Home Depot has benefited from increased demand during the coronavirus pandemic. This report will analyze Home Depot's business and prospects to determine if Home Depot's stock performance in 2020 was a one-off occurrence or if the business has enough future growth to justify an investment.
Business Size Up
Home Depot is the world's largest home improvement retailer. Home Depot operates 2,291 stores in North America: USA (86.5%), Canada (8%) and Mexico (5.5%), along with a network of distribution and fulfillment centers. Home Depot serves two core markets Do-It-Yourself (DIY) (60% of sales) and professional contractors (Pros) (40% of sales.) 9.3% of Home Depot's sales came from e-commerce platforms, up 19.3% over 2018.
The One Home Depot strategy is a 5-year 11-billion-dollar investment plan beginning in 2017 with three goals:
Revamp Home Depots' supply chain.
Improve Home Depot's technology platform.
Remodel physical locations.
Home Depot's supply chain revamp seeks to achieve the fastest delivery capabilities in the home improvement sector. By upgrading existing facilities and adding 150 new fulfillment facilities, Home Depot plans to enable next-day delivery for 90% of US households. Upstream distribution capacity through fulfillment centers reduces the burden on individual stores. Stores will no-longer require warehouse functionality as "ship from store" is phased out in major markets. As inventory becomes more centralized and delivery speed increases, stores can carry less inventory, reducing Home Depot's working capital. Home Depot's best-in-class supply chain is a distinct competitive advantage that will allow them to avoid disruption by online-only retailers. The supply chain needed to deliver home-improvement items, usually big and heavy, is different from electronics and small goods in which online retailers specialize. Home Depot's store footprint provides another competitive advantage as the appearance of goods and installation advice from industry professionals is highly valued. In 2019, customers picked up 50% of Home Depot's online orders in-store.
Home Depot seeks to improve both DIY and Pro experiences through investments in technology and store upgrades. Home Depot is investing in improving its website and creating personalized customer engagements from the design to the purchase decision. Home Depot's store upgrades include an app that allows customers to locate materials independently. The store investments include a redesigned front-end, more intuitive product stocking and online order pickup lockers. Pro initiatives include inventory management systems, custom product offerings, in-store Pro desk services, and enhanced credit programs. Home Depot's Pro Xtra loyalty program is a competitive advantage as Home Depot offers exclusive products, product discounts, dedicated sales staff and other services (mentioned above) that differentiate it from Lowes (Home Depot's closest competitor).
Home Depot has friendly shareholder policies. A continuously growing dividend, maintaining a high ROIC through returning excess liquidity to shareholders and conducting share repurchases after the business needs are met. Home Depot should see an acceleration in both dividend and share repurchases post 2022, as the accelerated capital expenditures from the One Home Depot strategy ends.
Being the largest home improvement business gives Home Depot significant power over suppliers. Home Depot sources merchandise from many different suppliers through a bidding system. The bidding system allows Home Depot to diversify its suppliers with no individual supplier accounting for more than 10% of inventory and gives Home Depot the power to drop individual suppliers without a negative impact on their business.
Individual buyers in the DIY segment do not significantly impact Home Depot as the incremental buyer has a small ticket size and visits the store on average five times a year. Pro customers have greater pricing power on Home Depot, as each pro customer contributes a significantly higher percentage of revenues than an individual DIY customer. Pro customers are more likely to cross-shop with Lowes and other smaller providers for the best price. Home Depot adds value to Pro's businesses through Pro services and offers special sales staff for Pros, saving time.
The Amazon effect has the potential to alter the current duopoly in the home improvement market. E-commerce risk is significant; however, I believe that the home improvement sector is somewhat shielded thanks to considerably higher shipping costs for big and bulky items and a much more complicated supply chain needed to deliver products in a similar timeframe. Making entering the home improvement industry an inefficient use of capital in the short-to-medium-term.
Most of the products Home Depot provides are commodities or can be purchased at competitors. As customers have no switching costs, Home Depot must continue to deliver low prices and good service to keep customers. Suggesting that margins have limited room to expand. With two major players (Home Depot and Lowes) the home improvement market is mature. Market saturation suggests any growth in the pie will be split amongst the two firms and that both firms will compete on price and service to retain their market position.
The drivers of the home improvement sector are per capita savings rates, private spending on home improvements, age of housing stock and housing starts. Through 2020 the savings rate in America increased from an average of 7.4% in the five years preceding the pandemic to 17.1% as of January 2021 (Fig 1)(FRED). Higher savings rates combined with greater demand for housing will increase housing starts and housing turnover. Both of which should spur demand for home building and improvement supplies. Home improvement sales are correlated to home turnover, increasing home prices and aging of US housing. Due to the age and condition of the US housing stock new owners often invest in home improvement upgrades over purchasing a larger home. Due to these trends the home improvement market is expected to grow at 4.2% from 2020-2025. (Ibis)
Home Depot's sales are tied to the housing market, which is driven by interest rates. If rates rise significantly in the future, home values will fall, causing a drop in consumer demand. As home values plummet, undertaking a large reinvestment plan into a property may no-longer make sense.
