Favorable Trends Make Home Depot a Buy

home depot stock

home-depot-logoAfter a rousing five-year growth trajectory, the question for Home Depot (NYSE: HD), the world’s largest home improvement retailer, is: can it continue? I say it can and recommend that you consider buying the stock.

As the housing market went from boom to bust in the middle of the last decade, HD’s stock tanked. From a high of $34.85 in 2006, the stock shed more than half its value, falling to a low of $15.73 in October 2008. Over that full three-year period, the stock generated a negative annual total return of 15.5%, and an initial investment of $10,000 shrank to $6,048.

But with the official end of the recession in 2009 and the return of the real estate market, HD shares came roaring back (it latest close was $80.08). For the five years ending in calendar year 2013, the stock generated a cumulative total return of more than 290 percent, for an annual average of 31.5 percent, outpacing yearly returns for the S&P 500 by more than 14 percentage points.

Underlying that performance has been strong financial management. While revenues grew over that same five-year period at an average of 3.6 percent a year, to $78.2 billion in the last full fiscal year, net income grew six times as fast, at a blistering 21 percent pace. The results reflect the strategy senior management adopted in the midst of the financial crisis to controlling costs and finding efficiencies in all operations – a strategy senior management continues to follow.  As a result, company profitability has more than doubled, from 3.2 percent of revenues in fiscal 2009, to 6.8 percent last year, and free cash flow has grown at an average of nearly 19 percent a year.

The strategy has enabled Home Depot to deliver shareholder value through stock buybacks and dividend increases. Last year, the company repurchased $8.5 billion of stock, and plans to buy another $5 billion this year. Meanwhile, its annual dividends have grown 15 percent a year over the last five years.

Concern that the company is still beholden to the rise and fall of the housing market, where recovery has been sluggish and sensitive to rising interest rates, raises questions about whether Home Depot can keep up the pace. A number of analysts say it can. The reason: even when housing prices aren’t rising, Baby Boomers are expected to continue to spend more time in their homes and more money on refurbishing them. The magic number for home improvement spending to grow is 25 – the number of years a house has stood. The median age of America’s housing stock is 34 years, and nearly two-thirds of it is 25 years old or older. All of this makes the prospects for HD to grow its revenues appear strong.

Another factor:  Home Depot has shed it former goal of rapidly expanding the number of its warehouse stores in favor growing store profits and gaining market share.  One tactic is smart price discounting:  rather than compete with Lowe’s, its chief rival, on prices across the board, Home Depot is focused in discounting specific product lines – like power tools – to draw customers in, and make up the margins on selling additional goods and services.  At the same time, the company now pays store managers bonuses on the basis of gains in sales revenue, profitability and inventory turnover.

Another way the company is driving market share is to improve its customer service, without increasing headcount. It’s accomplishing that by shifting more hourly personnel from other tasks to walking the floor to help customers and increasing training to make its sales associates more knowledgeable on all sorts of home improvement projects. It’s also taken discussing and rewarding sales associates for examples of outstanding service.  The company’s goal is to make an emotional connection with shoppers through extraordinary service.

Home Depot stores serve three markets: do-it-yourselfers (DIYs), homeowners who do their own installations; do-it-for-me customers (DIMs), homeowners who buy the store’s products and hire contractors to do the installation (often through Home Depot’s network); and professional remodelers, contractors and repair people.  It sells appliances, tools, paint, flooring, lumber, plumbing, electrical, kitchen, garden and other home improvement supplies from some 2,260 stores in the U.S., Canada and Mexico.  Last year, 3.5 percent of its sales were transacted online, a number that rivals those of Walmart and Target.

At a price of $80.08, HD is trading at a trailing 12-month PE of 20.4 times earnings of $3.39 a share, comfortably below the industry average of 25.4.  With a dividend of $1.88, it’s yielding 2.35 percent, better than the industry’s 2.2 percent. With a Wall Street consensus EPS target of $5.12 for fiscal 2016, HD’s has a forward PE of 16.1.

But more importantly, the Wall Street consensus is that HD’s earnings will grow a more than robust 16.1 percent a year over the next five years. That translates into to a dividend-adjusted Price to Earnings Growth ratio of 0.84, the second most attractive of the Dow 30 stocks. By my standards, a PEG below 1.2 is a buy. That makes HD is a strong buy in my book. If it maintains its present course and metrics, the stock could reach $96 a year from now, and $111 within two years.

About Lawrence Meyers
 lawrence meyersLarry is regarded as one of the nation’s experts on alternative consumer finance. He consults for hedge funds and private equity via his Council Member status at Gerson Lehman Group, and as a member of Coleman Research Group’s Executive Forum. He also consults for Credit Access Businesses and Credit Services Organizations in Texas. His Op-Eds and Letters to the Editor have appeared in over two dozen major newspapers. He also brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses of all stripes. You can reach him at [email protected]

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