Why I think Home Depot shares might be a great investment… but not right now

Home Depot is an impressive business that has grown steadily recently — so why is our author taking a wait-and-see approach to the shares?

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Close up of a young man renovating and painting the house

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Key Points

  • Home Depot has grown its business impressively over the last five years
  • The share price is down more than 25% since the start of the year
  • US retail faces an uncertain time with consumer spending declining and excess inventories

Shares in Home Depot (NYSE:HD) have fallen sharply this year. At the moment, the stock is over 25% lower than it was at the beginning of January.

The recent price decline only takes the edge off what has been a generally impressive run for the stock, though. Despite this year’s drop, Home Depot shares are still 91% higher than they were five years ago.

I think that Home Depot might be a great addition to my portfolio, but I’m not buying them right now. Here’s why.

Business overview

Home Depot is a home improvement retailer, a bit like B&Q in the UK. The company sells various home and garden improvement products, rents equipment, and provides installation services.

Around 91% of Home Depot’s revenue comes from the US (this will be important later). In addition to DIY enthusiasts, the company has initiatives dedicated to professional tradespeople.

Strengths

Since Home Depot is a retail company, I would typically expect to see narrow margins. But the company has a gross margin above 30% and profit margins in excess of 10%. 

Compared to its main rival Lowe’s (8.8%), UK-equivalent Kingfisher (6.4%), and retail giant Wal-Mart (2.3%), these profit margins are impressive. And the good news doesn’t stop there.

Over the last five years, Home Depot has grown its business impressively. Revenues have increased by around 60%, and expanding margins mean that net income has more than doubled.

In addition, the company is steadily lowering its outstanding share count, has its debt under control, and produces solid returns on its fixed assets. Overall, I think there’s a lot to like about Home Depot’s stock.

Headwinds

With all this, why am I not buying Home Depot shares right now? The answer has more to do with the macroeconomic situation in the US than the business itself.

Retail in the US is currently in a difficult period. Recently, Target announced that it had a huge inventory surplus that it was going to have to sell at a discount as demand for non-essential items had slowed down.

I don’t see Target’s issues as a result of poor management. Instead, I think they’re the result of issues that might well affect Home Depot.

Target has too much stock because it has had to buy in significant inventory to cope with supply constraints. Now, though, declining US consumer spending – especially on discretionary items – means it has more than it can cope with.

I’m concerned that other retailers, including Home Depot (which generates 91% of its revenue in the US), might find themselves confronted with similar difficulties. Even if they don’t face the same inventory problems, Home Depot’s sales might slow due to high inflation dampening demand.

At the moment, Home Depot stock trades at a price-to-earnings (P/E) ratio of 19, which is a touch higher than the S&P 500 average. At that level, I think that the company is priced for continued growth, rather than a short-term headwind. 

As a result, my plan is to see how Home Depot’s business fares over the next few months. If its earnings fall and the stock drops, I’ll be looking at making an investment.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be considered so you should consider taking independent financial advice.

Stephen Wright has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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