Home Depot's 3-Year Growth Potential

| About: Home Depot, (HD)

Home Depot (NYSE:HD) announced strong fourth-quarter and full-year results for 2012 on Tuesday. The company grew sales 14% from the fourth quarter of 2011 and 6% year-over-year. Reported earnings increased 32% quarter-over-quarter and 17% year-over-year.

Earnings per share beat analysts' consensus estimate by $0.04 at $0.68 for the fourth quarter. Year-over-year EPS was also positive, improving 21% at $3.00 from $2.47 in 2011.

Sales improvements for the company continue to reflect the housing market's ongoing recovery. Existing-home sales, a key driver of product sales for Home Depot, increased 0.4% in January to a seasonally adjusted annual rate of 4.92 million. At the current sales rate, turnover for existing homes is now 4.2 months, according to the National Association of Realtors.

January new home sales also trended upward, according to a report Tuesday by the U.S. Census Bureau. New home sales in January increased 15.6% to a seasonally adjusted annual rate of 437,000. The turnover rate for new home sales also increased in January to 4.1 months from 4.8 months.

Housing economists predict continued improvements in these sales rates, which should continue having a positive effect on product sales for Home Depot. Freddie Mac estimates total homes sales to improve to a seasonally adjusted annual rate of 5.30 million in the first quarter of 2013 with additional gains extending through the remainder of the forecast.

Construction starts have also showed similar rates of improvement, according to the U.S. Census Bureau. Single-family privately owned housing starts increased 0.8% from December 2012 and were 102,000 units higher on a seasonally adjusted annual basis than January 2012. Freddie Mac also expects housing starts to continue trending up, increasing to a seasonally adjusted annual rate of .90 million in the first quarter of 2013 and improving to 1.10 million in the first quarter of 2014.

Other factors supporting sales growth for Home Depot include continued demand for housing repair items related to damages from Hurricane Sandy and the company's customer experience initiatives focused around technology.

In the fourth quarter, New York, and New Jersey, were the company's top-selling regions due to hurricane-related repair activity. According to Craig Menear, Home Depot's Executive Vice President of Merchandising, increased sales in the Northern division, specifically for generators, plywood, safety and security items, extension cords, water heaters and cleaning supplies exemplified the hurricane-related sales demand. Overall, management reported approximately $242 million in sales attributed to Hurricane Sandy repair activity in the fourth quarter of 2012 and the company expects the effects to continue through the first quarter of 2013.

Customer service initiatives, implemented as a result of feedback from customer satisfaction scores, continue to be another key sales driver for Home Depot. Fourth-quarter initiatives included the company's new buy online ship to store feature, which helped annual transactions reach record levels for the company in 2012.

All of these factors led to increased revenue and net earnings for Home Depot in 2012, which in turn resulted in increased free cash flow of 26% from 2011.

Historically, the company has maintained low free cash flow levels, choosing to use cash for stock repurchases and capital spending.

Management's 2013 guidance appears to be centered around a continuation of this strategy. In the company's fourth-quarter earnings release, management's guidance reported $1.5 billion allocated to capital spending in 2013, up from $1.3 billion in 2012 and slightly above the previous four-year average of $1.2 billion. According to Carol Tome, Home Depot's Chief Financial Officer, 29% of the allocated funds will be put toward IT improvements and 71% toward business supply chain improvements.

In 2013 guidance, Home Depot's management also outlined its intention to open nine new stores which will include two store openings in the U.S. and seven in Mexico.

The aggressive capital spending for the year appears to be part of a broader three-year growth strategy for the company that should result in significant stock value increases for Home Depot by 2015.

In fourth-quarter 2012 earnings remarks, management also discussed a second component to its three-year growth strategy, which includes the Board approval of a $17 billion repurchase program. In 2013 the company plans to repurchase shares totaling approximately $4.5 billion. The remaining share repurchases will take place in 2014 and 2015 resulting in stock value increases over the three-year period from the decrease in shares outstanding.

In 2013, the increase in capital expenditure projects could weigh on profitability for the year pushing net margins down and slowing earnings growth. Additionally, free cash flow levels are likely to decrease slightly due to increases in capital expenditures, dividends and share repurchases. However, increased sales and net margins from technological efficiencies and supply chain improvements should lead to higher profitability in 2014 and 2015.

For investors this three-year plan could mean slower growth in 2013 resulting in a one-year price target1 of $66.77, making the stock overvalued at its current closing price of $67.56 on February 26. Yet, over the three-year period the company's strategic plans are expected to have significant growth effects resulting in a three-year price target1 of $70.74.

With a three-year price target of $70.74 the stock has stronger upside potential for intermediate-term investors. Given the company's strong earnings report, its strategic three-year plan and the expanding macroeconomic demand, the stock is also specifically attractive for stockholders seeking to gain from the continued effects of an improving U.S. housing market recovery.

1 Price targets are derived from Bodie, Kane and Marcus' intrinsic value formula. The intrinsic value formula discounts the projected future cash flow by the risk-free rate on the Treasury note plus a beta of 0.88 times the market's expected risk premium. The market risk premium is based on average Dow Jones Industrial Average index returns.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Tagged: , Home Improvement Stores, Earnings
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