With interest rates rising thanks to the Federal Reserve's aggressive tightening monetary policy, the S&P 500 is in bear market territory, down 24% this year. Unsurprisingly, investors are seeking safer assets in this uncertain economic environment. And this situation has crushed some of the most outstanding businesses out there.
Even Home Depot (HD -0.36%), a blue-chip company, hasn't been spared from the market turmoil. Its shares are down more than 30% in 2022, so is now the time to buy the dip?
Recent headwinds
While Home Depot's stock price has performed poorly this year along with the broader market, there are some important challenges that the business is facing right now. Chief among them is the cooling housing market, spurred by mortgage rates that haven't been this high in over 10 years. Financing a home purchase is getting more expensive, and this stymies buyer demand.
According to data from Redfin, a real-estate brokerage, the median home sales price in the U.S. has fallen for three straight months. And in August, the number of homes sold was down 17.5% from the prior-year month.
Because Home Depot is the world's biggest home improvement retailer, the housing market has an impact on its business prospects. If home values aren't rising as quickly as they once were, consumers will hold off completing expensive renovation projects. This is in stark contrast to what we saw during the depths of the pandemic, when stimulus payments and reduced spending on travel and other leisure activities translated to a boon for Home Depot.
While management continues to point out that order backlogs for renovation projects remain strong, this is something investors need to closely monitor in the next few quarters. Indeed, sales for fiscal 2022 are expected to grow just 3% compared to 14.4% in fiscal 2021, demonstrating a sharp slowdown.
We also can't ignore the surging inflation that is affecting the U.S. economy. Individuals must deal with rising costs for basic necessities, while companies' expenses go up. In Home Depot's case, management mentioned that half of the inventory increase in the quarter was directly attributed to cost inflation. Also, customer transactions were down 3% year over year in the latest quarter, but the average ticket size was up 9.1%. It could take some time for this inflationary pressure to work itself out.
Favorable characteristics
Despite macroeconomic issues, Home Depot has historically been a superb business. From fiscal 2016 through fiscal 2021 (ended Jan. 30), revenue increased 59.8% and net income rose 106.1%. And the stock has followed this strong fundamental performance, up 71% over the past five years versus the S&P 500's total return of 54%.
With trailing 12-month sales of $155.2 billion, Home Depot's competitive advantage stems from its massive scale. The business's sheer size allows it to secure attractive terms with its base of fragmented suppliers, while also leveraging fixed expenses, mostly from operating the footprint of 2,316 stores. Home Depot's profit margin has expanded significantly over the past decade.
Additionally, Home Depot benefits from switching costs, particularly with its professional customers, who account for nearly 50% of total company sales. Having the right tools, equipment, and supplies on hand means that Home Depot is a mission-critical partner for contractors, plumbers, and electricians to help them get jobs done faster. These valuable customers are less likely to switch over to competitors once they've grown accustomed to working with Home Depot.
The company generates lots of free cash flow as well, to the tune of $14 billion last fiscal year. And this affords management the ability to return excess capital back to shareholders. The business paid out $7 billion in dividends and repurchased almost $15 billion worth of stock in fiscal 2021. And this generous policy is likely to continue far into the future.
Current valuation
After the stock's fall this year, Home Depot sells for a price-to-earnings ratio of 17.3. Not only is this lower than the company's trailing five-year valuation, but it makes shares cheaper than the S&P 500's P/E of 18 right now. That looks like a good deal, so investors would be wise to consider adding Home Depot to their portfolios.
