Most would agree that Home Depot (HD) stock had a great first quarter, and its strong performance is simply a continuation of the past couple years; shares were trading around $40 at the start of 2012. .
Still, HD stock is down 3% year-to-date — is the market being unfair? It certainly seems like Home Depot will have a tougher time with millennials, who seem less enthusiastic about buying homes than their parents were.
Does Home Depot still have room for growth?
HD Stock Pros
Strong Market Position: The home improvement industry is a duopoly, dominated by Home Depot and Lowe’s. The threat of new entrants is low and the barriers to entry are high, since there are high startup costs in building up a large-scale retail chain and incumbents benefit from economies of scale. HD is one of the few big-box retailers withstanding the e-commerce revolution; Home Depot’s online sales recently rose 21.5%.
Home Depot’s online sales have been increasing at a 40% annual rate over the last three years, and are forecast to grow 20% annually until 2020. Also, it may be difficult for Amazon (AMZN) to take business from Home Depot. People often need advice from Home Depot staff before buying home improvement tools, and many products sold at Home Depot are heavy and fragile, making them not so easy to ship.
Rising Operating Margins: Home Depot’s operating margin has gone up in recent years, from a low of 6.1% in 2009 to 13.3% in fiscal 2016. Sales, General and Administrative expenses increased from $16.03 billion in 2012 to $16.8 billion in 2016, while gross profit grew from $24 billion to $30 billion.
Consistently Growing Dividend: HD stock has consistently been increasing its dividend, which was $0.68 a share in 2007 and now is $2.36 a share. Home Depot kept its dividend flat from 2008 to 2010, but then it started taking off. The dividend yield is now a respectable 2.1%, and the payout ratio is 42%. Best of all, further dividend hikes may be on the way.
HD Stock Cons
Higher Labor Costs Coming: Home Depot will face higher labor costs because of minimum wage hikes in both California and New York. Both states are on track to raise the statewide minimum wage from $9 in New York and $10 in California in 2016 to $15 an hour by 2022. There are 232 Home Depot stores in California, and 100 in New York, out of 2,000 in the United States and 2,200 in North America. HD generated $238,596 in revenue per employee in the quarter ending on January 31st of this year, so the wage hike will not be as hard on Home Depot as it will be for firms like Starbucks (SBUX) and McDonald’s (MCD), which sell much less per employee.
Reliance on the Housing Market: Home Depot’s fortunes are tied to those of the housing market and the construction of new homes. When the housing market is doing well, Home Depot does well, and when the housing market does poorly, Home Depot stock slips. Home Depot’s operating income in fiscal 2007 was $9.67 billion, when the housing market was at its peak, but in fiscal 2009 this was only $4.36 billion. The housing market may be doing well now, but it is cyclical and could always see trouble next year. With many still expecting the Federal Reserve to hike rates later this year, increased borrowing costs could cause a hiccup in the housing market.
Millennials Not Buying Homes: Home ownership among the young is down; in 2005, 43% of adults under 35 owned a home, while today only 35% do. Some think this may be because millennials simply don’t want to buy homes. Last year, rent on housing increased while borrowing costs remained low, yet millennials remained lukewarm about home ownership. Home Depot is confident this will change eventually, but for now HD is selling them things like window treatments, which don’t go against rental agreements.
Home Depot Stock: The Verdict
Home Depot stock has a rich valuation, currently trading at 25 times earnings. Yet Home Depot’s revenue in fiscal 2016 was $88 billion, and Home Depot is the fourth-largest retailer in the United States, behind only Wal-Mart (WMT), Kroger (KR) and Costco (COST). With 2,200 stores, it doesn’t look like there’s that much more room for growth in North America. Having left China in 2012, it does not look like Home Depot will not be expanding overseas anytime soon, so it doesn’t make sense for Home Depot stock to be trading at such a high valuation.
As of writing, Lucas Hahn did not hold a position in any of the aforementioned securities.
