May 6, 2021

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Home Improvement

The Home Depot: Great Metrics And Fairly Priced (NYSE:HD)

Company Description

The Home Depot Inc (NYSE: HD) is the world’s largest home improvement retailer based on net sales (expected to be around $US 130 B in 2020). The company operates 2,300 warehouse-style stores offering more than 30,000 products in store and 1 million products online in the US, Canada and Mexico.

The company offers a wide range of building materials, home improvement products, lawn and garden products, décor products and provides a number of services including home improvement installation services and tool and equipment rental.

The Home Depot opened its first stores in Atlanta in 1979 and went public in 1981

The company has one reportable operating segment but does break-down sales by product category (without providing category profitability):

Source: Author’s compilation using data from The Home Depot’s 10-K.

Business Overview

According to one of the founders of The Home Depot, Bernie Marcus, the original strategy concept was to provide the most complete assortment of lumber, building materials and home improvement products, competitively priced in a service-oriented retail situation.

It is fair to say that current management has remained true to the original strategy and the company has continued to innovate and continuously improve its offerings and service performance.

Addressable Market in the United States

According to Statista, in 2019 the US retail market for building materials and garden supply had net sales of around $US 385 B. The market is thought to be extremely fragmented with The Home Depot having the largest market-share (around 26%) with the 2nd largest company in the market being Lowes (NYSE:LOW) with a market-share around 17%.

I estimate that the building materials and garden market is mature and is growing close to the US GDP (although by all accounts 2019 was not a good year for this sector). Between 2014 and 2019, US GDP had a compound annual growth rate (“CAGR”) of approximately 4.1% and I have assumed that the sector mirrors this number.

This market is not only mature but a significant level of sales are probably cyclical. Morningstar estimates that The Home Depot’s revenues comprise consumer maintenance projects (55% of sales) and the remainder are related to new housing construction. The housing construction market is particularly cyclical.

In the following chart I have estimated the size of the US market and the market shares of The Home Depot and Lowes since 2014:

Source: Author’s model.

The data is tending to suggest that The Home Depot is growing faster than the market and gaining share whilst Lowes is growing at around the same level as the market.

International Expansion

The Home Depot has expanded its reach internationally through a relatively small acquisition in Canada in 1994. Today the company has expanded organically to 182 Canadian stores. In 2001 the company acquired its first Mexican store and today has 124 stores. However not all the international expansions have been successful. In 2006 the company acquired 12 stores in China but by 2012 they were all closed with a “clash of cultures” being slated as the reason for The Home Depot format not working in China.

In 2019 international sales represented 8% of total net sales revenues. The international sales CAGR for the last 5 years has been much lower than the US at around 1% (confirming that the sector is mature).

The Home Depot Strategy

In 2017 the company announced a new strategic initiative to kick start its next phase of growth – it is called One Home Depot. This multi-year strategy, which is still active, is designed to further enhance the customer experience (both digitally and in-store). The strategy is summarized on the following company chart:

Source: The Home Depot 2020 Investor Conference.

The company has indicated that the reinvestment required to support this strategy over the next few years is:

  • Stores $5 B.
  • Technology $2.5 B.
  • Supply Chain $1.2 B.

This is reasonably close to the $2.4 B which has been reinvested, on average, for the last 5 years (not withstanding the recently announced acquisition of HD Supply).

On balance this strategy appears to be an extension of the company’s long-term strategic approach focusing on customer service, product knowledge and innovation in both product and service.

The Home Depot’s Historical Financial Performance

The Home Depot’s consolidated historical revenues and adjusted operating margins are shown in the chart below:

Source: Author’s compilation using The Home Depot 10-K filings.

It should be noted that I have made an adjustment to The Home Depot’s reported Operating Income.

Prior to 2019 I treated operating leases as debt and made the corresponding adjustments to the Income statement (this adjustment is now part of the Accounting Standards).

