The Home Depot Inc. (HD, Financial) has been one of the best-performing retail stocks in the entire market since the Great Recession ended.
The company has been able to take advantage of robust spending in both residential and commercial construction in the years since, and its earnings have continued to make new highs. That has been followed by an equally outstanding stock performance as shares are up about 1,000% since the 2009 bottom.
The stock has languished a bit as of late, failing to reclaim the all-time high it set back in September, but it is very close after a recent rally. The question for investors is, with shares back near their highs, is now the time to buy Home Depot stock?
Business overview
Home Depot has a market capitalization above $230 billion, making it the world’s largest home improvement retailer. It produces approximately $110 billion in annual revenue from its nearly 2,300 stores, which are spread across the U.S., Canada and Mexico. The company was founded in 1978 and went public just a few years later.
While there are other home improvement retailers, Home Depot has built an advantage over its rivals in recent years via scale and its focus on the customer. The company has managed to put together several years of very high rates of comparable sales growth, which has helped it not only boost revenue, but margins as well, in addition to buying back large amounts of its own stock. This combination has led to extraordinary earnings per share growth, expanding that metric by a staggering 22% annually on average since 2009. That outstanding growth record has set Home Depot apart from its rivals, and led to the enormous gains shareholders have enjoyed since 2009.
Home Depot does have a fairly nice problem to face in the coming years; it has been so successful in growing its business in the past decade that further growth will be much more challenging. Indeed, the company's advantage in the lucrative home improvement market is well intact, but it has simply grown its comparable sales so much in recent years that further improvement has become more difficult due to the law of large numbers.
The retailer's competitive advantages and, indeed, its performances of late don’t suggest any material signs of slowing. This year’s results will be hit by the lack of an extra operating week that was present last year, but otherwise, the company continues to produce great results. In other words, the only headwind for Home Depot is its own ability to continue to succeed in the market it has performed very well in for many years.
Housing and construction data remain favorable to the industry as a whole and the company said it remains bullish on its markets. If those markets begin to slow, obviously, Home Depot will need to adjust. At this point, though, there is no sign of that occurring.
Growth prospects
We see Home Depot growing 8% annually in the years to come as it continues to see a virtuous combination of factors driving that result. First, the company continues to expect mid-single-digit comparable sales growth for this year, which is largely congruent with the numbers it has been producing for years. There is no let up in the company’s ability to grow its stores’ productivity, which is helping to drive not only revenue, but profitability higher as well.
The second factor for earnings growth is margin expansion, driven mostly by better comparable sales. Home Depot’s gross margins don’t really move much, so they have never been much of a factor in earnings growth. However, higher comparable sales and spending discipline have combined to create a long-term margin tailwind as selling, general and administrative costs have slowly declined as a percentage of revenue. We expect this will continue as long as comparable sales continue to perform well, which they certainly are at the moment.
Third, Home Depot uses its ample cash to buy back billions of dollars of its own stock each year. That helps with a low-single-digit tailwind to earnings per share over and above the rate of actual earnings growth on a dollar basis. The company continues to generate more cash than it needs to run the business and is returning it to shareholders via dividends and buybacks, with the latter helping to improve the earnings per share growth.
While Home Depot has a very high bar to crest based upon its years of strong performance, we still see robust earnings per share growth in front of it given these factors. The days of 20%-plus annual earnings growth are gone given the massive size of the company and the length of the recovery in housing and construction, but the retailer is far from done in terms of long-term growth. This is Home Depot’s defining characteristic and we like the stock because of it.
Valuation and expected returns
While the valuation of the stock has deteriorated for investors in recent months with the rally back toward all-time highs, we still see a very positive total return outlook for the stock. We expect to see approximately 9% total annual returns in the coming years for shareholders that buy today, which represents strong growth potential.
These gains should accrue from the current 2.6% dividend yield, 8% earnings per share growth and a small, sub-2% headwind from the valuation. Indeed, the stock trades at about 21 times earnings against our fair value estimate of 19 times earnings. Even with this headwind, we see Home Depot producing attractive total returns for shareholders in the coming years.
Investors would do well to remember that in addition to very strong earnings growth prospects, Home Depot offers investors robust dividend growth as well. The dividend has grown at an average annual rate of about 20% since 2009, and we see continued payout growth as another positive of owning the stock.
Final thoughts
Home Depot continues to benefit from its leadership position in a lucrative sector of retail. The company continues to forecast strong growth ahead and we believe the growth story is far from over. We see years of robust earnings expansion along with a strong current yield that should see the payout grow nicely as well.
While the valuation has moved in excess of our fair value estimate lately, the growth story at Home Depot is good enough that we continue to rate the stock a buy. Should the valuation continue to move higher, we’ll likely reassess our rating. But for now, we like Home Depot and its outstanding performance in a resilient sector of retail. Those looking for a large capitalization growth stock or a large capitalization dividend growth story need look no further than Home Depot.
Disclosure: No positions in any stocks mentioned.
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