Home Depot (HD 0.86%) is beating the broad market year to date as investors reward the company for showing healthy sales growth and rising profitability. That rally might be just the start, considering the prospects for continued recovery in the housing market. On the other hand, the retailer could soon face disappointing operating trends as it passes $100 billion of annual revenue and must find new avenues for additional gains.
Below, we'll look at a few good reasons to buy shares in the home-improvement titan, as well as reasons to pass up on this investment.
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Why buy Home Depot stock
There's no shortage of reasons to like Home Depot's business. It's growing faster than most other national retailers, for one. Comparable-store sales gains sped up to a blistering 6.3% pace last quarter -- from 5.5% in the prior quarter. That acceleration surprised the management team, which responded by raising their full-year revenue outlook. Home Depot is now on track to expand comps by 5.5% in 2017 to ensure another year of market share gains against rival Lowe's, which is expecting to boost its comps by less than 4%.
Home Depot's dominance extends to the bottom line, too. Its operating margin is rising toward 15% of sales, a record high. Lowe's, meanwhile, just reduced its profitability outlook and is stuck closer to a 10% margin.
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Home Depot's financial efficiency is top notch as well. It generates tons of cash from the business, which management directs toward reducing the share count and hiking the dividend. Both capital return channels end up boosting investors' overall returns.
Why pass on the stock
Home Depot is highly sensitive to shifts in the housing market, and any stall in its recovery would likely put an end to the company's impressive sales growth streak. For now, at least, management sees room for perhaps years of additional gains due to favorable metrics such as below-average household formation rates, rising home prices, and the elevated age of housing inventory. A pullback in consumer spending could easily turn these forecasts around, though.
In any case, the business will see increasing challenges from online rivals as well. Stumbles here would likely show up in slowing customer traffic, paired with falling profit margins as Home Depot cuts prices to protect its market share, just as many other formerly successful retailers have been forced to do lately.
There's no evidence yet that Home Depot is losing ground to e-commerce specialists. Instead, customer traffic gains increased in the most recent quarter just as profitability improved.
The bottom line
The biggest risk for investors in purchasing a high-performing business like this is paying too much. There's no question that Home Depot's stock is valued at a hefty premium to peers. You'd have to pay nearly two times the $96 billion of sales it has generated over the past year for this stock, or about double Lowe's valuation.
That premium doesn't leave a lot of room for error in the growth initiatives that CEO Craig Menear and his executive team are pursuing. If you're the type of investor who prefers a wide margin of safety, then this isn't your stock. Sure, Wall Street is getting nervous about retailers in general, but that pessimism hasn't extended to Home Depot shares.
If you have a long enough time horizon, however, and prefer businesses that pair dominant market positions with operating results, you're not going to find many better brick-and-mortar retail bets than this one. Those characteristics tend to help companies earn their premiums and should reward patient Home Depot shareholders, too.
