Home Depot (HD) has had a nice run lately. HD stock is up 11% year-to-date in 2014, outperforming the 8% gain for the S&P 500, and up about 230% in the last five years to double the major indices.
To top it off, Home Depot earnings this week were once again a hit, pushing the world’s largest home improvement retailer to new all-time highs and sparking a spate of upgrades. UBS and Argus reaffirmed their “buy” ratings on HD stock, with both increasing their price targets for Home Depot, to $98 and $100 per share, respectively.
But even though the housing market is “back” and even though HD stock has made a habit of outperformance, I’m skeptical that the run can continue.
Here’s why I think it might be time to cut back on Home Depot in your portfolio:
HD Stock Ran Too Much
Now, I’m not one of those bears who think the housing market is going to go bust again. I remain convinced the recovery in real estate prices is durable, and that even a modest rise in mortgage interest rates won’t deter people from buying — or more importantly for Home Depot stock, fixing up — their homes.
But even if the real estate market stays firm, the fact is that HD stock has already appreciated as far as it can on a change in sentiment around housing. The 230% run in the past five years is proof positive that investors have baked in success for housing.
The challenge is how Home Depot will keep this up.
HD stock is a bit rich valuation-wise for a brick-and-mortar retailer, with a forward price-to-earnings ratio of 17.5. While the company has managed to swim against the tide that is clearly going out for retail stocks like Target (TGT), Best Buy (BBY) and Walmart (WMT), it’s fair to question why investors would continue paying a premium for shares given the broader industry troubles.
As for HD stock and its fundamentals, good earnings certainly haven’t been great earnings. Consider that FY2013 revenue of $78.8 billion for Home Depot was less than 20% higher than revenue for FY2009 of $66.2 billion. Not exactly a dramatic growth story there when you annualize it out to about 4% sales growth per year.
The profits actually have largely come from stock buybacks and efficiencies, not top-line growth … and while that’s nice to have in an era of declining retail stocks it’s certainly not proof that HD stock is a locked-in winner.
Home Depot Has Troubles
The real story behind Home Depot stock to me isn’t earnings, but its ability to funnel cash to shareholders.
HD has been spending like mad to deliver capital to shareholders via dividends and buybacks — as evidenced by a $2 billion debt offering this year to fuel HD stock repurchase plans. The dividend also has roughly doubled from just under 24 cents per share quarterly in 2009 to 47 cents now.
That’s great if you bought shares a few years back … but now, investors need to ask what HD stock is going to do for them at current levels.
Yes, annual dividends have grown nicely and have continued upside since distributions are just about 41% of Home Depot earnings. But the headline yield is a mere 2.1%. If and when the Fed raises rates in 2015 then you can expect income investors to move swiftly out of stocks like HD.
And even if you want to ride this Home Depot momentum a bit longer, it’s worth noting that the stock is dramatically above its 50-day average — and in fact is the most overbought stock in the Dow Jones Industrial Average according to the analysts at Bespoke Investment Group.
Lastly, HD is banking big on e-commerce. The company trumpeted that sales surged 40% year-over-year in the latest quarter… but remember, these items account for just 4% of total revenue. That’s not really a game changer, and Home Depot will need to stay very focused on growing this segment.
That’s easier said than done, not just because of price competition from sites like Amazon (AMZN) but also because many homeowners can find unique and distinctive products at a host of smaller sites — while Home Depot’s selection remains largely targeted toward contractors with limited options and rather conventional styles.
If you have a good cost-basis in HD stock, then by all means hold for future dividend growth if you’re willing to park your money in this retailer for 10 or 20 years. But new money should stay out — Home Depot has delivered big gains lately, but I remain skeptical that the outperformance will continue.
Jeff Reeves is the editor of InvestorPlace.com and the author of The Frugal Investor’s Guide to Finding Great Stocks. As of this writing, he did not hold a position in any of the aforementioned securities. Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP.