Home Depot (NYSE:HD): Advantages in Size, Balanced International Presence and Strong Management
Home Depot was originally begun as a one-stop DIY shop. Now, the company has expanded to over 2,200 stores that together offer a wide range of products and services, including over 700,000 building materials, home improvement supplies, and lawn and garden materials as well as how-to clinics for families and workshops for kids. Home Depot's main product revenue streams are in indoor garden materials, paint, kitchen and bath materials, outdoor garden materials, and appliances, in that order (Source: S&P Capital IQ). The company's services center on professional home renovation as well as onsite professional work.
As a United States-based company with limited international presence (international operations make up around 13% of their store base), Home Depot essentially has the best of both worlds: on the one hand, they are still able to diversify the geographic composition of their customer base and gain an edge over less international competitors through increasing their own market share; and at the same time, they are able to limit their exposure to the risks that come with very international businesses, such as foreign exchange risk.
Currently, Home Depot has operations in Canada, Mexico, where the company is the largest home retailer, Guam, and the Virgin Islands; in total, the company has around 300 stores abroad. The company has divested their China operations, after finding insufficient success there for a number of reasons, including the purchasing preferences and patterns of consumers there. Specifically, due to the massive population in China, the majority of people live in apartments, which are usually priced along with the other apartments in the building or even the village, as it is called; that is, pricing is usually not apartment-specific, and consequently, people are less inclined and incentivized to purchase goods and services to improve their homes, especially before selling. Home Depot's decision to divest their China operations has positively impacted their performance thus far and speaks to the company's adaptability and in-depth focus on their core business.
Home Depot's current CEO is Craig Menear, who has developed an in-depth understanding of the company through his 20 years of working there. Home Depot's current CIO is Matthew Carey, who previously served as senior vice president and chief technology officer at eBay (EBAY). His experience with eBay will be invaluable for Home Depot as the company continues to grow their e-commerce branch and overall online presence, which is also a main focus of Meaner.
The company's sheer size is a major asset, particularly in providing more bargaining power with their vendors and capitalizing on economies of scale, which in turn allows Home Depot to continuously offer low prices and thus instill customer loyalty.
Home Depot over Lowe's
Lowe's (LOW) is, as most know, Home Depot's main competitor in the home improvement industry.
Although, Home Depot was founded in 1978 (by Bernie Marcus and Arthur Blank), a whole 3 decades after Lowe's, for the past decade, Home Depot has been the larger, more dominant company, as evidenced by their 58% market share compared to Lowe's 39% market share. Home Depot's relatively rapid and stable rise speaks to the strength of their leadership, the efficiency of their operations, and their superior supply chain management systems, namely their modernized, centralized network of distribution centers.
Home Depot, with their more niche products and more bulk buying options, caters to contractors and professionals, while Lowe's caters to the average Joe. Consequently, Home Depot's average basket size is significantly larger than that of Lowe's.
Home Depot's overall ambience, rooted largely in their darker colors, is said to attract more men, while Lowe's, with their lighter colors and ambience that reflects that, attracts primarily women.
In the last few years, relative to Lowe's, Home Depot has found much more success in their e-commerce initiatives and increasing their online presence. In FY15, online sales made up 6% of Home Depot's total sales; in contrast, online sales only made up 3% of Lowe's total sales.
The $1 billion online sales growth represents 18% of Home Depot's total annual sales growth of FY15.
Home Depot in the Age of E-commerce
E-commerce has already claimed over 7% of the retail market and is expected to further rise in the coming years. As such, it poses a threat to brick and mortar stores in the retail industry as well as other industries. However, this threat is largely mitigated for Home Depot for several key reasons.
Home Depot, even more so than Lowe's, not only as a home improvement store but more specifically as one that caters toward professionals and contractors with bulk buying needs, primarily deals with big ticket items. These heavy, bulky goods are difficult and expensive to ship and thus not ideal online purchases. Consumers in the home improvement industry prefer to purchase in stores out of necessity (for example, exact color shade is frequently a factor and cannot easily be discerned online) and for the experience.
Furthermore, beyond their high caliber customer service, Home Depot's employees have specialized knowledge. Additionally, Home Depot is driving more store traffic through the aforementioned in store clinics and workshops.
The company is taking measures to adapt to the rise of e-commerce, including moving toward online advertising and restructuring their stores to allocate more space to items that customers can, do, and must purchase in store while reducing space for products, like patio furniture, that customers tend to buy online. Home Depot's own online store is ranked as the 5th largest online retailer in the country.
Adapting to the Home Improvement Industry Saturation: Gaining Market Share Elsewhere
As previously mentioned, the home improvement industry is a rather saturated one. Home Depot does nonetheless derives gains in spite of or perhaps because of this. The high concentration of the home improvement industry creates high barriers to entry and ensures that brand equity is highly valued by customers, which in turn maintains Home Depot's position and sustainability.
Beyond this, Home Depot is taking additional measures to expand into other markets as well.
Recently, Home Depot acquired Interline, which is a player in the pro market. Together, Home Depot and Interline only represent 5% of the pro market (Source: Credit Suisse Q1 Follow Up: Raising Estimates), which stands in stark contrast to Home Depot's aforementioned 58% market share in the home improvement industry. Overall, the pro market is a highly diffuse one (Source: Credit Suisse Q1 Follow Up: Raising Estimates) since it is mostly comprised of small companies with no clear leader or even dominant players, which creates massive opportunity for Home Depot, a large, well established company, to rapidly gain market share, particularly with the addition of Interline's resources.
As previously mentioned, appliances are one of Home Depot's main revenue streams, making up over 7% of their revenue in FY15 and is expected to grow in the coming years (Source: S&P Capital IQ). The appliances market, unlike the pro market, does have market leaders, but these leaders are weak ones, namely Sears (SHLD), which is in decline. Home Depot, as a large and healthy company is well positioned to successfully take market share in this market as well from their current market leaders.
For FY15, it has been noted that the gap between Home Depot's and Lowe's gross margins is decreasing, but a large part of Home Depot's expenses that contributed to these lowering margins is from the Interline acquisition and fixed costs needed to begin manufacturing appliances, which are otherwise low margin goods. Both of these expenses will likely ultimately produce returns for the company in the long run.
Hidden Drivers of the Housing Market
Recent news on the housing market has been quite focused, arguably overly focused, on the impact of interest rates, particularly with Brexit creating an environment of international uncertainty, the election coming up (the Federal Reserve is unlikely to raise interest rates during the core of the election season to avoid being viewed as a partisan entity; consequently, the Federal Funds Futures remains approximately the same during these months), and the unexpectedly weak May jobs report.
Consequently, the 30-Year Mortgage Rates are at near historic lows; homebuilder confidence is at a 2016 high; the housing market's compounded annual growth rate is at 4.5% for 2016 to 2019; and the S&P Home Improvement Retail index has increased (Source: Bloomberg terminal).
However, there are two additional main drivers of the housing market that are not nearly as commonly discussed or even well known.
One main factor is new and existing home inventory. More specifically, new home inventory is at an all-time high (Source: Bloomberg), which is beneficial for Home Depot's business since it increases the number of customers and consequently revenue as well. More importantly, at the same time, existing home inventory is declining at an accelerating rate (Source: Bloomberg terminal). This leads to increasing sales volume and consequently rising home prices, which benefit Home Depot's business through also increasing number of customers and therefore revenue.
Age distribution is the other main factor. The average age of the first time homebuyer is 33, which is the age the oldest of the millennial population, who make up 34% of the United States population, has recently reached.
Although some may point to the trend of members of Generation Y preferring to live with their parents for longer periods of time due to student debt and student loans, the sheer size of the millennial population cannot be underestimated and will contribute to increased growth in the housing market over the next decade. Furthermore, in late June of 2016, the millennial employment to population ratio reached a post-recession high (Source: Bloomberg terminal), indicating a greater ability and inclination, among millennials, to purchase home improvement goods and services.
Warm Weather and the Wrongful Attribution of Home Depot's Top Line Growth
Warmer weather in the recent months has been identified as a driver of Home Depot's growth, which can hardly be doubted, especially since this connection makes intuitive sense as well. However, this warmer weather, especially since it alone has been a major topic of discussion among the general public in other sectors and contexts as well, has caused an underappreciation of Home Depot's growth; that is, the company's growth has been overly attributed to warm weather and thus seen as cyclical and even unstable and unsustainable.
