Tax reform is in the air, and investors are treating it as an early Christmas gift for full-tax-paying companies. One such company is Home Depot Inc (NYSE:HD). HD stock is up more than 2% since Friday.
I’ve said time and time again that HD stock will be a big winner if tax reform goes through. Home Depot’s effective income tax rate was above 36% in both 2015 and 2016. It’s also hovering above 36% so far in 2017.
Consequently, any cuts to the corporate tax rate would help HD stock. Likewise, any significant cuts to the corporate tax rate would significantly help HD stock.
Use last year as an example. Pre-tax earnings at Home Depot were $12.5 billion. Provision for income taxes totaled $4.5 billion, or about 36% of pre-tax income. Net income, then, was about $8 billion.
But if the tax rate had been 20% (as opposed to 36%), then provision for income taxes would have totaled $2.5 billion ($2 billion less). Net income under such circumstances would have been $10 billion.
That is a huge 25% increase over reported net income in fiscal 2016.
Thus, it is easy to see that lowering the corporate tax rate from 35% to 20% would be hugely additive to Home Depot’s bottom line. That is why HD stock is rallying in the first trading day after the the Senate passed its tax reform bill.
Have you missed the rally? Hardly. HD stock is only slightly overvalued if no tax reform materializes. But it’s significantly undervalued if full tax reform materializes soon.
Home Depot Is a Secular Growth Story
As I’ve said multiple times before, Home Depot is a secular growth story. That makes HD stock an attractive long-term investment.
Home Depot has been around for 40 years and has been flourishing as the go-to home improvement retailer right from the start. Those 40 years of experience as a market leader in a market with enduring demand, gives HD a long track record of weathering storms, surviving threats and continuing to deliver out-sized shareholder returns. This long track record deserves a premium valuation.
Over the past 5 years, HD stock has traded around 23 times trailing earnings. Earnings growth during that stretch was around 20% per year. Comparable sales rose by 5-6% per year on average. Margins trended healthily upward.
But this year, HD expects comparable sales growth to hit 6.5%. The outsized growth is being driven by a confluence of tailwinds. Those tailwinds include growing smart home tech adoption, hurricane-related rebuilding efforts, market share gains on the back of waning competition (see Sears Holdings Corp (NASDAQ:SHLD)), a booming digital business and an increasingly popular (and hard to replicate) Pro Services business.
While the nature of these tailwinds will surely change over time, Home Depot will continue to benefit from a plethora of tailwinds into the foreseeable thanks to its leadership position in the secular growth home-building and home-improvement markets.
Consequently, the earnings growth outlook for HD stock is pretty promising. Even without tax reform, earnings growth over the next several years should look similar to what it has looked like over the past several years.
By the same token, the valuation on HD stock should look similar to what it has looked like over the past several years. The trailing 5-year average price-to-earnings multiple is 23. A 23 multiple on next year’s earnings estimate of $8.44 per share implies a 1-year forward price target of $194. Discount that by 10%, and you get a fair value in the high $170’s.
HD Stock Is a Big Winner With Tax Reform Coming
So, without any tax reform materializing, HD stock is still only slightly overvalued at these levels.
But tax reform is coming.
And if the corporate tax rate does get cut from 35% to 20%, earnings estimates on HD stock will come up in a big way. Given that such a tax reduction would’ve increased 2016 earnings by 25%, it’s not unlikely to think that earnings estimates could come up by 20%-plus.
If that happens, then HD stock is dramatically undervalued at $185.
Bottom Line on HD Stock
Home Depot is a secular growth company with mid-single-digit positive comparable sales growth, a healthy margin expansion narrative and a big tax rate.
That is a winning combination in a market full of investors getting excited about tax reform.
As such, I don’t see any reason to dump HD stock. I remain bullish.
As of this writing, Luke Lango was long HD.