Top-Line Is Driving Up The Valuations Of Home Depot

| About: Home Depot, (HD)

Summary

Revenue to rise by ~6%.

Bottom line to rise mainly on account of top line.

HD would increase its debt levels to reduce WACC.

I maintain by buy call with a target price of $164 per share till Jun'17.

In this article, I would try to focus on the expected future performance of HD whereas in my previous write-up I focused primarily on the fundamental analysis of the firm. Further, it is worth noting that my estimates in this writing would be conservative, considering volatile global economic environment coupled with the cyclical nature of the industry in which HD is operating. Moreover, I am basing my analysis mainly on the past trends and patterns as sometimes history is the best judge of the future, chiefly when the future is too uncertain or volatile.

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I expect the top line to swell at an average normalized rate of ~6% against the past 5-year average of ~5%. The rationale behind this number is the recent rise in the residential construction spending in U.S., moreover, it is noteworthy to state that consensus expectation dictates HD' s revenue for FY17 to increase by ~7% YoY. Additionally, as I have stated in one of my published articles that it is highly unlikely that Fed would increase its interest rates, especially after Brexit.

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Further, I opine earnings of the company to rise mainly on the back of a surge in the top line coupled with mild margin accretion. Plus, as the graph below depicts, the net margin expansion would largely be arrested by the rise in the interest-bearing liabilities of the firm. This is because, in my view, HD would increase the composition of debt in its capital structure as the cost of debt ( i.e. 1.20%) is much lower than its cost of equity ( i.e. 9%). Thus, in order to bring down WACC and ramp-up the valuations for the firm, future capital expenditure warrants for a larger portion of debt.

Moreover, the entity' s return on equity is blossoming on the back of rising financial leverage coupled with accelerating earnings. However, this is also increasing the firm' s financial risk.

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The following graph shows the falling WACC on the back of rising proportion of debt in the company' s capital structure.

Following is the current capital structure and cost of capital of the firm.

Forecasted financial statements for the next three years are presented below.

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Valuation

The company is positively creating value for its shareholders as it EVA ( Economic Value Added) is positive figure coupled with soaring ROIC ( Return on invested capital).

Hence, I maintain a " Buy" call on the stock with a target price of$164 per share till Jun' 17, giving a colossal upside of 27.6% to the current closing. On the relative basis, the stock is trading at a P/E multiple of 22.22x against the home improvement sector P/E of ~25x, trading at a mild discount to the peer companies. However, in my view, the stock should be trading at a premium due to its inherent growth potential coupled with market leadership position in the industry.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.