Michael Santoli

Home Depot: Still the Most Important Stock (for Better and Worse)

Michael Santoli

The stories of U.S. economic prospects, consumer conditions and stock-market outlook continue to be told most forthrightly by folks wearing orange aprons.

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Reuters

Home Depot Inc. (HD) was anointed here several months ago as perhaps the most important stock in the world for the way its profit revival, financial management, highly geared exposure to the housing recovery and favored status among global investors encapsulated the major animating trends of the current bull market.

Home Depot’s excellent second-quarter operating results Tuesday morning confirmed the company’s exemplary status as an economic and market bellwether – which is both encouraging and a bit worrisome for those puzzling over whether the 2013 rally can continue to draw on the same energy sources.

The company outpaced the published forecasts nearly across the board, its per-share earnings climbing more than 22% to $1.24, ahead of estimates for $1.21, with U.S. comparable-store sales surging 11.4% from a year earlier. The Atlanta company boosted its full-year profit guidance to $3.60 a share, up from $3.52 (though still shy of the Wall Street consensus projection of $3.65).

Solid evidence

These results are solid evidence that the domestic housing recovery has good momentum and is stoking consumer appetites for building supplies and other big-ticket durable goods. With government budget cuts, payroll-tax increases and conservative corporate capital spending dragging on growth, housing-led consumer activity is a key driver of what slowish growth the economy has shown this year.

Along with a strong quarter for Best Buy Co. (BBY), the numbers imply that households now prefer to spend spare cash (and run up credit-card balances) on stuff that will last a while, even as they show restraint on, say, new clothes purchases. Recent soft reports from Macy’s Inc. (M) and teen retailers spread some concern over the vigor of the consumer, but it now appears a category-by-category story of shifting spending priorities.

Home Depot is also the quintessential corporate giant in terms of how it’s achieving those impressive profit gains. Through tight expense management and aggressive financial engineering, Home Depot last quarter converted 9.5% sales growth into a 17.5% operating-profit gain and, in turn, spun that into a 22.8% rise in diluted per-share earnings, through one of Corporate America’s biggest share-buyback campaigns.

Cash-rich and with ready access to generationally cheap debt, big companies have been feasting on their own shares. Home Depot in the first half of 2013 bought back $4.3 billion worth of stock, having bought in more than $10 billion over the prior three years. Home Depot says it intends to bid for another $2.2 billion by year’s end.

All these elements have turned Home Depot into one of the most beloved large stocks in the market. Yet it is also among the more expensive mega-cap names, at more than 20-times expected 2013 earnings, near the top of its 10-year range. Its valuation is inflated by the kind of optimism that was confirmed by its latest results, but it’s also hindering the stock’s ability to capture further upside on the news.

Before the market opened, Home Depot shares gained as much as 3% on its report, but the stock traded lower in the regular session and recently was about flat, just above $75.

Rising concerns

In this way, too, Home Depot encapsulates the situation of the market as a whole – up a lot year to date, fully valued if not overvalued, benefiting from the world’s zeal to harness the domestic housing comeback but pulled below recent all-time highs by concerns over rising interest rates, Federal Reserve intentions and mixed economic data.

Home Depot shares are up more than 18% year to date, versus a bit better than 15% for the S&P 500 index. Yet they are down 6.5% from their July peak, and since the March 31 article cited its rich valuation as the world’s most important stock, it has underperformed the broader consumer-discretionary sector.

This could be the surprise for investors in the latter part of the year – the widely embraced fundamental themes that benefited the domestic-consumer and financial-stock leaders into the summer might need to give way to a new group subject to less confidently regarded forces. Homebuilding stocks have already suffered a mini-bear market amid higher rates, despite the still-improving home-sale data. Retail is looking hit-or-miss.

Globally exposed industrials and capital-spending dependent technology companies will probably have to take the fore if the 2013 rally is to run another leg higher, suggests Michael Wilson, chief investment officer for Morgan Stanley Wealth Management.

Questions abound as to whether those industrials can thrive in a spotty market for capital goods globally, or whether indeed companies will soon open their sewn-shut wallets for deferred technology upgrades. It’s far from clear how this will play out.

But that’s how markets work – what seems like a sure thing and an easy trade have often been well discovered, while the uncomfortable, risky-seeming portfolio moves hold the most promise.

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