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Home Depot Stock Could Be Headed for Some Hard Times

Vince Martin

It would appear foolish to argue against Home Depot (NYSE:HD). Home Depot clearly is one of the best retailers in the world – and the dominant force in U.S. home improvement. Annual revenue recently eclipsed $100 billion. And HD stock has been a star performer since the financial crisis: Home Depot stock has gained over 400% since late 2011.

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But I’ve argued for close to eighteen months now that HD stock is too expensive, as I wrote in December 2017. The stock admittedly has gained about 6% since then, and paid another 3%+ in dividends. But that performance has been worse than that of the market as a whole and includes a 15% gain so far this year.

Indeed, looking at the chart, Home Depot stock seems to have a clear path toward retaking all-time highs, reached last September, of $215. But looking at the business, there are concerns here. The housing market isn’t exactly strong. The economy is in year ten of an expansion, which may reverse. Home Depot’s top competitor is retooling, and Home Depot stock isn’t exactly cheap.

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To be sure, Home Depot is a wonderful company; that’s not in dispute. The question is at what price investors should be willing to invest in that wonderful company.

HD Stock Underperforms?

Like a number of housing stocks, HD stock has benefited from the reversal in market sentiment in 2019. The reversal isn’t necessarily surprising: in December, I called out the iShares US Home Construction ETF (BATS:ITB) as my choice for the Best ETF of 2019.

Home Depot stock is a significant holding of that ETF, though the two largest positions are homebuilders Lennar (NYSE:LEN) and D.R. Horton (NYSE:DHI).

And in fact, the ETF has outperformed HD stock, returning 19% YTD. As I wrote in December, the problem for trying to time the lows in Home Depot stock was that other housing plays looked much more attractive.

That’s been the case so far this year, and it’s still the case. LEN and DHI still trade a single-digit multiples to earnings per share. Construction suppliers like American Woodmark (NASDAQ:AMWD) and Jeld-Wen (NYSE:JELD) have rebounded this year – but remain cheap, and well off 2018 highs.

The issue with HD stock thus remains. To own it, an investor has to have some faith in the mid-term housing market (and the economy) staying strong enough to drive renovation spending. If the market does stay strong, however, there are better choices out there. If it doesn’t, investors won’t keep paying nearly 20x earnings for a cyclical retailer like Home Depot.

Home Depot Stock Has Stalled out Before

Meanwhile, it might seem like HD stock simply outperforms the market no matter what. Over time, that has been true. But HD also has had long periods of not just underperformance but negative performance.

Between the beginning of 2000 and the beginning of 2010, a ten-year stretch, Home Depot stock lost nearly half its value. Obviously, there’s some cherry-picking there: the start of the decade saw the dot-com boom (which boosted stocks outside of tech) and the end of the decade came just months after the worst moments of the financial crisis. Still, for about twelve years, HD stock was dead money.

That’s not to say that HD is going to lose half of its value this decade or even that it will stall out for the next few years. Rather, the point is that valuation and timing matter, even for a quality company. That’s doubly true for a cyclical play like Home Depot.

And at this point in the cycle, almost 20x earnings simply isn’t cheap. In fact, the stock is just a few dollars from the average analyst target price. That’s exactly where it sat in late 2017. A year later, HD was down 15%.

Is Lowe’s on the Way?

In addition, Home Depot’s biggest competitor, Lowe’s Companies (NYSE:LOW), is affecting a turnaround. And as James Brumley wrote last month, Lowe’s “is finally starting to close the gap”.

It’s not quite a zero-sum game between Home Depot and Lowe’s. Better sales at Lowe’s may not come from its larger rival, but from independent stores and those that operate under the Ace Hardware and True Value banners.

Still, a stronger Lowe’s means tougher competition for Home Depot. And with investors expecting 4-6% same-store sales growth going forward, and the stock not cheap (again, due to cyclical exposure), it doesn’t take much to change the narrative here.

Be Careful with HD

None of this is to say that Home Depot is a short. But, at these prices, it’s not a slam dunk, either. Any housing hiccups could end the recent rally. Macro concerns tanked the stock in the fourth quarter, and may return again soon. If the external environment stays benign, investors might benefit more from other housing plays.

It does seem from my perspective like the rally is due to stall out. There’s at least a case for taking profits – or hoping for a better price.

As of this writing, Vince Martin has no positions in any securities mentioned.

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