After a rough late 2018, shares of home improvement retailer Home Depot (NYSE:HD) have staged a huge rally in 2019, rising 35% year-to-date to fresh all time highs. But, with HD stock price north of $230, I’m worried that valuation friction will ultimately short circuit this big 2019 rally in Home Depot stock.
To be sure, there’s a lot to like about HD stock here and now. The U.S. economy is picking up steam. Housing data broadly looks pretty good. The labor market remains healthy. Rates are still low. Trade conditions are improving. Hurricane Dorian has done huge damage in the Southeast, requiring massive rebuilding efforts.
But, there’s also one big thing not to like about HD stock here and now: valuation.
Home Depot is firing off multi-year low revenue, comparable sales, margin, and profit growth rates. Yet, HD stock trades at its richest valuation in several years. That’s not a winning combination – especially if the long end of the yield curve rises as the outlook for the U.S. economy improves (low rates help support big valuations).
As such, I’m worried about HD stock here and now. I love Home Depot stock long term. But, I don’t think the current valuation is sustainable in the coming months.
Lots to Like About Home Depot Stock
There’s a lot to like about the fundamentals underlying Home Depot stock.
In the near term, the U.S. economy is picking up steam, as evidenced by a huge upswing in Citi’s Economic Surprise Index, which measures how U.S. economic data is doing with respect to consensus estimates. For the first time in 2019, that Index just swung into positive territory. At the same time, housing data broadly looks pretty good. Existing and new home sales are still largely trending higher, as are building permits and new housing starts. Trade tensions between the U.S. and China are easing. Hurricane Dorian should provide a near term lift to home improvement and repair sales in the Southeast.
Against the backdrop of all that, rates are still low, Americans are still working, and wages are still moving higher. Thus, in the near term, Home Depot should benefit as the U.S. economy and housing market gain momentum against the backdrop of a healthy labor market.
Meanwhile, in the long run, Home Depot has crafted a niche for itself as America’s favorite home improvement retailer by becoming a one-stop shop that offers everything home improvement from product sales, to expert help, to installation services, and much more. It’s tough to see anyone unseating Home Depot in this market — they are just so big and so dominant in the home improvement space.
Consequently, long term, as goes the U.S. economy and housing market, so will go Home Depot stock.
In the big picture, then, both the near- and long-term fundamentals supporting HD stock are favorable. That should lead to shares heading higher, right?
Current Valuation is Unsustainable
The one big impediment to Home Depot stock heading higher in the near term is the stock’s valuation.
Consider this. Home Depot’s sales are expected to rise just over 2% this year on a 4% increase in comparable sales. Both of those growth rates are multi-year low growth rates. Over the next several years, Home Depot’s sales growth isn’t projected to rise much above 5% — slower than what the company has reported over the past five years.
Meanwhile, margins are expected to rise very slightly this year, a sharp divergence from the big margin expansion years Home Depot experienced earlier this decade. According to Street estimates, margins aren’t expected to move much higher over the next several years as it seems like gross margins are maxed out, and mid-single-digit revenue growth isn’t enough to drive significant operating leverage.
Moving down the income statement, profit growth is expected at less than 3% this year. Since 2014, Home Depot has fired off nothing but double-digit profit growth rates. Home Depot is projected to be a sub-10% profit grower over the next five years.
The big picture shows Home Depot is firing off multi-year low growth rates, and will remain in slow-growth mode for the foreseeable future. In stark contrast to this reality, Home Depot stock trades at 23-times forward earnings, versus a five-year average forward earnings multiple of 20x.
To be sure, this valuation premium is warranted by the fact that the 10-year Treasury yield has dipped to 1.6%. Yet, the long end of the yield curve is starting to move higher. It should continue to move higher for the foreseeable future as the outlook for the U.S. economy improves. As it does, HD stock’s extended 23x forward earnings multiple will be under pressure.
Bottom Line on Home Depot Stock
Long term, I like Home Depot stock. This is a company which has sustainable dominance in the secular growth U.S. home improvement retail market. That sustained dominance will drive steady revenue and profit growth in the long run — the sum of which should drive HD stock higher.
But, in the near term, nothing about Home Depot shares appeals to me. The current valuation is extended relative to its historical norm. Yet, the company growth profile is weak relative to its historical norm. This divergence is not a favorable one. While it is supported today by low yields, yields should creep higher over the next few months as the U.S. economic outlook improves. As they do creep higher, the divergence between the stock’s valuation and growth profile will be corrected.
This correction should ultimately result in HD stock pulling back towards $200.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.