E-commerce allows competitors to easily enter HD's industry, provide price transparency and allows consumers to comparison shop for most items. Lowes has been a large beneficiary of cross-shopping as they are focused on gaining market share. Lowes has historically been a winner with DIY customers; however, now Lowes is placing increasing emphasis on Pro customers. Increasing competition could force HD to compete more heavily on price, placing pressure on margins downwards.
Home Depot purchased HD Supply in Nov. 2020. Home Depot must successfully integrate Interline with HD Supply to achieve economies of scale. HD Supply was purchased for 8 billion (10% of assets), integration failure would cause a multi-year drag on earnings.
Home Depot maintains a strong financial position in 2021.
During 2020 Home Depot experienced a 19.9% increase in sales; Home Depot managed to retain ~34% gross profit margin, their long-term average since 2006 (Fig 2). Retaining Home Depot's long-run average profit margin is evidence of its supply chain resilience. Another positive is days of inventory went down 5%, showing investments in its supply chain are paying dividends. Home Depot is holding significantly more cash than prior years ~7.9 billion (Fig 3). Home Depot is holding this cash to allow for increased flexibility during 2021 - I believe that Home Depot will return this capital to shareholders within the next 24 months through buybacks to normalizes its cash balance (7.7 billion buybacks authorized) (Fig 4).
Home Depot is a stable business with minimal CAPEX needs. Over the past five years, CAPEX has been 2% of sales / 21% of net income. Management has guided CAPEX should stay in this range into the future. Home Depot's advantage is that they are the largest player in the home improvement space, giving home depot CAPEX economies of scale. For Lowes to match Home Depot's CAPEX spend, it would need to invest close to 1.5x the percentage of sales and net income. Other important sources and uses of cash are highlighted in Fig 5. I expect share repurchases to normalize over the next year to 66% of operating income (Fig 5).
Future Business Prospects
I believe that Home Depot will strengthen over the next five years and continue to lead the home improvement sector. The home improvement sector has multiple positive drivers: low mortgage rates driving home prices higher, 40% of US homes being over 40 years old, high consumer savings rates and a surge in new construction adding capacity to the housing market. We are also seeing families allocate more of their wallets to home improvement. Additionally, with greater demand for housing among millennials, there will be greater housing turnover, a driver for home improvement revenues. I have reflected these ideas through a 5.7% revenue CAGR. To account for pulled demand forward, which resulted in a 20% increase in sales during 2021, I have taken guidance from Lowes, which expects their sales to drop by 7% in 2022. I used a 3% decline for Home Depot because of their HD Supply acquisition. Acquiring the market leader in the maintenance and repairs sector provides Home Depot significant operational synergies. Home Depot can exercise greater buying power and achieve cost synergies by integrating the Interline platform with HD Supply.
I believe that Home Depot's supply chain improvements will yield significant savings - as it allows Home Depot to have significantly less working capital and allows employees to be more productive as stocking takes less time. I believe that competition for Pro clients from Lowes will not allow Home Depot to reduce their COGS margins significantly. I believe that industry-wide operating expenses will increase as firms pay to retain knowledgeable staff and increase cleaning into the long-term. To reflect these ideas, I have improved Home Depot's COGS margins by 1.0% while increasing operating expenses by 2.0% over the period. The other notable change is implementing Joe Biden's proposed 28% tax rate from 2023 to 2026.
Home Depot is a well-run company, demonstrated by being ahead of the curve when investing in its supply chain to reduce costs and handle future growth. Home Depot operates in an industry with multiple tailwinds. Home Depot's enviable position is known in the market. Home Depot is a wonderful company; however, at $273/share, it trades above a fair price. A significant portion of Home Depot's stock returns have come from the repricing return. My best estimate of Home Depot's CAGR over the next five years is 5.10% (Fig 6&7). Assuming that Home Depot returns to its average P/E multiple (between March 2007-2017 (19.02x)), we can expect the stock to contract by 3.63%. Home Depot is generous in returning capital to shareholders; it returns 5.04% of the current share price to investors (based on $273 stock price). I believe that earnings will compound at an annual rate of 3.69%, faster than the US economy (Fig 7). If Home Depot experiences a significant pullback, I will initiate a position within my portfolio (Fig 8).
(Home Depot Annual Report)
· Other resources
o S&P Capital IQ
o Lowes Analyst Day Presentation
o Home Depot Presentation at Raymond James
o Home Depot Earnings Call
o Wells Fargo – Orange Crush – April 2018
o Exane BNP Paribas – Dominated DIY, Up Next, Commercial – October 2020