The meteoric like rise of shares of Home Depot during 2012 was very impressive: shares of the company spiked by nearly 47%. What could have driven such a sharp rise in the company's stock during the year? Moreover, will this rally continue in 2013? Let's examine these issues.
According to the latest retail sales report, the total U.S retail sales (in pdf formant) rose by 5.5% during the first eleven months of 2012. A close examination of the particular sector related to Home Depot - Building material – reveals this sector grew by nearly 6% during the past eleven months. The growth in sales of HD and rival Lowe's Companies wasn’t much different from the general market: as of the third quarter HD’s sales grew by 4.6% compared to the same quarter in 2011 and Lowe’s by nearly 2%.
So if sales have increased during the year but not by such a large margin, what could account for the rise in HD’s stock? At least four factors come to mind:
- The housing market has shown signs of recovery during recent years: the number of new homes sold (as an indicator to the progress of the housing market) as of November was nearly 15% higher than the same time in 2011. The chart below shows the growth in sales in the past year and a half. The rise in the housing market was also reflected in the rise in stocks of big building companies such as D.R. Horton or Lennar Corporation . During the year Horton’s stock increased by nearly 57% and Lennar by almost 97%. But unlike the modest growth in sales of Home Depot or Lowe's in the recent quarter, the home builders revenues rose by a much higher rate: as of the third quarter Horton's sales rose by 21.6% and Lennar's revenuers by 34%. The recent rally, however, in the housing market seems to have slowed down as indicated in the chart above. The efforts of the Federal Reserve to heat up the housing market with its recent quantitative easing program might be have diminishing return compared to previous QE programs. This could suggest the housing market might continue to slowdown. If the housing market will cool down, it will reflect in a slowdown in not only housing builders’ stocks such as Lennar and Horton but also other related industries’ stocks such as Home Depot.
- The company’s profitability is rising: During recent quarters the company’s operating profitability has increased from nearly 9% as of the last quarter of 2011 (fiscal year) to 10% as of the final quarter of 2012. This might not seem such a sharp gain, but on a yearly basis for every 1% rise in profitability, the company's profits rise by $700 million. Let's make a very crude calculation for the effect of a 1% rise in profitability of the company's stock, assuming this gain will be constant and reflect in HD's cash flow. Under an assumption of a 10X multiplier, then this will lead to a $4.8 bump in the stock price.
- The company’s stock buyback program: during the first ten months of 2012 the company purchased nearly $2.6 billion worth of shares. In 2011, the company purchased nearly $3.2 billion worth. This program is more than covered by the company's free cash flow. As long as the company keeps its stock purchase program, this will reduce the number of stocks, show the company’s management believes in the company, and keep the demand for the stock strong.
- Low Risk: Home Depot isn't showing signs of financial risk: HD's debt to equity is stable at 0.61 (as of the recent quarter), which is very close to the ratio of Lowe's at 0.64. Moreover, the company’s dividends payments are more than covered by its free cash flow (the total cash from operating activities and investment activities): as of the first ten months of 2012 HD’s free cash flow reached $4.4 billion. The dividends payments were $1.3 billion. Thus, the high cash flow puts HD at a low liquidity or financial risk.
Home Depot is a very stable company, with strong fundamentals, growth in revenues and relatively low cash or financial risk. The sharp growth in the company's stock was plausibly driven by hype over the housing market, the stock buyback program of the company and perhaps the rise in demand for low risk companies in times of uncertainty. The company's stock appreciation along with its dividend payment (1.83% annual yields) puts HD as a very reasonable investment. But if the housing market will start to slowdown, the strong rise in the company's stock might shift gear and also cool down in 2013.