However, Home Depot's revenue growth of close to 7% is more than the weather effects could have accounted for (Source: Credit Suisse Raising Estimates and Reaffirming Outperform). In short, Home Depot's growth and growth potential, albeit as a value and non-growth oriented company, are consequently underestimated.
Home Depot through the Business Cycle
It is important too to note something else frequently overlooked: Home Depot's ability to perform throughout the business cycle. In weak economic times, the company will gain revenue from their DIY products and services while in strong economic times, they will gain revenue instead from professional sales. Furthermore, their widely diversified customer base helps them in maintaining additional stability, in spite of the notions that the company is highly correlated with and dependent on macroeconomic factors.
Intrinsic Valuation: Discounted Cash Flow Model and Dividend Discount Model
I completed bear, base and bull case discounted cash flow models for Home Depot.
For revenue growth, I assumed recession level revenue growth for the bear, the average of the past 5 years for base, and slightly above the average of the past 5 years for bull. I projected cost of goods sold (i.e. variable costs) to grow at 90% of revenue and operating expenses (i.e. fixed costs) to grow at 75% of revenue.
For expected return on the market incorporated in the discount rate, I used 11% for bear, 9% for base and 7% for bull, from slightly adjusting each based on the average return of the S&P in the past few years.
Using the Gordon Growth Model, I arrived at a terminal growth rate of 2%.
With all this, I arrived at a 3-year price target range of $142.6 to $170.5 with an implied per share price of $158.9, representing an upside of 19% from their current price of $134.78, as of Friday, July 16th, 2016, market close.
My sensitivity analysis of this discounted cash flow model, with a discount rate range of 6.7% to 10.7% and a terminal growth rate range of 1% to 3%, yielded a wider possible per share price range of $110 to $236.
The dividend discount models, using the H Model and the 2 Stage Model, I completed (assuming a future growth rate of 8%, a transition period half life of 1 year, and the aforementioned base case expected return on the market) arrived at target prices within this discounted cash flow model 3-year price target range.
Returning Value to Shareholders: Dividends and Share Repurchase
On the topic of dividends, it is important to highlight the ways in which Home Depot returns value to their shareholders, not only through potential share price rises.
With regards to dividends, Home Depot has paid uninterrupted dividends since 1987, has increased their dividends continuously since 2009, has a 23% historical average annual dividend per a share growth rate, and has a 2% 12-month dividend yield, compared to Lowe's 1.41% 12-month dividend yield.
Moving forward, in the most recent earnings call, management stated that the company's dividend payout ratio would likely remain at 50%, which implies that dividend growth will likely be in line with earnings growth.
Home Depot also has a robust share repurchase program, which has been a core component of their strategy for the past 2 decades. The company consistently utilizes excess cash to repurchase shares and plans to continue to do so as long as their company fundamentals remain sound, as they currently are. They still have $11 billion remaining in their current buyback authorization and are on track to expend $25 billion in stock repurchase by the end of FY17. Overall, their reliable share repurchase program speaks to the company's unwavering support for their own stock and reliable return for shareholders.
In the past 5 years, Home Depot has returned $41 billion, which is over 20% of their market cap (Source: Morningstar), to shareholders through dividends and share buybacks.
Relative Analysis: Comparable Companies
Sell side consensus is that Home Depot's P/E ratio will fall to 14.1 by FY20, although currently, Home Depot's P/E ratio is arguably somewhat high at 19.4 (Source: Bloomberg terminal). The question then becomes whether the company will grow into this lower P/E ratio.
Compared to Lowe's, Home Depot has a slightly higher EV/EBITDA ratio but also a slightly higher EPS (Source: Bloomberg terminal).
Home Depot may, at first glance, seem to have a high debt/equity ratio, but a closer look at the company's debt market indicates that Home Depot is actually not highly leveraged. Their bond credit rating by S&P and Fitch is A (Source: Bloomberg terminal), which is excellent for a corporate bond. Their spread on bonds is around 72 basis points, which is quite tight (Source: Bloomberg terminal). Furthermore, their leverage ratios of total debt to EBITDA and net debt to EBITDA are between 1 and 2, primarily below 1.5 (Source: Bloomberg terminal). Home Depot has also stated that they will ensure that these ratios do not surpass 2 (Source: Bloomberg terminal) thereby providing great financial security for them and their shareholders.