The chart shows:

  • the impact of the GFC on both revenues and margins.
  • the uninterrupted growth in revenues and margins post-GFC.
  • the impact of operating leverage on the operating margin.

The Home Depot Moat

My moat assessment for The Home Depot is shown in the following table:

Source: Author’s compilation.

The sources of The Home Depot moat are:

  • its excellent brand which is well respected by its customer base.
  • the cost advantage it gains from its suppliers by virtue of its scale.

Compared to its competitors I believe that The Home Depot’s moat may be wide and deep. This is supported by the company’s return on invested capital (ROIC) which is shown in the chart below:

Author’s compilation using data from The Home Depot 10-K filings

The chart shows the spectacular improvement in the ROIC that has taken place over the last 10 years.

So how has The Home Depot increased its ROIC?

A review of Home Depot’s cash flow statements for the last 10 years reveals the following information:

Source: Author’s compilation using data from Home Depot’s 10-K filings.

The data indicates that over the last 10 years Home Depot has used 3 main drivers to increase its ROIC:

  • it has grown revenues at a CAGR of 5.2%.
  • it has increased its capital efficiency by reducing its net invested capital from $36,274 M in 2010 to $32,128 M in 2019 through a combination of increasing debt and buying back shares.
  • it has had the benefit of a lowering of its effective tax rate from 36.7% to 23.6% because of changes to the US tax code.

Recent Events

The Home Depot business has boomed during the COVID-19 pandemic. At the end of the 3rd quarter, year to date revenues were 18% higher than the previous year (driven by the US as International sales were lower) but margins were lower as a result of higher pandemic related staffing costs.

The Home Depot announced earlier in November the intention to acquire HD Supply. This is an interesting move as HD Supply was spun off from The Home Depot to private equity in August 2007 for a reported price of $8,300 M.

Recent Share Price Action

The chart indicates that The Home Depot has significantly outperformed the S&P500 over the last 12 months and the share price is currently close to a record high.

Historical Shareholder Returns

The data from Morningstar shows what a wonderful investment The Home Depot has been for many years. The returns from the stock have been consistently higher than the broader market although interestingly the stock has marginally under-performed relative to its sector.

Key Risks Facing The Home Depot

I think that there are relatively few long-term structural risks facing The Home Depot given that the underlying market for its products are cyclical (particularly sales to home builders) and mature (based on long-term demographics).

The near-term performance of the company will be heavily influenced by macro-economic conditions although the impact of the COVID-19 economic shock has been surprisingly positive for the company.

I suspect that the risks of significant challenges to the company’s preeminent position in the Sector are relatively low. I also suspect that the company’s supplier base is also not able to jeopardize its market position.

The remaining risks are within the company’s control and relate to strategy execution. Could the company lose its way strategically by changing the fundamentals of its offering or through a series of poor investments / acquisitions? It is possible but the company’s track record has been excellent, so I suspect that these risks are also relatively low.

My Investment Thesis for The Home Depot

At the time of writing this report the company’s consensus revenue forecast for 2020 was 18% higher than 2019 actuals and it is projected that 2021 revenues will only increase by 1% over 2020. This would indicate that the analysts believe that revenues in 2020 have been “pulled through” from future years.

According to Trading Economics, the US housing market is expected to enter a cyclical decline in 2021. There is also reasonable uncertainty around the projection for general economic conditions in the US. For these reasons I expect that The Home Depot’s revenue growth will return to more moderate levels post-pandemic. Revenue growth will be marginally higher than the sector average as the company continues to grind its market-share higher – although I am not expecting any dramatic increases in share as the marginal cost to achieve this would be quite high because of the sector is highly fragmented.

The Home Depot’s operating margins have been reasonably steady for the last few years. There may be opportunities to squeeze a few more margin points through technology efficiencies over the next few years as well as gaining some small increments through operating leverage. Overall, I think that any changes in operating margins are likely to be relatively modest.

