Buy Home Depot On The Breakout
Summary
- HD has just broken out.
- Shares are fairly valued.
- Capital returns, higher margins, and comparable sales should power shares higher in the years to come.
Home improvement has been hot for years as consumers have spent their earnings on fixing up their residences. In addition, strong construction for residential and commercial has helped suppliers of building materials, with Home Depot (NYSE:HD) being an obvious beneficiary.
Shares rallied hard out of the pandemic-induced low in early-2020, but spent several months consolidating in a range of roughly $260 to $290. The false breakdown in late February portended a reversal and eventual ending of the trading range, as seen below.
Source: StockCharts
This development is exceedingly bullish as the top of the former trading range now becomes support to use on any pullbacks. Volume was good during the rally and eventual breakout, and the accumulation/distribution line continues to show strong accumulation, another bullish sign.
And finally, the PPO shows not only the excessively bullish momentum worked off during the sideways trading, but a bullish crossover has also occurred along with a centerline support test. This, combined with the trading range breakout, all points to higher prices to come.
But there are fundamental reasons to be bullish on Home Depot as well, creating a situation where the chart and the business are aligning for future profits for shareholders.
Growth, growth, and more growth
Home Depot has grown immensely since the Great Recession, which was more than a decade ago. The resulting economic expansion – as well as rising real estate prices – has provided consumers all the incentive they need to improve their living spaces. Home Depot has been the beneficiary of a rising tide, but also its own execution.
Source: Seeking Alpha
We see steady revenue growth until the most recent year, which saw a massive spike higher in revenue due to the stay-at-home phenomenon we’re all familiar with. This extended to businesses like furniture suppliers, home accessories, flooring suppliers, etc. Home Depot certainly took advantage of its “essential” status and remained open and thriving during the pandemic.
Importantly, the revenue gains from last year appear to be quite sticky, and in other words, were not a one-time spike that will evaporate as we move forward. Yes, growth appears to have been pulled forward, but that’s hardly a disaster; it simply accrues benefits to Home Depot more quickly than it otherwise would have.
We can see the reason for the spike below, as well as the outlook that shows demand is sticky, and was simply pulled forward, rather than excess demand that was fleeting.
Source: TIKR.com
Home Depot has been a comparable sales machine for a decade or more, and that was only improved last year. But the nearly-20% gain in comparable sales is obviously impossible to replicate, and indeed, I’d suggest we’ll never see a value like that again from Home Depot.
However, the fact that there is any improvement at all on last year’s numbers, as indicated by the 0.9% comparable sales gain estimate for this year, shows just how good Home Depot is at attracting and retaining demand. It looks like next year will see Home Depot back on its typical mid-single digit comparable sales gain track, which is great news.
Constantly higher comparable sales have helped Home Depot grow its margins over time as well, despite the fact that it deliberately invests in pricing such that it doesn’t see any gains in gross margins over time.
Source: TIKR.com
This strategy has worked beautifully because it allows Home Depot to grab more and more revenue while leveraging down its operating costs, represented above by SG&A. As SG&A costs come down gradually over time, and as revenue rises, operating margin dollars see outsized gains. This is the formula Home Depot has used for years, and it works.
In addition, strong margins and low capex have afforded Home Depot the ability to return huge amounts of cash to shareholders over time without borrowing to do so, which is not something every blue chip stock can claim.
Source: TIKR.com
The first two numbers – operating cash and capital expenditures – make up free cash flow. The second two are the capital returns Home Depot has made over the years, and as we can see, the company has modified its capital returns to meet its cash generation, with the exception of last year. Home Depot took a conservative approach to capital returns in 2020, as did just about every other company, given the extreme uncertainty of the situation. However, it turned out the company produced more FCF than it ever had in its history, and I fully expect Home Depot to put that cash to use in the coming years, which is another potential tailwind for the stock via higher dividends and share repurchases.
Apart from that, homebuilders remain bullish despite the recent rise in interest rates, which is good for Home Depot. The low-rate environment has proven bullish for Home Depot for years, so if things stay that way, it will be status quo. However, if rates do rise, homeowners will have higher incentive to stay where they are as mortgage loans to move will be relatively more expensive. This can also support Home Depot because consumers that are unwilling or unable to move are more likely to improve their current house. This virtuous cycle isn’t new, and it isn’t opinion, either; moves up and down in rates over time have been supportive of Home Depot either way for years.
Home Depot is also well supported by an ever expanding labor pool in the US, and with job growth recovery well underway, we should see more normalized conditions for this year and beyond, which is a good thing for Home Depot. In short, this company has a variety of ways it can win, and it certainly appears to me there are many good years in front of Home Depot.
Valuation is fair, but not cheap
The good news is I’m certainly not the only one that feels Home Depot has a bright future, as we see robust EPS forecasts for the years to come.
Source: Seeking Alpha
Growth is slated to be in the high-single digits for most of the coming years, which should be enough to support the current valuation.
Speaking of the valuation, below I’ve plotted five years of forward PE ratio data to give us an idea of where the stock is trading today.
Source: TIKR.com
Shares are at 22X next year’s earnings, and about 24X this year. While that’s toward the top of the historical range, it is by no means excessive. The average is 21X forward earnings for the past five years, but more recently, it was closer to 23X. Either way, Home Depot looks fairly valued.
I won’t call it cheap, because it isn’t, but then again market leaders rarely ever get to the point where they are cheap. Fairly priced is good enough for Home Depot, and I think shareholders will see solid returns in the years to come.
Use the top of the former trading range as your guide if we get a pullback, and buy at the top of the former range near $290. Apart from that, enjoy the rising dividends and share repurchases, and the fact that Home Depot can be a long-term winner than can help you sleep well at night.
This article was written by
I've been covering financial markets for ten years, using a combination of technical and fundamental analysis to identify potential winners (and losers) early, particularly when it comes to growth stocks.
Analyst’s 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.
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Comments (29)
what P/E do you predict for HD will be the end result of this "real correction"?
