Share price of Home Depot (HD) steadily rose by 45.1% in the past 12 months. At $69.03, the stock is trading near its 52-week high of $69.19 just achieved recently and offers a solid 2.3% dividend yield. Given the ongoing recovery of the U.S. housing market, home-improvement retailing appears to be a lucrative sector to leverage the uptrend and I am of the opinion that investors should gain the exposure by investing in Home Depot. There are four compelling reasons backing my view:
1. From a relative valuation perspective, Home Depot shares appear to be reasonably priced based on the firm's solid financials relative to that of its industry peers (see chart below). Consensus estimates on average predict the company's revenue, EBITDA, and EPS to grow at two-year CAGRs of 3.7%, 9.2% and 16.2%, respectively. Those figures are fairly in line with Lowe's (LOW) consensus growth estimates of 3.7%, 8.6% and 22.6%, respectively. Similarly, Home Depot's long-term EPS growth rate is forecast to be 15.2%, only marginally below that of Lowe's at 16.3%. On the profit side, however, Home Depot demonstrates a superior performance as the company's various profitability margins and capital return metrics are considerably above Lowe's level. Home Depot also carries a relatively lower level of debt as reflected by its markedly lower debt to EBITDA multiple. In terms of liquidity, Home Depot generates a higher free cash flow margin. Due to the firm's robust profitability and lower leverage, it was able to maintain a higher interest coverage ratio. Both the company's current and quick ratios are above Lowe's level, reflecting a healthy balance sheet condition.
To summarize, given Home Depot's in-line growth potential but superior profitability and liquidity performance, I believe the stock's fair value should command a solid premium over Lowe's valuation. The current stock valuation at 19.5x forward EPS (next 12 months) is trading at a 7.0% premium over Lowe's P/E multiple, suggesting a reasonable valuation level on a relative basis. The same conclusion can be reaffirmed by the two companies' PEG ratio comparison as Home Depot's 1.26x is 12.8% above that of Lowe's (see chart above).
2. Home Depot has a track record of improving capital returns and maintaining steady profitability margins. Over the past five years, the company has seen a significant rise across its ROE, ROA and ROIC measures, and it has also been able to sustain a solid profitability and free cash flow generation (see charts below). Home Depot's revenue, EBITDA and EPS growth rates have also fully recovered from their bottoms in 2008/2009 over the same period (see chart below). The shares' trailing P/E multiple has expanded accordingly provided the positive fundamental developments, indicating a reasonable valuation trend (see chart below)
3. The stock continues to be favored by the market. The consensus revenue, EBITDA, and EPS estimates for fiscal 2013 and fiscal 2014 have experienced multiple upward revisions over the past 12 months (see charts below). Sell-side analysts' average long-term assumption for the stock's EPS growth has been raised from 14.5% to 15.2% and the average target price has increased from $50.02 to $71.20 (see charts below).
4. On February 22, 2013, Oppenheimer upgraded its stock rating from market perform to market outperform and raised the target price from $67 to $76 citing the positive development on U.S. consumer spending. In a research note dated February 21, 2013, Peter Wahlstrom at Morningstar elaborated on his positive view on Home Depot's growth prospects which I tend to agree on (sourced from Thomson One, Equity Research):
We project Home Depot to be a primary beneficiary of the ongoing recovery in the U.S. home-improvement retail market as housing turnover, unemployment, and consumer spending trends stabilize and improve beyond 2012. The company is refocused on its core business (the orange boxes) and has embarked on a complete operational review, from logistics to merchandising. We believe this supply-chain restructuring initiative will continue to drive operational and financial performance and ultimately strengthen the firm's competitive position. We have increased confidence in our upbeat revenue and earnings outlook as macroeconomic headwinds reverse and the firm's restructuring efforts bear fruit. We project Home Depot to generate double-digit earnings growth and more than $5 billion of free cash flow in 2013, driven by an improving U.S. economic recovery and positive operating leverage on a fixed-cost base.
Bottom line, in the light of Home Depot's solid financials, reasonable valuation, as well as the positive macroeconomic backdrop, the stock should be worth your consideration if you feel comfortable with the U.S. housing sector and the prospects of consumer spending.
All charts are created by the author except for the consensus estimate tables, which are sourced from Capital IQ, and all financial data used in the article and the charts is sourced from Capital IQ unless otherwise specified.