Name That Trade – $HD: Let’s… Do This??

by Dan February 20, 2015 1:59 pm • Commentary

The Home Depot (HD) reports their Q4 results Tuesday prior to the open, the options market is implying a 3.5% one day move vs the 4 qtr avg of about the same and the 8 qtr avg of about 3%.  

The stock had a monster 2014, up 27%, and is already up 5% in 2015. A continued period of record low rates, a stable housing market, low gas at the pump is benefiting their consumers, and almost 90% of their sales come from the U.S., shielding them from the negative effects of the surging dollar. The company seems to be in a sweet spot.  The stock is within 2% from its all time highs made earlier in the week. But it’s trading at 21x expected 2015 earnings growth so I think it is safe to say sentiment reflects the bull case with the trailing P/E at 13 year highs:  [private]

[caption id="attachment_51137" align="aligncenter" width="600"]XOM 10 yr trailing P/E ratio from Bloomberg HD 10 yr trailing P/E ratio from Bloomberg[/caption]

The company has done a very effective job in the last couple years managing earnings growth that has almost been four times sales growth as they have been aggressively buying back stock. In December 2013 the company entered into an accelerated share buyback to the tune of $3 billion and then in early June the company issued $2 billion in debt to buy back more stock. At some point this buyback bonanza is gonna stop and investors may start to question how much they are willing to pay for the “Fortress America” trade.

I suspect the stock is priced for perfection, and the slightest miss or guide down could cause the stock to give back the year to date gains.  The stock seems extended, now 17% above its 200 day moving average, the largest gap in almost 2 years:

[caption id="attachment_51138" align="aligncenter" width="600"]HD 1yr chart from Bloomberg HD 1yr chart from Bloomberg[/caption]

The last time the stock was that far extended from its 200 day was back in mid 2013. That preceded a 10% drop and then a long base for almost a year in and around $80:

[caption id="attachment_51139" align="aligncenter" width="600"]HD 5yr chart from Bloomberg HD 5yr chart from Bloomberg[/caption]

The company has done a fairly good job squeezing double digit earnings growth despite only growing sales in the mid single digits for the last five years.  While issuing debt to buy back stock in 2014 was probably good balance sheet management, I doubt it would make sense in 2015 as the Fed is getting ready to raise rates. And that could cause a hiccup in the housing market.  I would also add that the company does have revenue exposure in Canada, and this morning’s worse than expected retail sales data (read here) and the cold weather in much of the U.S. could weigh on guidance.

OnNov 18th the company reported Q3 results that beat expectations and issued guidance that was basically inline to a tad light of consenus.  At its lows that morning the stock was down nearly 5% and closed down 2% on the day. The stock has since risen 19%, and I suspect a beat on Q4 is not enough to keep this party going, it will take a meaningful raise of forward guidance.

My trade idea is less predicated on next week’s earnings report and more so on the fact that the stock feels in many ways to adequately reflect the good news, and any change to future buyback plans, a rapid rise in interest rates and the potential negative effects of poor weather could cause the stock to re-trace a bit of the recent move.


Hypothetical Trade: HD ($111.30) Buy to Open April 110 / 100 Put Spread for 2.30

-Buy to Open 1 April 110 Put for 3.05

-Sell to Open 1 April 100 Put at .75

Break-Even on April Expiration:

Profits: between 107.70 and 100 make up to 7.70, max gain of 7.70 below 100

Losses:  up to 2.30 between 107.70 and 110, max loss of 2.30 above 110 or about 2% of the underlying stock price.

Rationale:   Break-even down 3%, risking 2% to make a defined risk bearish play that a very overbought stock with extreme positive sentiment turns over the next 2 months. We’d love to catch the market on an up opening after the Greece deal is announced as it seems that despite not being down on no deal we’ll probably be up on the actual deal. That could be a fade the news moment but we don’t want to be early.