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Why options might be the best way to play Home Depot ahead of earnings

Wednesday on CNBC's "Fast Money" we discussed some unusual options action in Home Depot, which hit a new high of $142.66 on Wednesday. Specifically, we saw an opening buyer pay 42 cents for 1,332 March 150 calls. Ultimately, about 2,000 of these traded. While we highlighted that the trader is betting on 6 percent upside in Home Depot over the coming month, we did not have time to examine whether that's reasonable.

Is it?

Home Depot is the world's largest home-improvement retailer, selling building materials and home improvement and lawn and garden products. The company also offers home improvement services. With nearly 400,000 employees and more than 2,200 stores in the U.S., Canada and Mexico, the typical store averages 105,000 square feet of indoor retail space with 35,000 products.

The growing e-commerce business offers more than one million products for online purchases, and many purchasers arrange for in-store pickup. Customers include "do-it-yourselfers," professional contractors, as well as customers who buy both products and services via their installation business. Although professional customers represent approximately 3 percent of the total customer base, they represent about 40 percent of gross revenues, and as such the company focuses heavily on this important group of customers.

Historically big box retailers have focused on two key areas for growth: increasing same-store sales (which in turn can also improve margins) and increasing the number of locations. While this was certainly Home Depot's strategy in the early years, more recently they have focused on online sales. Consequently, the company has seen sales growth and broader margins in recent years, even as many other retailers contracted as consumers migrated increasingly to online purchases. For example, while the 2,274 store locations as of January 31, 2016 was exactly the same as it was 6 years earlier in January of 2010, revenues grew about 34 percent over that period. Earnings grew from $1.67 per share in the 12 months ended January 2010 to $6.20 per share last year.

Granted, 2010 was in the throes of the housing crisis; but even compared to the pre-credit crisis peak earnings of $2.72 per share in 2006, the growth on roughly the same number of locations is impressive and enviable. Lowe's, Home Depot's largest competitor, also experienced impressive growth over the same period, however, to do so, their store count grew nearly 9 percent over the same time frame. Additionally, they logged sales of $293 per-retail-square-foot in the most recent fiscal year, which is substantially lower than the $374 per-square-foot that Home Depot achieved during the same period.

Online sales represented 5.6 percent of total revenues in the most recently reported quarter, up 17 percent from the prior quarter. Impressive considering many of the company's products require a forklift, which might also explain why 40 percent of those online purchases were picked up in the store, one of the few online instances that justifies a bricks-and-mortar presence. A history of consistently delivering impressive growth and regular dividend increases helps explain Wall Street's bullish sentiment.

Of the 36 analysts surveyed by Bloomberg, there are 22 "buy" ratings on the stock, 11 "holds" and no "sells" (the remaining analysts surveyed did not issue buy/sell recommendations). One of the top ranked analysts, Christopher Horvers of J.P. Morgan, reaffirmed his bullish "overweight" rating on Wednesday with a $149 price target — but there's the rub. Mr. Horvers's target is less than 5 percent above the current stock price.

Even with the stock trading at all-time highs, bulls could point to fundamentals; seven consecutive years of double-digit earnings growth and high single-digit revenue growth even as other big box retailers such as Walmart and Target have had none. For a retailer, the margins are enviable and growing. For comparison, in 2010, Target had net income margins of roughly 4 percent, the same as they do today. Home Depot, which had similar net margins of 4.3 percent in 2010, has seen those margins nearly double to 8.3 percent. Although it's a fair criticism to suggest Home Depot does not compete directly with Target, in many areas they do compete directly with another big and storied retailer, Sears. Both sell tools, home appliances, lawn and garden equipment and, to a small extent, auto supplies. Since 2010, Sears sales have fallen by half. Net margins of just 0.6 percent in 2010 and 0.2 percent in 2011 have been negative every year since. Sears' sales-per-square-foot of $128.56 (and declining fast) are roughly one-third those of Home Depot.

These companies sell the same appliances, so product differentiation didn't apply here. Craftsman-branded tools at Sears (recently sold to Stanley Black & Decker) have historically enjoyed more cache than the Husky-branded tools at Home Depot. So, the outperformance of one versus the other is largely one of better management and operations, at least in the segments where these businesses compete.

At less than 20 times forward earnings, with 15 to 20 percent earnings per share (EPS) growth, propelled by a strong housing market, good management, improving margins and increasing market share versus poorly managed competitors such as Sears, the bulls have a reasonable case. The company is growing earnings faster than the S&P 500 yet trades at a discount to it.

Technically it looks good, too, with the stock on Wednesday hitting an all-time closing high. A reversal would be a warning sign, but we haven't seen one yet. To anyone who is buying the stock today, it might seem to be an all-clear. On the macroeconomic front, home price appreciation, housing turnover, household formation and an aging housing stock are also tailwinds for their business.

The cracks in the bull case are that the equity bull market is long in the tooth. Interest rates are rising, and as they do, that could crimp both home price appreciation and turnover. While it's true that Home Depot's multiples look reasonable in the context of S&P 500 multiples all are well above average. At historical multiples for Home Depot, which existed while the company enjoyed similar growth, Home Depot would be 15 to 30 percent cheaper than it is today. Even if 10-year Treasury rates remain steady — thus minimizing the impact on mortgage rates tied to them at historically low levels — inflation fears could raise the short-end of the curve. An inverted yield curve has historically slowed economic growth, and the rhetoric of pro-growth President Donald Trump is unproven.

Options are currently pricing in a one-day earnings related move of 2.4 percent when the company report results next Tuesday. That is smaller than the historical average move of almost 2.9 percent. Put simply, options are cheap. Recent activity could be an effort to make a cheap bet that the rally could continue, with earnings as the catalyst to propel it to new heights. My counterpoint would be that the one month move following earnings is usually small, roughly 4.5 percent. Consequently, if I was inclined to use options to press bullish bets—a strategy I vastly favor over buying the stock here—I would use options closer to at-the-money, and might even consider call spreads.

While we usually talk about using "regular" expirations on Options Action (those that occur on the third Friday of every month), one of the advantages of weekly options is that there are often more strikes available. In Home Depot's case, weekly options have "dollar strikes" whereas the regular options have strikes $5 apart. For example one could spend about $2 to buy the March 31 expiration 143/150 call spread (prices are about $2.60 and 60 cents respectively). Options will have a slight "vol suck" after earnings are announced as options decay once the event has passed; the short 150 calls would help mitigate that. Additionally, since a 6-percent move over the ensuing month following earnings is unusual, the 150s have only a 20-percent probability of being in play.

Commentary by Michael Khouw, president of Optimize Advisors and co-author of "The Options Edge." He is also a regular on the CNBC show "Options Action." Follow him on Twitter @Michael_Khouw.

For more insight from CNBC contributors, follow @CNBCopinion on Twitter.

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