Home Depot: I See Further Upside

About: The Home Depot, Inc. (HD), Includes: LOW
by: Discount Fountain

Home Depot has seen an improvement in sales growth from the last quarter.

Home ownership rates in the United States still have room for growth going forward.

Should we see continued growth in free cash flow, then I see further upside for the stock.

Back in October of last year, I made the argument that Home Depot (HD) could see little upside heading into 2019, due to risks to the housing market as well as pressure on free cash flow due to rising short-term debt and capital expenditures.

However, the stock subsequently performed better than I anticipated, and we did see a rebound above the $200 level in 2019.

Source: investing.com

When analyzing the housing market in the United States, we see that home ownership rates are still well below levels seen in 2009:

Source: tradingeconomics.com

Assuming we see a continued rising trend in home ownership, then the long-term potential for this stock remains solid.

While this could be the case, one risk factor that I pointed out last time was the fact that while earnings have been seeing solid growth, net sales have been lagging behind, recorded at 6.6% in Q2 2018. With lower income taxes resulting in an artificial boost to earnings, net sales would need to see an increase if organic growth is set to continue.

When analyzing performance for Q4 2018, sales growth was up by 10.9 percent compared to the same quarter in 2017.

Source: Home Depot – Fourth Quarter and Fiscal 2018 Results

Again, we see that net earnings have been artificially inflated by the effect of lower income taxes, with earnings growth before provision of income taxes standing at 5.8%.

From a financial standpoint, sales growth would likely need to continue to be in the double-digits for organic earnings growth to continue. It is likely that the market would punish Home Depot for weak sales, even though earnings growth may look high on paper. In this regard, this month’s earnings will be a significant telling point as to whether the company can achieve this.

At the current price, Home Depot is paying out a yield of 2.80% with a payout ratio of 56.8%.

Source: dividend.com

Home Depot is paying a good dividend, but ideally the payout ratio would be lower so that more cash can be reinvested into the business.

For instance, competitor Lowe’s (LOW) payout ratio is currently 37%. While the dividend yield is lower, dividend growth has been sustained for the past 56 years.

Source: dividend.com

Moreover, we can see that over the past five years, free cash flow growth for Home Depot has been just slightly greater than its competitor while Home Depot remains more expensive on a price to free cash flow basis.

Free Cash Flow Growth

Source: ycharts.com

Price to Free Cash Flow

Source: ycharts.com

That said, the price to free cash flow ratio has been trading more or less stationary over the past couple of years, while free cash flow itself has continued to grow. This could be a sign that even with the price growth we have seen, the stock is still undervalued on a free cash flow basis. Moreover, the fact that Home Depot has been able to consistently grow free cash flow in spite of being in a highly capital intensive industry is quite impressive.

Ultimately, sales growth has improved from the last quarter and I would be interested to see if double-digit growth continues when earnings are reported in May. Should this be the case, then I see the stock moving higher from here provided that we continue to see vibrant growth in free cash flow.

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.

Additional disclosure: This article is written on an "as is" basis and without warranty. The content represents my opinion only and in no way constitutes professional investment advice. It is the responsibility of the reader to conduct their due diligence and seek investment advice from a licensed professional before making any investment decisions.