The Dow Jones Industrial Average is one of the most closely watched indices in the world. Created in 1896, it is also one of the oldest stock exchanges globally.
It is comprised of 30 of the largest stocks in the U.S., representing a wide variety of industries. Because of their size, these stocks tend to be popular among investors.
Home Depot (HD, Financial) is an excellent example of a Dow Jones stock. It is an industry leader, well-known and sports a large $231.8 billion market cap. Moreover, the company still has solid growth prospects despite its large size.
Business overview and growth prospects
The Home Depot was founded in 1978 and through prudent management has grown into one of the largest retailers in the world. The company has more than $100 billion in annual revenue, generated through 2,300 stores in the U.S., Canada and Mexico.
In recent years, very strong housing and commercial construction markets have seen The Home Depot accrue significant benefits, and the share price has risen in sympathy. Home Depot’s store base has been stagnant for some time, meaning it has not been a source of growth, but its comparable sales gains have been more than enough to power the stock.
Home Depot reported first quarter earnings on May 15, and investors didn’t take very well to the results. Comparable sales were up 4.2% globally but 3.9% in the U.S., a departure from much stronger numbers in recent years. Indeed, a big reason why Home Depot shares have performed as well as they have is because it has been able to generate comparable sales gains in the mid-single digits.
Despite the relative weakness in the first quarter’s results, Home Depot still guided for 5% comparable sales for the fiscal year, so the relatively low number in the first quarter appears to be temporary. To that end, management said that the first two weeks of the second quarter were in the low double digits for comparable sales as weakness in the first quarter was due to seasonal items. With the critical spring selling season off to a very good start, per management’s guidance, the weakness seen in the first quarter should abate in the second quarter.
Gross margins gained 40 basis points during the quarter, but that was more than offset by a 90 basis point increase in SG&A costs, which caused operating margins to fall 40 basis points in the first quarter. This is also different from what investors have become accustomed to with Home Depot, where in recent years constantly rising comparable sales have driven significant margin gains. Guidance is for margins to rebound in the remaining quarters of this fiscal year, however, and for earnings per share to rise 28%, helped by a lower tax rate.
The share count was down almost 4% against last year’s first quarter as Home Depot continues to buy back stock. Indeed, since 2009, when Home Depot began to buy back stock in earnest, it has reduced the float by nearly 40%. That has helped boost earnings per share over and above its already-impressive rate of growth in that time frame, producing very strong returns for shareholders.
The buyback should continue to be a low single digit tailwind for earnings per share in the coming years as management continues to spend billions of dollars annually on its own stock.
In the coming years, we see Home Depot producing about 10% average annual earnings per share growth, as the tax benefit will only be present for 2018. We also believe relative weakness in comparable sales and margins are temporary and that Home Depot will be back on track later this year. This growth will come from comparable sales increases as well as rising margins, consistent with Home Depot’s track record.
Expected returns and dividend analysis
Home Depot is moderately overvalued today as the stock has continued to rise despite a minor slowdown in earnings growth. The stock trades for a price-earnings multiple of 20.8 on this year’s estimate of earnings per share of $9.50. The stock’s longer-term average valuation is 18.1 times earnings, which we see as fair value. Therefore, we see Home Depot experiencing a 2.7% headwind to total returns in the coming years from a valuation that should normalize over time. Investors are giving Home Depot the benefit of the doubt with the relatively weak first quarter, and the valuation reflects that.
Home Depot isn’t a traditional income stock, but its dividend growth has been superb in recent years. The dividend has risen about 350% since 2009 and while that level of growth isn’t realistic moving forward, we think the dividend will rise in the high single digits in the years to come.
The current yield is 2.1% but is extremely well-covered at just over 40% of earnings. Home Depot spends heavily on stock buybacks and thus, its available cash for dividends is lower than it otherwise would be. However, management is committed to continuing to grow the dividend. For dividend growth investors, it is one more reason to like the stock. Given what we see as a rising share price, Home Depot’s yield should remain around where it is today, just above 2%, in the coming years.
The stock should experience 9.4% total annual returns moving forward as the current yield of 2.1% and valuation headwind of 2.7% roughly offset each other. That leaves the projected earnings per share growth rate of 10% to power the company’s shareholder returns. We see Home Depot as a strong, long-term growth story that is slightly overvalued today, but with dividend growth to help boost shareholder returns over time.
Home Depot isn’t a traditional income stock given that its yield is just over the broader market, but it does offer investors exposure to a significant, long-term growth story. Its sheer size dictates it cannot replicate the performance of the past decade in the coming years, but we still see 10% average annual growth in earnings per share. The valuation is slightly high at present, which should roughly offset the current yield. We rate the stock as a hold as a result.
Disclosure: I am not long any of the stocks mentioned in this article.
