Although Home Depot (currently trading at $390.71 per share) has gained 12.9% over the last six months, it has trailed the S&P 500’s 26.5% return during that period. This was partly due to its softer quarterly results and might have investors contemplating their next move.

Is there a buying opportunity in Home Depot, or does it present a risk to your portfolio? Check out our in-depth research report to see what our analysts have to say, it’s free for active Edge members.

Why Is Home Depot Not Exciting?

We're cautious about Home Depot. Here are three reasons why HD doesn't excite us and a stock we'd rather own.

1. Shrinking Same-Store Sales Indicate Waning Demand

Same-store sales is an industry measure of whether revenue is growing at existing stores, and it is driven by customer visits (often called traffic) and the average spending per customer (ticket).

Home Depot’s demand has been shrinking over the last two years as its same-store sales have averaged 1.6% annual declines.

2. Low Gross Margin Hinders Flexibility

Gross profit margins are an important measure of a retailer’s pricing power, product differentiation, and negotiating leverage.

Home Depot’s gross margin is slightly below the average retailer, giving it less room to invest in areas such as marketing and talent to grow its brand. As you can see below, it averaged a 33.5% gross margin over the last two years. That means Home Depot paid its suppliers a lot of money ($66.53 for every $100 in revenue) to run its business.

3. Free Cash Flow Margin Dropping

Free cash flow isn't a prominently featured metric in company financials and earnings releases, but we think it's telling because it accounts for all operating and capital expenses, making it tough to manipulate. Cash is king.

As you can see below, Home Depot’s margin dropped by 2.4 percentage points over the last year. This decrease warrants extra caution because Home Depot failed to grow its same-store sales. Its cash profitability could decay further if it tries to reignite growth by opening new stores.

Final Judgment

Home Depot isn’t a terrible business, but it doesn’t pass our quality test. With its shares trailing the market in recent months, the stock trades at 24.8× forward P/E (or $390.71 per share). Investors with a higher risk tolerance might like the company, but we don’t really see a big opportunity at the moment. We're fairly confident there are better stocks to buy right now. Let us point you toward the most dominant software business in the world.

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