety that has been available for much of 2019 has now dried up.

Recent Rally

Not long ago the shares were trading under $160. During the Christmas Eve selloff, Home Depot traded down to a 52-week low $158.09. That was only six months ago, but in our fast-moving market, it seems like forever.

Like the major market indexes, Home Depot quickly rallied off of those lows, yet it still spent much of the year trading in the $180s. At the lows, this stock carried a 16-times trailing-12-months price-earnings multiple.

When it was trading in the $180s, the multiple was 18 times earnings, and today, with the stock near the highs, the shares are being valued at 21 times.

When a multiple expands like this, it’s important to note whether a company’s growth prospects have increased accordingly. If they have, the move can be rationalized fundamentally. If they have not, the move is likely driven by speculation or sentiment.

Home Depot originally issued its fiscal 2019 guidance in February, within its fourth-quarter report. Management guided for revenue growth of 3.3%, same-store-sales growth of roughly 5%, a gross-margin rate of roughly 34%, a net-margin rate of roughly 14.4%, and a tax rate of 25.5%.

Management further expected to see cash flows from business operations of roughly $14.1 billion, net interest expense of roughly $1.2 billion, and capital spending of roughly $2.7 billion.

With a portion of the remaining cash, management expected to spend roughly $5 billion on share repurchases in 2019. It’s also worth noting that Home Depot earlier in the year increased its dividend, bumping the quarterly payment to $1.36 from $1.03. This 32% increase marked the company’s 10th consecutive annual dividend increase.

During the first-quarter-earnings conference call in May, Home Depot CFO Carol Tomé said, “Our view on the U.S. economy and the drivers of home-improvement spend are not fundamentally different from what we shared with you back in February.”

Management noted that lumber deflation remains a concern, and how the wet spring will ultimately affect the lumberyards is still unclear. Home Depot does not include commodity inflation/deflation speculation into its forward guidance figures.

During the first-quarter conference call, management highlighted that lumber prices could have a significant impact on the 2019 sales-guidance figure. We won’t get more clarity on that data point until the second half of the fiscal year.

Elevated Multiples 

The current consensus analyst estimate for Home Depot’s 2019 — $10.12 a share — is essentially in line with the original expectations management presented.

In other words, Home Depot’s bottom-line expectations have not increased alongside the stock’s rising multiple. So the rally we’ve seen in Home Depot in the past couple of months is based primarily on improved market sentiment.

At current levels, I believe Home Depot is fully valued. The shares aren’t exceedingly expensive — but neither are they cheap.

Over the past decade, Home Depot’s average p/e multiple is 20.1 times. Looking back a bit further, its average 20-year multiple is 21.3 times. Today’s 21.3 times premium is in line with these historical averages.

While Home Depot’s EPS growth rate for 2019 is in line with analyst estimates, the growth rate the company is expected to report for 2019, 2020, and 2021 is well below the one to which investors have become accustomed.

From 2011 to 2018, Home Depot produced average EPS growth of 22.11%. After posting 33% EPS growth for 2018, the company is expected to post bottom-line growth of 2% for 2019. For 2020 and 2021 expectations are better at 9% EPS growth per year.

This slowdown should be priced into the shares. With this in mind, I don’t believe that the company deserves an outsized premium relative to its historical averages.

Home Depot remains a top dividend-growth pick and a blue-chip name in the retail space. Investors could certainly do worse than paying full price for a high-quality asset like this.

But whatever margin of safety that was previously available in the stock in the aftermath of the Christmas Eve selloff appears to have evaporated. True value investors should likely look elsewhere.

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