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Home Depot Inc (HD) Stock Could Soar on Tax Reform

Luke Lango

We all know the reasons to own Home Depot Inc (NYSE:HD) stock. It’s the leader in a secular growth home-building and home-improvement market that has steady demand. Operations are getting a big long-term boost from smart home tech and a big short-term boost from multiple hurricanes (where there is destruction, there is rebuilding). Appliance market share is booming thanks to the sudden demise of Sears Holdings Corp (NASDAQ:SHLD). Moreover, HD stock has not only proven itself to be immune to the Amazon.com, Inc. (NASDAQ:AMZN) disease plaguing the rest of retail, but also shown a great ability to steadily grow its own e-commerce business.

HD Stock Could Soar on Tax Reform

Source: Mike Mozart via Flickr (Modified)

All in all, the reasons to own HD stock stretch far and wide. That is why the stock has been a steady grower for the past five years.

But growth is starting to slow. Granted, topline momentum looks as good as ever, but it looks like Home Depot is starting to max out on its ability to leverage operating expenses. That is weighing on overall earnings growth and bringing forth the realization that the days of 15%-to-20%-plus earnings growth are over.

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Does that mean HD stock is a sell? Not necessarily. There is one thing that could drive earnings materially higher, and it has nothing to do with anything Home Depot does.

Valuation and Tax Cuts

There is no hiding it. The valuation on HD stock feels stretched at these levels.

HD stock is trading at 22.7 times fiscal 2017 earnings. Meanwhile, analysts are looking at 11.1% earnings growth from 2017 to 2019. That gives HD stock a price-to-earnings/growth (PEG) ratio of just over 2.

That isn’t terribly attractive. The S&P 500 is trading around 19.4 times fiscal 2017 earnings. Earnings are expected to grow 10.6% per year from 2017 to 2019, which gives the market a PEG ratio of about 1.8.

Right now, HD stock gives investors less bang for their buck than the overall market.

Plus, the current 23.8 times trailing price-to-earnings multiple is above where the stock has traded historically over the past five years (average P/E of about 23). That premium valuation comes despite drastically lower earnings growth projections.

Over the past five years, Home Depot has turned roughly 5% annual comp growth into 20%-plus annual earnings growth. That was driven largely by tremendous Opex leverage (the Opex rate fell from 25% in 2011 to 20% last year).

But that Opex leverage is starting to slow. The Opex rate has fallen 50 basis points so far this year.

Therefore, although comps will likely remain in the 5% range into the foreseeable future, earnings growth will be much slower than 20% per year. Earnings are expected to grow just 13% this year, and analysts think that level of low-teen growth is what we should expect over the next five years.

Why, then, is HD stock trading at a premium P/E multiple despite much, much lower growth projections?

The answer is tax cuts. Home Depot is a relatively full tax payer. The effective income tax rate was above 36% in both fiscal 2016 and fiscal 2015, and it’s hovering around 36% so far in fiscal 2017.

Thus, any cuts in the corporate tax rate to the low-20s would imply huge profit gains for Home Depot. Take fiscal 2016. If the effective income tax rate was 20%, earnings per share would’ve been $8.10, more than 25% higher than what was reported.

That is a huge gain.

Bottom Line on HD Stock

If you’re a shareholder, I think you should continue to hold HD stock for now.

The underlying growth story is and will remain very strong. The only concern here is valuation, but even that looks reasonable if you consider potential tax cuts. Progress is being made on those tax cuts, and so long as the news out of Washington remains largely positive, then HD stock will head higher.

As of this writing, Luke Lango was long HD. 

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