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It’s Time to Do Some Profit Taking in Home Depot Stock

Home Depot stock was a great buy in early 2019; not so much anymore

For the past several months, I’ve been sounding the bull horn on shares of Home Depot (NYSE:HD). During that stretch, HD stock has risen nearly 30%.

It's Time to Do Some Profit Taking in Home Depot Stock
Source: Helen89 / Shutterstock.com

As enthusiastic as I was (see here and here), not might be the time to start taking those earnings before they evaporate. Instead, it’s time to switch into a neutral stance. For early 2019 dip-buyers, that means it’s time to do some profit-taking.

The “sell the rally” thesis is pretty simple. The fundamentals are deteriorating. Comparable sales growth is slowing. Macroeconomic risks are rising. Margins are flattening out. Profit growth has been relatively anemic.

At the same time, HD stock has sprinted to a premium valuation, and these conditions can’t last forever.

This combination of deteriorating fundamentals and a premium valuation is not a winning one. Instead, it is one that will probably result in HD stock either coming back down towards $200, or trading sideways for the foreseeable future.

Either way, I don’t see Home Depot stock gaining much ground from here over the next few months.

Fundamentals Are Weakening

Although Home Depot is up nearly 30% year-to-date, it cannot be ignored that the company’s core growth fundamentals, while still solid, are weakening.

The story is simple. Home Depot is a home improvement retailer. As a home improvement retailer, this company grows largely with the U.S. economy, and to a lesser extent, the global economy. The global economy is slowing and is projected to keep slowing, weighed by escalating trade tensions. The U.S. economy is similarly slowing and is projected to keep slowing, also weighed by escalating trade tensions.

In other words, the U.S.-China trade war is creating a problematic outlook for Home Depot. I think this trade war will eventually come to a beneficial resolution. But, at the moment, both sides are upping the ante with more tariffs and more threats. So long as this ante keeps getting upped, economies around the world will continue to slow, and Home Depot’s growth trajectory will flatten out.

Home Depot’s numbers confirm this story. Comparable sales rose 2.5% in the first quarter of 2019 and 3% in the second quarter of 2019. That’s a big slowdown from 5.2% comp Home Depot reported in 2018. Further, comparable sales are expected to rise just 4% this year, marking the worst comp since 2011.

At the same time, margins are under pressure for a variety of reasons and likely won’t improve until top-line momentum returns and allows for more operating leverage. Thus, profit growth has been depressed year-to-date (EPS up less than 4% year-over-year last quarter), and will likely remain depressed until the trade war stops creating macroeconomic headwinds.

Broadly, while the Home Depot growth narrative should remain largely positive for the foreseeable future, it will remain less positive than it has been over the past few years. The unfortunate thing here is that HD stock isn’t priced for “less positive.”

Valuation Is Rich on Home Depot Stock

The present valuation on Home Depot stock is rich; too rich considering the company’s go-forward growth prospects.

HD stock trades at 21.5-times forward earnings. The five-year-average forward earnings multiple for this stock is roughly 20. Thus, HD stock is trading at an above-average valuation today, despite the fact that the company is firing off multi-year worst growth rates, and the fact that those depressed growth rates are here to stay for the foreseeable future.

That doesn’t add up.

Let’s model this out. Home Depot has been a mid-to-high single-digit revenue grower for the past several years. Given that the global economy is slowing, it is likely that Home Depot’s revenue growth rates similarly slow into the mid-single-digit range. At that growth rate, it will be tough to drive robust operating leverage. Instead, margins will likely only inch higher over the next several years, especially considering they are basically at all-time highs.

Net net, Home Depot reasonably projects as a mid-single-digit revenue grower over the next several years, with tepid margin drivers. Some buybacks are in the mix, too. That should drive mid-to-high single-digit profit growth, paving the path for around $15 to $15.50 in EPS by fiscal 2025.

Combining the high-end of that range with the historically average 20-times forward earnings multiple, that equates to a 2024 price target for HD stock of $310. Discounted back by 8% per year (accounting for the yield), which implies a 2019 price target of about $210, below today’s price tag of $220.

Bottom Line on Home Depot Stock

Home Depot stock was a great buy in early 2019. Not so much anymore. The valuation is stretched, and the fundamentals are weakening. This discrepancy ultimately means that HD stock may be maxed out and that weakness in the foreseeable future is likely.

Because of this, I think profit-taking is the right move here and now.

As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media, https://investorplace.com/2019/08/time-profit-taking-home-depot-stock/.

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