When rates go up, one sector of the economy that gets hit the hardest is the housing sector. Accordingly, as markets have tumbled over the past two months due to concerns over rising rates curtailing economic growth, home improvement retailer Home Depot (NYSE:HD) has been among one of the biggest losers. During that stretch, HD stock has dropped more than 20% off recent highs.
This drop is warranted. Housing data is weak and only getting weaker as rates go higher. A big part of Home Depot’s growth is big ticket home improvement transactions. It is only a matter of time before weak housing data washes out Home Depot’s big ticket growth, and drags the company’s overall growth trajectory lower. This will have an effect on margins, too, and overall earnings growth will slow into the foreseeable future.
But, this drop is also an opportunity. Given its defensible position as the go-to retailer in a secular demand industry, Home Depot stock is a long-term winner. There will be bumps in the road, but ultimately, this stock will head higher in the long run.
As such, you want to buy HD stock on big dips like this one. But, you want to wait for the right price, too. Below $170, the price feels pretty good, and this looks like a good time to start slowly buying into recent weakness.
HD Stock Is A Long-Term Winner
At its core, Home Depot stock is a long-term winner.
The home improvement space is one characterized by secular demand. While economic booms and busts will create surges and lulls in home improvement demand, the long-term growth trend in the home improvement space is upward and outward.
Home Depot has emerged as the unchallenged leader in this space. Granted, Lowe’s (NYSE:LOW) has something to say about that. But, Lowe’s is a $70 billion company. Home Depot is a $200 billion company. There really isn’t much of a comparison. Home Depot is No. 1. Lowe’s is a distant No. 2.
As the unchallenged leader in the secular demand home improvement space, HD has secured for itself a healthy and sustainable long-term growth trajectory. Over the past twenty years, Home Depot’s revenues have gone from under $3 billion to over $100 billion, and net profits have gone from under $100 million to over $10 billion. Growth from then until now has been fairly consistent, with one big hiccup in the 2008 housing crisis.
This trend will continue. As goes the U.S. economy and housing sector, so goes Home Depot. Long-term, the U.S. economy will only grow, and the housing sector will only grow with the economy. As such, long term, HD stock is a winner.
Home Depot Growth Will Slow
Near term, the story is much different.
There are warning signs everywhere that the U.S. economy, and in particular the housing sector, is slowing. Home-builder sentiment dropped to its lowest reading this month since August 2016. That follows what has been a multi-month downtrend in housing starts and permits that started early this year. Also, economists are rapidly cutting their U.S. GDP growth forecasts for 2019 and after, as further rate hikes and bigger tariffs are expected to slow economic expansion.
Overall, the writing is on the wall. The U.S. economy is slowing, and will continue to slow so long as the Federal Reserve continues to hike and President Trump continues to play hard ball with China. The sector most at risk in this slowdown? The housing sector. As rates go up, it will be tough to sustain demand in a slowing economy. We are already seeing cracks start to form, and those cracks could become more severe the longer this slowdown lingers.
Because of this slowing economic backdrop, the near-term outlook for Home Depot stock isn’t all that rosy. Over the past several years, HD has been defined by consistent and steady 5-7% comparable sales growth and margin expansion. But, last quarter, comparable sales rose just 4.8%, and that growth is expected to cool further next quarter. Meanwhile, operating margins on the year are expected to be flat at 14.5%.
Thus, over the next several years, HD’s growth profile will deteriorate. It won’t go negative like it did in 2008 because the economy won’t collapse like it did back then. But, the economy will slow from this boom, and HD’s growth will slow, too.
Valuation Looks Good Even Considering Slower Growth
The bull thesis on HD stock rests on the idea that it has fallen so far and so fast, that even in a slow growth scenario, fundamentals support further upside.
Over the next several years, comparable sales growth will likely run around 2-4%, while margins will only move mildly higher. Under those assumptions, a realistic five-year forward earnings-per-share target for this company is around $14, versus $9.80 expected this year.
Home Depot stock normally trades around 20x forward earnings. If you throw a 20x forward multiple on fiscal 2023 EPS of $14, and discount back by 10% per year, you arrive at a 2018 price target of $190. Using a market average 16x forward multiple and the same calculus, you arrive at a 2018 price target of $150.
HD stock currently trades right in between those reasonable, slow growth year-end price targets. As such, this looks like a good time to start gradually buying into weakness.
Bottom Line on HD Stock
This stock is a long-term winner undergoing near-term turbulence. The near-term turbulence is justified, but it is also an opportunity. Below $170, the price feels right to start slowly buying into this sell off.
As of this writing, Luke Lango was long HD.