We have a bullish long term outlook on Home Depot (HD) stock and view it as a buy today due to its combination of an attractive dividend and strong growth prospects. Home Depot stock has enjoyed a tremendous rally over the past several years, and further gains could be in store. Despite the difficulties facing the broader retail industry, Home Depot continues to generate strong growth rates. In turn, shareholders will continue to be rewarded with high dividend growth.

Home Depot: The Home Improvement Giant

As the leading home improvement retailer with almost 2,300 stores in the US, Canada, and Mexico, Home Depot generates around $108 billion in annual revenue. The company’s 2018 results were strong, showing impressive revenue and comparable store sales growth combining with a lower tax rate and share repurchases to drive 33.5% earnings-per-share growth for the year.

Home Depot’s growth will largely be driven by its competitive advantages. These consist of economies of scale, brand power, and its profitable network of business relationships that it enjoys as the largest business in this space. The company expects to combine these capabilities with its heavy reinvestment in stores to drive 5% same-store sales growth while flexing its strong balance sheet and free cash flow generation to buy back shares.

We believe that over the long term, these initiatives will result in annualized earnings per share growth to 8%. While this might seem a bit ambitious, it is less than half of what the company has been able to generate over the past decade.

That being said, there remain several challenges for the company to overcome. Home prices, housing starts, and turnover cadence are all seeing slowing growth, indicating that the housing market is well into its bull cycle. Given that Home Depot’s sales are largely driven by these factors, the company will have to improve efficiencies and innovate to continue driving strong growth. The good news is that the company’s core home-improvement retail business (~55% of sales) is fairly recession resistant since homeowners tend to stay put and improve their existing homes rather than move (which is more common during periods of rising home prices). Another challenge is the rise of e-commerce competition from companies like Amazon (AMZN), in addition to renewed pressure from chief bricks-and-mortar store rival Lowes (LOW) and to a lesser extent Walmart (WMT) and Tractor Supply Co. (TSCO).

In light of these increasing headwinds and expectations for slowing growth, we believe shares should trade around 19 times earnings, slightly below recent valuation multiples. Given that shares currently trade for 20.6 times our earnings estimate for this year, we expect a slight 1.6% annual multiple contraction in the coming years. Factoring in the 8% expected annual earnings per share growth and the 2.6% dividend yield, we forecast 9% total annualized returns for the foreseeable future.

Along with its strong competitive advantages and solid total return outlook, Home Depot has a healthy balance sheet. While the company has taken on debt over the years to fuel aggressive stock buyback programs, its leverage ratio of just 1.5X EBITDA remains quite conservative. In addition, Home Depot is sitting on $1.77 billion in cash, giving it plenty of liquidity.

Final Thoughts

Home Depot continues to grow organically and is making aggressive investments in its stores and stock, which we see as prudent relative to growing store count and/or acquisition-fueled growth given the slowing nature of the housing industry and increasing competition in the space. The stock’s growth and dividend will combine to deliver what we expect to be ~9% total annualized returns for shareholders in the years to come. Meanwhile, the solid core home improvement retail business, the company’s scale, brand, and network competitive advantages, and a solid balance sheet combine to make the investment fairly low risk from a long-term perspective.

While 9% is not an enormous return, given the company’s conservative balance sheet and business model, it is a very attractive risk-adjusted return. Therefore, even though we expect that shares will see some multiple contraction in the coming years, we view shares as a buy at current prices and even better when they trade at 19 times earnings.