To Buy Home Depot Stock, You Have to Really Trust the Economy

Home Depot is making all the right moves - but investors need to watch the housing cycle

Here's How Home Depot Stock Could Bounce Back To $200 This Year

Source: Mike Mozart via Flickr (Modified)

From one viewpoint, Home Depot (NYSE:HD) is a slam-dunk buy. After all, there’s a school of thought that investing simply comes down to owning the best businesses and holding them for the long-term. As Warren Buffett put it, “It’s far better to own a wonderful business at a fair price than a fair business at wonderful price.” And it’s hard to argue that Home Depot isn’t a wonderful business.

Its market position seems pretty much unassailable. The company is headed toward $100 billion in revenue. It’s moved relatively smoothly into e-commerce, preventing (NASDAQ:AMZN) from finding a competitive opening. It continues to outgrow rival Lowe’s (NYSE:LOW), and Home Depot stock has outperformed LOW over pretty much every time frame.

Based solely on those critieria, at any moderate valuation — and HD trades just under 20x forward earnings — Home Depot should be worth owning for the long haul. And indeed, HD has been a wonderful long-term investment, returning an average of 11.6% annually, including dividends over the past 20 years.

But there’s another broad school of thought that argues that price — and timing — do matter. And oddly enough, Home Depot stock proves that argument as well. In the 2000s, Home Depot stock lost nearly 58% of its value. Obviously, that decade ended with the country still barely out of the throes of the housing crisis. HD has gained 1,200%+ from March 2009 bottoms.

Still, this is a cyclical stock. And while 20x earnings sounds cheap, investors in HD really need to trust the cycle. I’m not sure that’s necessarily wise at the moment.

Home Depot Continues to Cruise …

Investors blanched at fiscal first-quarter results in May, sending HD down after earnings. As Ian Bezek detailed at the time, it was a mixed-quarter, particularly relative to expectations.

But expectations aside, there’s really nothing wrong with Home Depot’s business. Same-store sales in a “disappointing” quarter still rose 4.2% year-over-year, including 3.9% in the U.S. Full-year guidance still projects 5% full-year comp growth and a 28% increase in net income. A lower tax rate is providing a benefit to the latter figure, but this remains a business growing nicely.

And Home Depot stock has more than regained those post-earnings losses. At $199, the stock is again threatening all-time highs of $207, reached in late January. But valuation hardly seems outrageous, at less than 20x Street consensus for FY19 (ending January 2020). If the current trends hold –and Home Depot can prove a (relatively) slow Q1 start was due largely to weather — traditional fundamentals would suggest new all-time highs are on the way.

… But Sector and Macro Risks Loom

The concern here, however, is how many factors remain outside Home Depot’s control. When the housing cycle turns, Home Depot gets punished. Same-store sales declined 6.7% in fiscal 2007, 8.7% in fiscal 2008, and 6.6% in fiscal 2009.

And elsewhere in the market, investors seem relatively concerned about the housing cycle. Homebuilders Lennar (NYSE:LEN) and D.R. Horton (NYSE:DHI) are down 25% and 21%, respectively, from 52-week highs. (I’ve argued the sell-off in LEN has gone too far, admittedly.) Several HD suppliers, like American Woodmark (NASDAQ:AMWD) and Mohawk Industries (NYSE:MHK) are near 52-week lows.

Admittedly, some of that pressure is coming from margin concerns, due to rising input costs. Home Depot, given its scale and dominance, probably can pass along some level of higher pricing to customers. But as Joseph Hargett pointed out, Home Depot has its own trade war concerns.

Meanwhile, a 20x forward multiple seems cheap in the context of current growth. But from a broader economic standpoint, the U.S. is Year 10 of an economic expansion. Multiples for cyclical stocks like HD should be compressing at this point — at least in theory. And if that cycle turns — as is inevitable — HD stock could take a hit.

Is HD a Buy?

As attractive as the long-term case for Home Depot looks, I’m of the opinion that the price, and the timing, aren’t necessarily right. That’s not to say that another housing crisis is on the way — or that HD is going to fall sharply, or should be shorted.

But 20x forward EPS at this point in the cycle simply isn’t a cheap multiple. And I’d add too that for HD to rise, it needs help from housing and the cycle as a whole. The declines in quality operators like MHK, AMWD, and LEN leave those stocks priced to rise much more if that scenario plays out.

To be sure, HD isn’t a bad investment. It’s treated shareholders very well over time, and I’m not anticipating another lost decade for the stock. Still, for investors looking to play housing, I’m not sure it’s the best play. And for investors nervous about the economy, and the market, going forward, it’s tough to stomach even a quality company like Home Depot at the current valuation.

As of this writing, Vince Martin has no positions in any securities mentioned.

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