Risk Factors
Nonetheless, there are a number of risks factors and potential downsides.
For one, the saturation of the home improvement industry is still a concern for Home Depot, since the company is a dominant player there, and it is not yet certain whether the company will be able to gain sufficient market share in the aforementioned pro and appliances markets.
The inevitable rise of interest rates at some point in the future will likely have a negative impact on Home Depot through the resulting decline in the housing market. Furthermore, the company's and industry's dependency on macroeconomic factors in general makes for increased unpredictability.
Although millennials do and will make up an increasingly large portion of Home Depot's customer base, their fickle shopping patterns may affect the company in unpredictable yet significant ways. Additionally, as more and more millennials facing rising student debt choose to live with their parents for longer, Home Depot and the housing market may be negatively impacted.
Increasing urbanization poses another potential threat to Home Depot. Lowe's has been attempting to adapt to this threat through implementing initiatives targeted at selling to populations in urban areas. The question then becomes whether Home Depot will be successful in doing the same.
Finally, Home Depot also faces competition from companies in adjacent industries, such as Wal-Mart (WMT), Costco (COST) and Amazon (AMZN), in unprecedented ways, as a result of the rapid rise in breadth of each of these companies.
Bottom Line
Home Depot equity as a value investment presents a myriad of strengths and other opportunities. These include their uniquely thriving dotcom store bolstered by the rise of e-commerce, the housing market boom (which is possibly even underestimated by recent measures), their ability to mitigate the risk of a saturated market through moving into other spaces, their advantages over their main competitors and their balanced international presence (large enough to gain a competitive edge and simultaneously little enough to avoid international risk).
However, it is nonetheless essential to gauge macroeconomic factors and trends, factor in the investment time horizon and complete additional intrinsic valuation, among other things, before making a final judgment call.
Addendum: A Leading or Lagging Indicator? An Exploration of Home Depot Stock Prices and Existing Home Sales as Indicators of the Markets
As an extension of this study, I examined correlations between Home Depot's stock price and existing United States home sales as well as the two as possible indicators, leading or lagging, of the markets.
I used the monthly data since 1999 on seasonally adjusted existing U.S. home sales (Source: Bloomberg terminal) to calculate the correlation and covariance coefficients between that all and Home Depot's stock price in the same time period. I found the correlation coefficient to be -0.026, and the covariance coefficient to be -75772.815.
I then repeated the above but instead with the 12-month moving average of seasonally adjusted existing U.S. home sales since 2000 to reduce noise in the data. I found the correlation coefficient to be -0.052 and the covariance coefficient to be -105774.371.
I also calculated the percent changes in seasonally adjusted existing U.S. home sales and percent changes in Home Depot's stock price (also monthly since 1999) and then calculated the correlation and covariance coefficients for that all as well. I found the correlation coefficient to be 0.077, and the covariance coefficient to be 0.
I then repeated the above but instead with the 12-month moving average of seasonally adjusted existing U.S. home sales since 2000 again to reduce noise in the data. I found the correlation coefficient to be 0.098, and the covariance coefficient to be 0.008.
I looked into the key turning points in the housing market via the ETSLMOM Index and examined whether Home Depot's stock price possibly served as a forward looking indicator for the housing market.
The main observation and insight from this is that in/because of the housing market crash during the most recent recession, Home Depot's stock price reached their low in March of 2009 whereas the ETSLMOM Index did not really plunge until November of 2009 (Source: Bloomberg terminal).
In a similar vein, I did lag testing by shifting the time frames for the process outlined in the first step of this examination and found the following: the correlation coefficient for the last 3 months is -0.73, for the last 6 months is 0.86, for the last 1 year is -0.45, for the last 3 years is 0.14, for the last 10 years is 0.23, and for the last 15 years is -0.02.
Although the many near 0 correlation coefficients coupled with the massive covariance coefficients do not allow for definitive conclusions to be drawn from this examination, from further studying the aforementioned key turning points, it seems that Home Depot's stock price serves as a leading indicator for existing U.S. home sales while existing U.S. home sales serves as a lagging indicator for Home Depot's stock price. A possible further explanation of this is that the stock price (i.e. market) incorporates many more factors/considerations than do consumers' purchasing decisions.
Additionally, it appears that the market is a 6-month forward indicator.
