Home Depot (HD -0.56%) is without a doubt experiencing a notable slowdown. Following a surge in demand and double-digit percentage sales growth in the pandemic-impacted fiscal years 2020 and 2021, recessionary fears have investors somewhat hesitant today.
As of this writing, the share prices of Home Depot trade about 29% below their peak price, which was set in December 2021. This drop reflects the pessimism surrounding the business.
Does this big price dip mean that this top retail stock is a screaming buy right now? It just might be.
The valuation is compelling
At a trailing price-to-earnings (P/E) ratio of 18.6, Home Depot shares are historically cheap. The 10-year trailing average P/E multiple is 22.2, so the current valuation represents a meaningful 16% discount.
Home Depot is also slightly cheaper than the overall S&P 500, which carries a P/E ratio of 18.8. Moreover, Home Depot stock trades well below rival Lowe's and its P/E multiple of 26.3.
This valuation disparity seems unwarranted to me. For reasons I'll discuss next, I think Home Depot is better than the average business in the S&P 500. And its financial metrics are superior to those of Lowe's. This suggests the valuation might just be compelling for prospective investors.
Top industry position
The home improvement industry is massive. Home Depot's leadership team estimates the total addressable market at about $950 billion. Even with trailing-12-month revenue of $155 billion, this company still has a sizable expansionary opportunity to exploit.
Home Depot's sheer scale, as exemplified by total sales and its more than 2,300 stores, allows it to provide a better shopping experience for its customers, especially when compared to independent retailers. Plus, the business invested heavily to fortify its omnichannel capabilities. Having a wider assortment of tools and supplies, better-trained staff, and better technology infrastructure means that Home Depot is in a good position to steal market share going forward.
The company generates about half of its sales from professional contractors, which is a huge advantage it has over Lowe's. Pros spend more and visit stores much more frequently than DIYers, and this results in greater return on invested capital (ROIC) and profit margins. In the last three fiscal years, Home Depot's ROIC and operating margin have far exceeded what Lowe's reported.
It's not all positive news, though. Home Depot is seeing softer demand trends, primarily due to macro concerns.
"While surveys suggest that Pro backlogs are lower than they were a year ago, they are still healthy and elevated relative to historical norms," CEO Ted Decker highlighted on the Q2 2023 earnings call. This could be a headwind right now, but when the economy gets back on solid footing and consumers are ready to tackle bigger renovation projects, Home Depot will benefit.
Zooming out, there are some favorable industry tailwinds to keep in mind. "We do think that supply-demand imbalance is an important part of that, along with the aging of the housing stock," CFO Richard McPhail said on the call. "So, again, we are bullish on the future of this market."
Near-term uncertainty
Favorable qualitative characteristics, coupled with an attractive valuation, might entice some investors to rush and buy the stock. But before doing so, it's best to acknowledge that the next few quarters might be a bumpy ride.
Take management's forecasts. It expects revenue and same-store sales to drop between 2% and 5% in fiscal 2023 on a year-over-year basis, with diluted earnings per share declining 10% (at the midpoint).
A key part of these softer estimates is consumer spending that's been focused on services more so than goods, as well as "pressure in certain big-ticket discretionary categories," according to Decker.
Buying Home Depot stock today is only a good idea if you plan to hold it for the next five years, with the understanding that there might be some pain in the near term. In other words, things might get worse before they get better. Long-term investors should have no issue with this reality.
