Justin Sullivan
Selling well-run companies with strong brands that have outperformed the market for long periods of time is always hard. While investing is obviously in most cases purely a financial decision, most people develop some affinity towards their best-performing stocks.
Home Depot (NYSE:HD) had been one of the better performing investments for a decade in the market prior the company’s recent struggles.
The leading home retailer was a $81 stock in early 2024, and the stock was up nearly 500% using total returns over the last decade. The S&P (SPY) 500 is up nearly 230% using total returns during the same time frame.
Still, Home Depot’s stock has gone nowhere over the last two years.
The leading retailer’s stock peaked in January of 2022, and the stock has not risen past those recent highest in the last 2 years. The S&P 500 has also outperformed Home Depot since early 2022 by nearly 10 percent.
I wrote about Home Depot in May of last year. I rated the stock as a sell primarily because of the weakening housing market, rising costs, and slowing sales. I am changing my rating of the company today to a strong sell. Home Depot has risen over the last several months with the overall market, but the company’s sales growth continues to slow, the housing market is showing new signs of weakening, and inflationary risks are likely to continue to put pressure on the interest rates and the overall economy as well. Home Depot’s recent guidance was disappointing, and the stock is trading at what should turn out to be an unrealistic valuation since the current earnings cycle is likely peaking.
The leading housing retailer recently reported normalized earnings per share of $2.82 and revenues of $34.79 billion, beating analyst expectations by $.02 a share and $111.45 million. Still, Home Depot’s earnings showed some clear weakness in the company’s core business, and management’s guidance was concerning as well. The retailer reported that same-store sales fell by 7.2% on a year-to-year basis, and the company guided to a 1% in same-store sales in 2024. The main reasons management cited for the weak guidance were inflation and higher mortgage rates, both factors that have caused the housing market to slow down.
The housing market continues to show signs of a further slowdown as well. The National Associate of Realtors recently reported that housing sales were down 1.7% on a year-to-year basis, and housing inventory was up 3.1% on a year-to-year basis. Mortgage rates remain at elevated levels as well. The average 30-year mortgage rate is currently 6.77%, much higher than 2 years ago when the rate was at 3.92%. Prices remain high even though the rate of inflation has moderated in recent months, with January’s inflation rate coming in at 3.09%.
Even though Powell recently talked about a likely interest rate cut coming in March, the Fed also pointed out the overall price levels continue to remain high. Mortgage rates are not likely to fall significantly anytime soon even if the Fed cuts rates next month. While Home Depot obviously benefits significantly from DIY projects other spending by existing homeowners, a weakening housing market still hurts the company in multiple ways, since homeowners are often less likely to improve a home that is falling in value, and a softening housing real estate market also means fewer homeowners. Housing prices are up 46% on average nationally since just 2019. The company has also seen a moderation in DIY demand since the pent-up demand coming out of the pandemic with more people working at home has slowed.
Home Depot’s margins also appear to be peaking, a sign that the company’s current earnings cycle is likely reaching a limit.
A chart of Home Depot’s Net Margins (Macrotrends)
Even though the retailer’s net margins remain solid, Home Depot’s net margins have fallen for three consecutive quarters. The company made a decision to increase wages by $1 billion last year, and the retailer has seen costs steadily rise for some time even as sales have slowed. The recent comments by the company’s CEO Ted Decker referring 2023 a year of moderation suggest that the company’s current earnings cycle is plateauing as well. Recent manufacturing and consumer spending data have showed continued weakness, and while the economic consensus is that the US economy will avoid a recession in 2024, this year is expected to be weak economically well. Wages have also not kept up with inflation over the last several years, and many people have now significantly depleted previous Covid savings.
This is why Home Depot’s stock looks overvalued at current levels using several metrics. The company currently trades at 23.59x expected non-GAAP forward earnings, 2.64x forecasted forward sales, and 16.43x predicted forward EBITDA. The retailer’s five-year average is 23.59x forecasted non-GAAP forward earnings, 2.46x predicted forward sales, and 15x expected forward sales. Home Depot is trading at a premium to the company’s historical valuation levels even though management recently reported record earnings and there are continuing signs of the retailer’s core business model slowing.
Even well run companies with strong brands become overvalued. While Home Depot has been one of the best-performing stocks in the market for some time, the company is facing new and significant headwinds that the retailer didn’t have to deal with in the past even while the stock trades at a premium valuation. With costs likely to continue to rise even while the housing market and overall economy slow, Home Depot looks overvalued at current levels.
