A Close Look At Home Depot: Cautiously Optimistic Outlook

| About: Home Depot, (HD)

Shares of The Home Depot (NYSE:HD) have been trading higher over the last year as one of the market's best performing large cap stocks. The stock has returned a gain of 79%, a gain greater than Apple (NASDAQ:AAPL), with its fundamental growth and a bullish sentiment regarding future growth in the housing market. The Home Depot has now separated itself from competitors, and has taken market share from rival Lowe's (NYSE:LOW). But after a 79% return is it now time to take profits? Is the stock getting too expensive?

In the last five years The Home Depot has increased its quarterly dividend from $0.225 to $0.29 for a near 30% premium. In comparison to other large cap companies this is somewhat conservative, as competitor Lowe's has increased its dividend by 100%. The Home Depot pays a yield of only 1.92%, which isn't attractive enough to entice an investment based on yield alone, but with its strong performance investors haven't complained. Because when you break down what's really led this stock higher, it has been an efficient executive staff that has been able to cut costs, increase margins, and remain stable in an unpredictable economy.

The Home Depot has constantly proved me wrong, and exceeded all expectations in terms of performance. Back in June I had thought the stock was at the top of its range, at $52 per share and would then pull back. However, since August the stock has outperformed the Dow Jones by more than 700% with a 15.21% gain, and is reaching a point where the thought of HD trading lower seems almost impossible. But fundamentally this is a company with very moderate growth, and as it gets more expensive investors must be aware of its valuation.

One reason that shares of HD have traded with optimism is because investors believe it is separating itself from Lowe's and will continue to steal market share while the industry itself is growing, and that home prices will continue to rise. Last quarter HD posted a 12.40% increase in net income year-over-year, but only a 1.70% gain in sales. This represents an improvement in margins, but still slowed growth. One of the keys to determine its upside is the company's margins. The company has operating margins of 10.08% over the last 12 months and a profit margin of 5.96%, which is significantly greater than competitors Lowe's and Lumber Liquidators (NYSE:LL). In fact, it's the margins of HD that have led to its rally over the last year, as its top line growth has been stagnant. Since fiscal 2009 the company's revenue growth is near breakeven, but HD has managed to almost double its margins. Take a look at the chart below to see its profit margin growth since fiscal 2009:


Profit Margin









Last 12 months


Information obtained from Google Finance

Looking back at its growth you can see the operational improvements that have occurred at The Home Depot. We must keep in mind that also incorporated is a housing recession, which further speaks to the efficiency of management. The company has a strong balance sheet and incredible operating cash flow of nearly $6.5 billion, therefore I believe the stock is still presenting upside.

The key to moving forward for Home Depot will be revenue growth. The company's already proved that it could maintain its top line while cutting costs and improving margins. Because when you think about it, the fact that HD has been able to grow revenue by only $500 million since 2008, meanwhile almost doubling its margins, is an incredible feat in this economy. It shows the perfect balance of efficiency and execution. However, eventually margins will level, and the company will be unable to squeeze higher profits. In 2007 the company reached sales of nearly $80 billion, and has an arguably better infrastructure in place for another round of strong revenue growth. And now that we are seeing some improvements in housing, including higher prices, I am buying into the hype of this company. But as an investor, since this is a company that does not return a great amount of capital to shareholder through dividends, it must continue to perform. After a near 80% return it will only continue to trade higher if demand increases, which would lead to larger profits now that the company has higher margins. The bottom line: The future looks bright for the company and its investors, but only if the company can grow revenue in the next year.

Disclosure: I 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. I have no business relationship with any company whose stock is mentioned in this article.