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Introduction

Home Depot (NYSE:HD) has done exceptionally well, and has rallied by 44% over the previous year. I believe that the stock is slightly overvalued, and overbought at the moment. The economic factors of the business are certainly serving it well, but the underlying problem is the way management deploys capital.

Qualitative Analysis

Source: Information pertaining to Home Depot came from the shareholder annual report, shareholder quarterly report, JPMorgan Chase shareholder annual report, along with YCharts.

One look at the cash flow statement will tell you one thing. The company likes to buy back shares. The company authorized a share buyback program of $17 billion that will end by fiscal year 2015 (January 31st). This share buyback will boost earnings by approximately 17% based on current market valuation. Home Depot's primary source of net income growth is through share buybacks, which is clearly illustrated in the chart below.


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Generally speaking, Home Depot spends four times more on share repurchases than on capital expenditures. Home Depot has made no meaningful improvements in the long-term growth of its business from 2008 through 2013. Wall Street has been chasing the stock to new all-time highs because of the share buybacks and the improving economic sentiment. These two factors will not be enough to justify an even higher valuation over the short-term, because these growth catalysts have been overly priced into the stock.


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The company has not increased its store square footage whatsoever. It did not expand its operations into emerging markets. There is no growth catalyst in the stock other than what analysts on Wall Street are already anticipating, which are the buybacks and the favorable economic environment.


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The company is responding to favorable economic conditions. The American population has continued to grow by 3 million people a year. Population growth implies a demographic need for housing. Economists estimated that there is pent-up demand and that household formation will return to 1.2 million a year as job conditions continue to improve (unemployment rate is currently 7.9%). During 2007-2011 only 845,000 housing units were built annually per year, with demolition and destruction of homes from natural disasters (Katrina, Sandy, etc.) has resulted in a 250,000 decrease in the number of homes over a 4-year average (basically 1,000,000 homes were lost). The demand curve for housing is shifting to the right as demand determinants are putting upwards pressure on the pricing of housing.

The improving economic conditions have helped Home Depot's revenues, but the favorable economic data seems to benefit lenders more so than Home Depot because Home Depot cannot rapidly expand its store footprint overnight, whereas lenders can ramp up lending due to idle capacity (excess cash on banks' balance sheets).

The lack of capital investment is a real sore spot for Home Depot going forward and it certainly does not help that the company is trading at P/E multiples that are at ten-year highs.


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These types of multiples cannot be justified based on the growth outlook I and other analysts have for the company. The price to earnings growth is 1.7 implying that the business is slightly overvalued from a price multiple to earnings growth perspective (generally a ratio less than 1 is considered good). The business does not have any growth catalysts other than an awesome share repurchase and some good economic signals. Those two factors have been overly baked into the stock and it is unlikely that the company will be able to surprise investors adequately enough to justify added demand for the shares.

Technical Analysis

When I look at Home Depot's stock chart, the only thing I see is the ultimate double top of the decade.


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Source: Chart from freestockcharts.com

The stock is trading above the 20-, 50-, and 200- Day Moving Averages. The stock has hit a decade long trend-line and based on the underlying fundamental factors it is unlikely that the stock will be able to extend this rally any further. It would be intelligent to sell based on technical weakness.

Notable support is $52.00, $62.00, and $66.50 per share. Notable resistance is $72.00, $80.70, and $92.55 per share.

Street Assessment

Analysts on a consensus basis have reasonable expectations for the company going forward.

Growth Est

HD

Industry

Sector

S&P 500

Current Qtr.

15.40%

33.20%

-12.50%

10.80%

Next Qtr.

16.80%

59.40%

-2.50%

16.30%

This Year

13.20%

11.60%

23.60%

8.10%

Next Year

16.00%

19.90%

-11.00%

12.90%

Past 5 Years (per annum)

15.11%

N/A

N/A

N/A

Next 5 Years (per annum)

14.19%

12.17%

14.12%

8.93%

Price/Earnings (avg. for comparison categories)

20.01

12.95

14.7

21.21

PEG Ratio (avg. for comparison categories)

1.41

0.7

0.32

2.48

Source: Table and data from Yahoo Finance

Analysts have reasonable expectations, as analysts on a consensus basis have a 5-year average growth rate forecast of 14.19% (based on the above table). This growth rate is below the industry average for next 5-years (12.17%).

Earnings History

12-Apr

12-Jul

12-Oct

13-Jan

EPS Est

0.65

0.97

0.7

0.64

EPS Actual

0.65

1.01

0.74

0.67

Difference

0

0.04

0.04

0.03

Surprise %

0.00%

4.10%

5.70%

4.70%

Source: Table and data from Yahoo Finance

The average surprise percentage is 3.6% above analyst forecast earnings over the past four quarters (based on the above table).

Forecast and History

Year

Basic EPS

P/E Multiple

2003

$ 1.57

10.55

2004

$ 1.88

15.07

2005

$ 2.27

14.65

2006

$ 2.73

12.09

2007

$ 2.80

12.06

2008

$ 2.38

10.95

2009

$ 1.34

14.17

2010

$ 1.58

16.25

2011

$ 2.03

17.12

2012

$ 2.49

17.35

2013

$ 3.03

21.96

Source: Data from YCharts

The EPS figure shows that throughout the 2003-2007 period, the company was able to grow earnings. Throughout 2007-2009 earnings were declining. The declining earnings were due to the great recession. Following the recession, from 2009 onwards the company was able to grow earnings to new all-time highs.


(Click to enlarge)

Source: Data from YCharts

By observing the chart we can conclude that the business is somewhat cyclical and is affected by macroeconomics. Therefore one of the largest risk factors to HD is the slowing of international gross domestic product growth. So as long as the global economy continues to grow, the company will generate reasonable returns over a 5-year time span based on the forecast below.


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By 2018 I anticipate the company to generate $7.01 in earnings per share. This is because of improving economic conditions and share buybacks.

The forecast is proprietary, and below is a non-linear chart indicating the price of the stock over the next 5 years.


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Below is a price chart incorporating the past 11 years and the next 6 years, detailing 17 years in pricing based on my forecast and price history on December 31st of each year.


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Source: Data from YCharts and price history is from Yahoo Finance.

Investment Strategy

HD currently trades at $70.74. I have a price forecast of $61.00 for January 31st 2014. The stock is currently trading above my valuation, and is due for profit taking.

Short Term

Over the next twelve months, the stock is likely to depreciate from $70.74 to $61.00 per share. This implies 14% downside from current levels. The technical analysis indicates a multi-year double top formation, implying technical weakness. The previously mentioned price forecast using fundamental analysis further supports the assessment.

Investors should sell short HD at $70.74 and buy to cover at $61.00 in order to pocket short-term gains of 14% in 2013.

A higher yielding investment opportunity albeit having higher risk is to buy the Jan. 18, 2014 puts at the $70.00 strike. The call premiums trade at $5.25. The price forecast for the end of 2014 is $61.00. The rate of return if the calls expire at $61.00 is 71.42%, the option will break-even when the stock trades at $64.75.

The risk-to-reward on the option is compelling. The risk is manageable (0.9 beta).

Conclusion

Home Depot isn't where the action is at. Buy financials to play the housing market recovery, not Home Depot. The conclusion is simple: sell Home Depot.

Source: Sell Home Depot: It Is A Bad Dow Stock