- Home Depot has seen a run up in its stock price with the recovery of the housing market.
- It is a classic cyclical stock and is very susceptible to a housing downturn.
- Current share price assumes unsustainable sales growth rates.
- There is at least 25% downside to today's prices.
Home Depot (NYSE:HD) has had a great run over the last five years since the great recession, comfortably outpacing the growth of the S&P 500 (see chart below).
Over the past four years, the company has grown its sales at an annualized rate of 4.5% per year, from $66.2B in FY09 to $78.8B in FY13. Operating income and net income have grown much more rapidly at annualized rates of 17.5% and 19.7%, respectively, as it increased its operating leverage. Gross margins increased slightly from 33.9% to 34.8%, but the real driver of increased operating income was the reduction in SG&A expenses from 24% to 21.1%.
Home Depot is the world's largest home improvement retailer, with 2263 stores at the end of FY13. The company has a policy of slow and steady expansion - store count has increased in the single digits for each of the last four years. Over the last three years, comparable store sales have grown at a healthy clip: 2.9%, 3.4% and 4.6%, respectively. However, Home Depot by the nature of its business is cyclical and dependent on the housing market. The following chart shows the trend in comparable store sales during the period of the 2007-2008 recession, which shows this very clearly:
Same-store sales took a severe hit during the housing crisis, but have recovered nicely since FY10. The trend shows that if there is a slowdown in housing, sales growth will be impacted significantly.
Store growth and comp growth assumptions
Home Depot has been very conservative in growing its store count, and I expect this trend to continue. I model an average growth rate of five stores per year, leading up to 2020.
I am using relatively optimistic assumptions to model out same-store sales growth, and have used a growth rate of 5% through 2020. As we will see later, the current stock price reflects growth assumptions that are even higher, and it is unlikely that the company will be able to maintain this rate of steady growth. However, I like to use aggressive assumptions to pressure test a bear case. The chart below shows the store count and same store sales growth in my model:
Home Depot has done a great job at squeezing out operating leverage. In my model, I have assumed that gross margins grow to around 35% and remain stable from there. I have also modeled SG&A expense to decline slightly each year to around 20.5% of sales by 2020. Its other main competitor, Lowe's (NYSE:LOW), spent 24% of sales on SG&A in FY13, hence I believe that these assumptions are also on the aggressive side.
To calculate cash flow, I have assumed the ratio of depreciation to capex remains relatively flat - net income for the Home Depot is lower than cash flow (since depreciation has been consistently higher than capex), and I have factored this into my analysis.
Using these assumptions and discount rates/terminal value growth rates of 10% and 3%, respectively, I get to a fair market value (FMV) of $63 for Home Depot, which is around a 22% discount to current prices. This suggests that the company is materially overvalued given its relatively low forward looking sales growth (5.2% annually in my model, with pretty robust and consistent same store sales growth). The margin expansion that it has realized in the past is also likely to slow down. As a result, I believe that there is little to no upside in my valuation model. The company would have to grow same store sales by over 8% annually through 2020 to justify its current share price. On the other hand, a slowdown in store sales growth to 3% yields an FMV of $54, or a discount of 33%. The complete valuation model is attached.
The Home Depot is a classic cyclical stock, and has performed very well for investors buying at the bottom of the cycle five years back. However, the current valuation suggests that the stock is priced for consistent, strong growth; while the industry it operates in tends to be very lumpy with periods of decline following growth periods. Based on my model, the stock price appears to have peaked and is at risk of entering a downward cycle. Investors should stay away from this one till more favorable entry points are available. The more aggressive ones might consider initiating a short position.
Additional disclosure: I am short HD $50 and $45 puts.