Home Depot Stock: Overvalued With Storms Brewing (NYSE:HD)

Past results are not always indicative of future performance. Selling bad performing stocks is easy, but often the hardest thing for investors to do is to know when to sell some of their best performing stocks when tax liabilities are relevant. Most good things do come to an end though, and even the best performing dividend champions that have been able to sustain the kind of revenue and income growth that got these companies on these impressive experience tough times.

Home Depot (HD) has been one of the best performing stocks in the market for some time, and the stock has consistently outperformed most of the broader indexes over the last decade. Home Depot has doubled over the last 4 years, and the stock is up nearly 20% in just the last year, since March of 2021. The stock got hit like most of the market during the Pandemic, but a strong recovery in the housing market fueled by pent up demand, DIY projects, and a strong overall recovery in the US economy, led to the stock performing very well coming out of the pandemic. Still, the stock has sold off hard over the last several months, with the sell-off starting in January of this year.

Home Depot’s stock has sold-off nearly 25% since peaking in December of 2021, and the company faces several main headwinds that should continue to pressure margins and earnings for at least the next year. The three main issues that Home Depot faces right now are; slowing demand in the housing and residential construction markets, rising costs, and supply chain issues because of the labor shortage and continued COVID restrictions in places such as China and other parts of Asia. These issues are impacting margins and earnings significantly, and the impact of these factors on Home Depot’s business model has been more than the market expected, and more than the impact many Companies have experienced.

There is strong evidence that housing demand is slowing, and that demand for new housing and residential construction will continue to slow in the back half of this year. A recent survey of nearly 4,000 home inspectors showed a strong consensus that the housing market is slowing down across the country, and that slowdown should accelerate this year as rates likely rise over the next 9-12 months. Between December of 2020 and December of 2021 housing prices rose by nearly 19%, which is 4x the national average since 1989. As we saw during the housing bubble, this rate of annual appreciation in housing prices is not sustainable.

There is also evidence that the residential construction market, most importantly, the DIY market, do-it-yourself market for residential projects, is slowing as well. John Morikis, the CEO of Sherwin-Williams (SHW), talked about the DIY trend normalizing on his company’s recent earnings call. He said, “We always expected the DIY to normalize and that the business would begin shifting into other segments of the business as people return back to business — I’m sorry, back to work. So we always expected that while DIY shifted down, other areas would go up, and we expect that.”

Even though Home Depot recently reported strong numbers in DIY projects and residential construction markets, both these markets should slow moving forward. Residential construction in 2020 was 50% higher than 2019, and at a 10 year high coming in at just over $9 billion dollars, and just under the 20 year high of $10 billion. Companies raved about pent up demand in 2020, but that demand has also shown to be somewhat fleeting in some industries.

Home Depot has also been hit harder than most companies by labor shortage and supply chain issues as well, with both those issues are inextricably linked together. Home Depot recently reported lumber costs were extremely volatile in the 4th quarter of 2021, with costs varying from $585 to $1200 dollars per 1,000 foot board. Lumber prices remain close to 25 year highs. Copper prices are close to a twenty year high as well. Supply chain issues and inflation hit Home Depot hard in the fourth quarter of 2021, with fourth quarter margins coming at 13.5% compared to the company’s 15.2% operating margin for the full year. Operating margins are at 4 year lows.

Margins contract significantly in the recent quarter, and there is no sign that costs are likely to come down anytime soon with the new conflict between Russia and Ukraine impacting the supply chain and raw material costs as well. Home depot’s margins in the 4th quarter of 2021 were the worst they’ve been over the last 4 years, and the recent margin compression suggests that the 15% operating margin the company has only been able to achieve recently is not sustainable. Home Depot’s average operating margin over the last 4 years is just over 14%, and even that number seems high in the current operating environment.

Home Depot’s stock isn’t cheap either. The stock trades at 20x next year projected earnings and has a price-to-earnings growth ratio of over 2. Full year earnings estimates are also likely to continue to fall as margin compression continues. Interest rates will likely be going up in the back half of the year, and that should put further pressure on the housing and residential construction markets. If margins remain strained around 13-14% a year, and earnings estimates come down, the stock will likely trade at around 17-18x 2023 earnings estimates of $16 a share this year, or around $290 a share.

Home Depot is a well-run company, and the company has done a good job of returning value to shareholders over the last 2 decades with both income and capital gains. Still, there are strong signs that the pent up demand we saw in 2021 in the housing and residential construction markets is not sustainable. Supply chain and labor shortage issues are impacting many companies, but many companies have not seen the kind of margin compression that Home Depot had in the company’s most recent quarter. With rates likely to rise significantly in the second half of the year and inflation causing continued margin compression, the best value in the market for the foreseeable future will likely be elsewhere.