Will the Housing Surge Return Home Depot to Greatness?

The financial crisis and following Great Recession brought many companies and industries to their knees. Two of Detroit's three big automakers went bankrupt and needed a taxpayer-funded bailout to keep their doors open, and the third had to leverage its entire heritage for loans to restructure its business model. Dow Jones Industrial Average  (DJINDICES: ^DJI  ) component Home Depot (NYSE: HD  ) also saw a difficult stretch of years during the recession and housing collapse, but is it now poised to surge on a housing recovery?

Many of the articles I read on a daily basis are one-sided, and that doesn't do any situation or investing thesis justice. There's never a guaranteed home run; even if the shares turn into multibaggers, there's always risk. And Home Depot is no exception, so let's look at both sides of the coin -- both the bull and bear case.

Bull case
If you crack open the income statement, you can quickly see one thing: consistent improvement. In the investing world, sustainable profit is key for finding market-beating companies. For an example of this, see Home Depot's revenue below.


Graph by author, information via Morningstar.com

Home Depot's revenue stream resembles a roller coaster ride, and rightfully so. After its sales surged on the housing bubble, they quickly crashed through the floor when that party ended. What's key is that the company became leaner through the years and is now, because of store expansion, back to revenue levels not seen since the peak of the housing bubble in 2006.

Another bright spot for Home Depot shareholders is how the company has consistently returned value to its investors through dividends and share buybacks. In fact, if you go back all the way to 2000, you'll see that Home Depot has never faltered, paying a consistently rising dividend that has never been cut.

An important characteristic of any successful long-term investment is a strong economic moat -- i.e., a competitive advantage that is difficult for competitors to overcome. Although economic moats come in many different forms, Home Depot's advantage is its low-cost offerings. Even during a massive housing collapse, it managed to generate returns on invested capital of 14% during the last five years -- pretty impressive. The sheer size of the company provides plenty of bargaining power with vendors, and Home Depot passes some of that value to its customers, creating brand loyalty that bolsters its leading market-share position.

Home Depot also finds itself in a sweet timing spot. Most do-it-yourself home improvement takes place when homes surpass 25 years in age, and nearly 70% of the market is in that age bracket. If we see a faster-than-predicted upturn in the housing market, it should drive top and bottom lines for the company, making it a valuable investment today, right? Not so fast. Here's where we have to distinguish between a valuable company and a valuable investment -- and those two don't always match up.

Bear case
There have been plenty of instances where a company was performing well, yet outside factors or expectations sent its stock tumbling irrationally. Look no further than Ford as a great example of a solid company that often experiences sell-offs due to macroeconomic fears, even as the company is cruising along.

In Home Depot's case, investors' expectations may not be met as it winds down its store expansion. Consider that Home Depot and Lowe's  (NYSE: LOW  ) collectively doubled their U.S. stores over the last nine years, adding 1,800 locations. As they slow expansion down and focus more on taking out smaller home-improvement niche competitors, we could see growth rates slow as well. That could be enough to send the stock price down as investors expect lofty expansion and growth numbers to continue appearing out of thin air.

The slowing store growth could also mean the market is reaching saturation, and that could cause more competitive pressure between Home Depot and rival Lowe's -- thereby weakening ROIC, margins, and overall profitability. Another thing investors should keep an eye on is home ownership, as home owners are more willing to spend money on home improvements than renters. In 2012, home ownership slipped slightly, and it's below the average rates of the last 15 years. If this trend continues, it could reduce Home Depot's historically consistent revenue stream.

Bottom line
While Home Depot's consistently profitable history is comforting for most investors, I'm not so sure the growth story will continue to impress, even amid a housing rebound. This is an interesting situation where the company itself seems poised for success, but growth expectations may limit the stock's upside. In the never-ending search for companies poised to beat the market going forward, I wouldn't place my bet on Home Depot at this time. If I were a shareholder already, I would lean toward holding and waiting to see what expectations analysts set going forward as store expansion slows. 

Home Depot stock may not be poised to continue its success during the economic recovery, but The Motley Fool can tell you about three stocks that are. Many global regions are still stuck in neutral, and their resurgence could result in windfall profits for select companies. A recent Motley Fool report, "3 Strong Buys for a Global Economic Recovery," outlines three companies that could take off when the global economy gains steam. Click here to read the full report!


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