Pressure from the investment community may build for management to make new investments to extend the company’s reach into adjacent markets or new countries in an effort to extend the company’s growth trajectory. I expect that management discipline will prevail and this pressure will be resisted. As a result, I have not factored in any major acquisitions. This means that the company may be able to reduce its rate of capital spend post completion of the “One Supply Chain” project although it should be noted that the company’s historical capital efficiency is very high relative to its competitors.

I have valued HD Supply separately therefore there was no need to include its revenues and margins in my forecast.

Valuation Assumptions

My investment thesis can then be summarized with the following valuation inputs:

  • Revenues will grow at 4 ± 2% for the next 5 years before growth begins to decline to GDP (0.9%) at the end of year 10.
  • Adjusted Operating Margins (which have been adjusted for the impact of operating lease expenses) will increase to 14.5 ± 1%) into perpetuity.
  • Capital productivity (as represented by Δ Sales / Net Capital) will decline from the current level of 4.65 and settle at 2.5 ± 0.5 (around about the 75th percentile of companies in the Sector).
  • The current Return on Invested Operating Capital (around 44%) will decline over time before settling at 12 ± 1% in perpetuity which reflects the enduring moat around business model.
  • I have used the Capital Asset Pricing Model (“CAPM”) to estimate the current cost of capital to be 5.77% and I expect that the mature cost of capital will be 5.5 ± 0.25% (this reflects the low uncertainty associated with The Home Depot’s future revenues and is about the median of the current US market).
  • I have valued the Management Options at $1,029 M using a Black-Scholes model.
  • I have estimated that the HD Supply equity is valued at $9,400 M which is reasonably close to what The Home Depot is tendering therefore there is no required adjustment necessary in the valuation.

Discounted Cash Flow Valuation

The DCF is relatively straight-forward. A Free Cash Flow to the Firm approach is used with a 3-stage model (high growth, declining growth, and maturity). The model only seeks to value the cash flows of the operating assets. The valuation has been performed in $USD:

Source: Author’s model

The model estimates The Home Depot’s Enterprise Value is $354,410 M and the Equity Value is $301,776 M.

This equates to a mid-point value per share of around $281.

I also developed a Monte Carlo simulation for the valuation based on the range of inputs for the valuation. The output of the simulation is developed after 100,000 iterations.

The Monte Carlo simulation can be used to help us to understand the major sources of sensitivity in the valuation. The valuation distribution is mainly influenced by the estimate for sales growth over the next 5 years.

The simulation indicates that at a discount rate of 5.5% : the valuation for The Home Depot is between $226 and $349 per share with a typical value around $281.

This would indicate that The Home Depot is currently fairly priced.

The Home Depot or Lowes – Which is Better?

The home improvement sector is dominated by The Home Depot and Lowes with an estimated combined market-share of 43%. Let us compare the financial and operating metrics of these 2 companies:

Source: Author’s compilation using data from each company’s 10-K filings.

The data clearly demonstrates that The Home Depot :

  • generates more revenues per store and more revenues per selling area.
  • procures its inputs cheaper as indicated by its higher gross margin.
  • gains greater operating leverage as indicated by its higher operating margin.
  • invests more efficiently as indicated by its higher ROIC.
  • is less risky as indicated by its significantly lower capital leverage.

For all these reasons I think that The Home Depot is a much higher quality company compared to Lowes.

Final Recommendation

For each company that I value I assess what role this company could potentially play in my portfolio. The cornerstone of my portfolio is what I term “Tier 1” companies. These are the companies that I hold for the long term and where I invest most of my cash.

My high-level assessment for The Home Depot is:

Source: Author’s assessment.

Clearly The Home Depot is an excellent company and at the right price would be an excellent addition to anyone’s portfolio. As the company is currently fairly priced, I think that the company is a HOLD.

If there was a significant pull back in The Home Depot’s stock price, then I would highly recommend that investors buy this stock aggressively.

Disclosure: I am/we are long HD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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