Home Depot's Risk/Reward Becoming More Balanced After Solid 2014

Home Depot recently reported 4Q results that were above expectations and were well received by investors. The company is executing at a high level and appears to have all of the momentum behind it. However, with the stock up 41% over the last year, Home Depot's stock no longer appears to be an obvious buy as the risk/reward starts to balance out. I'll discuss the details and other thoughts on the strong quarter below.

 

Home Depot Upside Remains, but is Less Pronounced

After a 41% increase in the stock over the last year, and another year of 20%+ EPS growth (the fifth straight year), investors are likely wondering how long Home Depot's momentum can continue. 

HD EPS.png

To answer this question, I've modeled the upside scenario for Home Depot in 2015 (you can find interactive financial models on my site, including a general Home Depot model). Assuming trends continue on a straight line, and applying a generous multiple, I arrive at a $140 target price over the next year (representing 25% upside). This target price is based on EPS of $5.30 in 2015 and $6.15 in 2016. This would represent 16% earnings growth in both years, which is 3% higher than management's guidance for 2015 (which was widely seen by the street as conservative). 

While that would appear like a healthy gain, the risk/reward levels are becoming more balanced. Based on the inputs I've used (see below for more details), I'm assuming a fairly optimistic scenario in which trends continue on a straight line. While these trends are certainly plausible, we should be cognizant that we're now in the sixth year since the end of the last recession. Additionally, I'm already modeling trends above management's guidance, and applying a generous multiple that is at the very high-end of its 10-year PEG ratio history. Simply applying a 21x multiple (its current multiple) to our optimistic estimates would leave us with just ~10% upside. When weighing that upside against potential risks (rising interest rates, potential inventory disruption from the west coast port labor dispute, weather impacts, an economic downturn, increased competition), Home Depot becomes less of an obvious buy.

 

Other Thoughts on the Fourth Quarter - The Positives

  • The 7.9% comp (8.9% in the US) shows that Home Depot's top-line momentum actually accelerated in 4Q. The consistent strength in monthly comps was also encouraging to see.
  • Home Depot once again outcomped Lowe's, which reported a U.S. same store sales growth of 7.4%.
  • Management has done a lot to really improve their e-commerce capabilities. Online sales are now $3.8B (in 2014) and they've become a material tailwind to comps (+110 bps for the year). 
  • Home Depot's operating margin will likely hit their long-term margin guidance of 13% some time in 2015. Expect investors to focus even more on how high margins can go from here.
  • Transactions show healthy increases, but even more importantly, ticket has also accelerated throughout the year. Ticket is an important indicator of whether pro customers (or contractors) are coming into the store. 
  • Other signs of the pro customer shopping more: transactions over $900 increased a strong 10.3%, and management reported strong results in pro-related categories.
  • Strong comps in January, early weather trends, and easy comparisons point to a potentially strong 1Q.
HD Comps.png

 

Other Thoughts on the Fourth Quarter - The Not-So-Positives

  • Management's guidance came in below street expectations, with share repurchase coming in below estimates
  • Gross margin gains are tapering off, and management's guidance of flat gross margin in 2015 suggest the story is shifting towards sales growth + SG&A leverage. 
  • The West Coast port labor dispute is worth keeping an eye on. Home Depot has so far been able to get inventory in, but if anything more disruptive happens, gross margin may be impacted.
  • Tax rate was abnormally low in 4Q and benefited EPS by $0.03. The quarter was still great, but the beat would have been by $0.08 instead of $0.11 if not for the tax rate benefit.
  • There are some concerns on how Walmart's increase in wages might impact Home Depot's workers. Management does not believe this will be a significant issue, since their workers are already paid above minimum wage. Their guidance reflects any expected wage increases.

 

*The Inputs

What were the inputs that I used for my optimistic scenario target price? For my 2015 EPS estimate, I assumed a 5.0% comp, which would represent only a slight moderation from the 5.3% comp posted in 2014. I also modeled a slight increase in gross margin (6 basis points), and significant SG&A leverage (77 basis points, or only 1.2% SG&A dollar growth). I also assumed $5.5B in share repurchases, which is $1B more than their guidance for the year.

For 2016, I assumed essentially similar trends. This includes a 4.5% comp, slight gross margin expansion (13 bps), significant SG&A leverage (67 bps, or 1.1% SG&A dollar growth), and $6.5B in share repurchases.

Applying a 23x multiple to the 2016 EPS estimate gets us to a one-year target of $141, which would represent 25% upside. Some might wonder how a 23x multiple might be justified for 16% EPS growth. One could argue that, given the market's current appetite for risk, the vastly improved economic backdrop today, and Home Depot's consistency in results, a 23x multiple (or about 1.4-1.5x PEG ratio) is not too far-fetched.