Soaring inflation that started several months ago has pinched consumers' wallets and forced the Federal Reserve to quickly increase interest rates to better balance supply and demand. And just recently, the central bank signaled that it will do whatever it takes to get prices under control, which could lead to financial stress for many Americans.
As a result of a slowing economy, the housing market has certainly started to soften as well. Could Home Depot (HD -0.50%), a $295 billion company that caters to that specific industry, see its business weaken and its stock fall as a result?
Macroeconomic concerns
Inflation is still raging. In the month of July, the Consumer Price Index was up 8.5% from a year ago. This means that the central bank will continue its aggressive policy of hiking interest rates in order to remedy the situation. This has caused mortgage rates to jump up meaningfully in 2022. The 30-year fixed rate is now 5.55%, the highest it's been since late November 2008 (not counting June 2022).
As mortgage rates go up, which increases the cost of financing, buying a home becomes more expensive. This can lead to lower demand, and a housing market that is cooling off a bit.
According to data from Redfin, a real estate brokerage, the median home price in the U.S. fell for the second consecutive month in July and now stands at $413,000. The number of homes sold in July was down 23.1% year over year. Consumers who are struggling to pay for everyday items like groceries and gas are increasingly likely to balk at purchasing a more expensive house.
How can a weaker housing market affect Home Depot's business? It has to do with a behavioral economic theory called the wealth effect. On Home Depot's first-quarter 2022 earnings call, its chief financial officer, Richard McPhail, said: "Over our history, we've seen that home price appreciation is the primary driver of home improvement demand. When your home appreciates in value, you view it as a smart investment and you spend more on it." Therefore, a weaker housing market could be a major headwind.
But so far, Home Depot management has said that there hasn't been many negative effects. It mentioned that more than half of the houses in the U.S. are more than 40 years old. And home prices have appreciated significantly over the past couple of years, despite the slight falloff recently.
In the most recent quarter (ended July 31), the company's revenue jumped 6.5% and net income rose 7.6% compared to the same period a year ago. Demand from consumers for renovation projects remains robust as both the professional and do-it-yourself segments grew and still have healthy project backlogs. This is a positive sign for shareholders.
Home Depot is a solid long-term investment
There have been multiple instances over the past decade when mortgage rates quickly spiked. But this didn't prevent Home Depot's business from continuing to hum along over the years. From fiscal 2011 through 2021 (ended Jan. 30 of this year), the company grew revenue 115% and diluted earnings per share by 529%. And the stock has followed this stellar fundamental performance, rising more than 400% over the past decade.
Home Depot's colossal size could dissuade some investors who might think that this business doesn't have much opportunity to expand. But according to management, Home Depot is slowly penetrating a massive $900 billion opportunity, with the DIY and the professional markets estimated to be $450 billion each. It's not too late to get in on this winning investment since Home Depot accounts for just 17% of the entire industry today.
For current shareholders, a softening housing market, coupled with higher interest rates, is not a reason to sell because this company still has a lot of market share to steal. And for those on the sidelines, Home Depot's attractive price-to-earnings ratio below 18 -- cheaper than the S&P 500's multiple of nearly 23 -- makes the stock a sound financial choice.
Neil Patel has positions in Home Depot. The Motley Fool has positions in and recommends Home Depot and Redfin. The Motley Fool recommends the following options: short August 2022 $13 calls on Redfin. The Motley Fool has a disclosure policy.
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