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Home Depot: Strong Performance But Growth Could Moderate (NYSE:HD)

Back in June, I made the argument that Home Depot (HD) was a strong company and that I would consider going long the stock even after the previous run-up (which I subsequently did).

Some made the argument that I had left it too late to buy at a price of $250.

Source: Previous Comment on Seeking Alpha

However, this argument was clearly without merit as the stock has continued to ascend to $285 at the time of writing:

Source: investing.com

Apart from the effects of lockdown having increased demand for home improvement products – what had impressed me about this stock was that Home Depot had been showing relatively higher growth in cash from operations compared to competitor Lowe’s (LOW), and up until COVID-19 had been showing an increase in average ticket and sales per retail square foot.

However, with lockdowns being lifted globally – with a growing preference to institute “local lockdowns” in order to strike a balance between controlling the pandemic while not jeopardizing economic growth – it is unclear as to whether the sharp rise in demand for home improvement products is set to continue. There is always the possibility that demand has peaked at this point, and growth could stagnate in the short to medium term.

Up until now, performance on a yearly basis has been quite impressive, with net sales up by 16 percent and net earnings up by just under 10 percent:

Source: Home Depot Second Quarter Results 2020

Additionally, even with lockdowns having been instituted – we have seen growth in customer transactions, as well as average ticket and sales per retail square foot:

Source: Home Depot Second Quarter Results 2020

With that being said, we can see that the stock’s EV/EBITDA is at a five-year high – even with earnings having seen growth:

Source: ycharts.com

In this regard, should we see a pullback in earnings from here – then the stock may be due for a short pullback. Particularly, it is important to remember that Home Depot has been by no means immune from the effects of the COVID-19 pandemic.

When looking back at first quarter results, we can see that net earnings actually dropped by over 10% from the previous year:

Source: Home Depot First Quarter Results 2020

In this regard, while the company had a strong bounce back in the second quarter – this has simply been making up for losses incurred in the previous quarter.

From this standpoint, it is quite possible that the stock is overvalued on an earnings basis right now. From my perspective, one would need to continue seeing double-digit earnings growth in Q3 to justify the current stock price. Should earnings growth moderate, then we could see a moderation in price to the $250-260 range.

In terms of demand, Home Depot still remains a strong company in this respect. Particularly, renovation demand in the United States has continued to rise even with lockdowns being lifted. However, this is somewhat of a double-edged sword in that lumber prices have trebled since the pandemic – which in turn makes it more costly for renovations – this might have the effect of balancing out demand going forward. Moreover, Home Depot’s costs have also risen, in that the company has had to spend more on expanding its workforce and also on safety measures to protect its own employees from COVID-19.

Additionally, while the company continues to show a low debt to equity ratio – we have seen this ratio trend at a five-year high as costs continue to rise:

Taking this into account, I see Home Depot as continuing to be a strong company. However, I am realistic in that the strong rates of growth we have been seeing cannot continue indefinitely, and we could see a moderation in price growth from here.

Disclosure: I am/we are long HD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Additional disclosure: This article is written on an “as is” basis and without warranty. The content represents my opinion only and in no way constitutes professional investment advice. It is the responsibility of the reader to conduct their due diligence and seek investment advice from a licensed professional before making any investment decisions.

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