04/28/14 Covered Call Pick: Home Depot, Inc. (NYSE:HD)
Home Depot (HD) is a big box store that supplies building materials, home improvement, and lawn and garden supplies and tools to consumers all across the United States as well as in Mexico, Canada, and Puerto Rico. The company, founded in Marietta, Georgia in 1978 has over 2,200 locations and is America's largest home improvement retailer.
Home Depot has a market capitalization of $109.65 billion with 1.38 million outstanding shares.
Home Depot currently pays a $0.47 quarterly dividend for a current yield of 2.40%.
With a beta of 0.89, HD currently trades with approximately 11% less volatility than the current market.
Over here in the U.S. it looks like we have finally beaten back the icy clutches of winter and are in the full swing of Spring. After such a frigid season, we expect to see over-exaggerated shifts in certain seasonal markets. Spring normally heralds a mass migration outdoors and, invariably, to Home Depot as the DIYers and green thumbs look to start swinging hammers and revitalizing their gardens.
The season shift isn't the sole reason why we like Home Depot though. We've recommended the stock multiple times in the past, and the company has continued to perform with exceptional execution. Their last earnings report for the fourth quarter of 2013 showed $17.7 billion in total sales with 4.4% same-store sales growth. The company also saw tickets over $900 increase by 5.5% as appliances and pro customers came out in droves. Gross margins also expanded to 35% as the company continues to tweak and improve their supply chain productivity.
Home Depot, which was one becoming slightly bloated, has not slimmed down to a more efficient beast, focusing solely on its core business over the past several years. The "orange box stores" are now the company's sole focus, and unlike the past where an aggressive domestic retail store expansion created an inefficient distribution network and led to cannibalization, the company has turned the firm around. This focus on supply chain and distribution efficiency has led to improved near-term operating margins and ROIC goals.
One concern that might be raised with a company that is so inherently focused on their retail stores is the shift from brick-and-mortar shopping to e-commerce. But the home improvement sector remains insulated from this demographic shift due to the high weight/value ratio of many of its products that prohibit cost-effective shipping. This allows Home Depot, as the leader in this space, to be insulated from one of the most devastating demographic trends that plague traditional brick-and-mortar retailers.
Home Depot's dominance in the home improvement space comes in no small part to their investment in their brand and their employees. HD has built a business that has, in its tenure, revolutionized DIY-culture, and provides customer service and expertise that is second-to-none and nearly impossible to replicate. This creates the type of experience that drives returning customers and creates brand loyalty. This has helped lead HD to deliver average ROIC of 14% through the last five years, despite the massive housing downturn.
Speaking of the housing market, many people think that Home Depot is directly tied to the cyclicality of the housing market. That would be an incorrect oversimplification. Morningstar's analysis of Home Depot notes that the two sections of Home Depot's core business, professional and retail, help diversify the company in terms of correlation to the housing market. While in weak economic times, the professional side of Home Depot's business might experience a downturn, retail consumers tend to remain in their homes and improve that equity by embarking on more DIY projects, thus increasing retail revenue. In strong economic times when home prices rise, a wealth effect is generated that psychologically creates a boost to home sales, which in turn bolsters the firm's professional sales. This diversified consumer base combined with an efficient supply chain and distribution network allows HD to keep costs controlled and helps prevent extreme revenue swings during cyclical swings in the housing market.
Home Depot is no longer the high-flying aggressive growth business of its early years, but that does not mean they have run out of steam. Home Depot is guiding Wall Street to a 16.5% increase in fiscal 2014 earnings. When compared to last year's 21% growth, this may seem quite poor, but when you look at Wall Street's expectations of 16.4% long-term earnings growth for HD compared to the growth of the average Dow stock at 9.2%, it would be hard to relegate Home Depot to the shelf of tired and exhausted companies.
For a Covered Call strategy on the stock we are recommending the August $85 out-of-the-money Call. We have a bullish thesis on the stock, as does Morningstar with an $80 fair-value estimate, and Barron's with a $95 price target over the next 12 months. The stock is currently trading around $80, allowing us to get better-than-fair value for the stock after taking into account the Call's premium. We do want to get a little bang for our buck in our premium to add a surge to the already substantial dividend yield for the stock, so we do not want to go too far out of the money. That is why we are recommending buying HD and selling the August $85 out-of-the-money Call.
- Buy 100 shares of HD @ $80.49 = $8,049 + Commission ($12.95) = $8,061.95
- Write 1 HD August 2014 $85 Call @ $105 - Commission ($8.70) = $96.30
Note: Prices may vary from the time of post. Actual commissions paid will vary returns.
Static Return (Not Called):
(Call)/Stock Price X (Days/Year)/Days to Expiration
(0.96 + 0.47)/80.62 X (365)/110
= 5.89% Static Return
(Call + Strike Price - Stock Price)/Stock Price X (Days/Year)/Days to Expiration
(0.96 + 0.47 + 85 - 80.62)/80.62 X (365)/110
= 23.91% If-Called Return
Disclosure: Clients and/or principles of OakTree Investment Advisors may or will have an investment in the above positions, but only on the same sides of the trades. The above numbers are analytic estimations based on information known at the time of this post. OakTree Investment Advisors does not guarantee the above, or any, result. All investment decisions should be made based upon individual's personal investment goals and risk tolerance.
Disclosure: I am long HD.
Additional disclosure: As active managers we may increase or decrease positions in companies we recommend depending on market conditions.