The Home Depot: Great Business, Strong Expected Returns For This Dow Stock - Sure Dividend

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The Home Depot: Great Business, Strong Expected Returns For This Dow Stock

Updated on June 17th, 2019 by Josh Arnold

Home improvement giant Home Depot (HD) has had a very nice 2019 thus far. After plummeting from $213 to just $158 near the end of last year, the stock has rallied again to get back near its former highs, trading in excess of $200.

In addition to its strong stock price gains, Home Depot rewards shareholders with impressive dividend increases. Home Depot is one of the highest dividend growth stocks in the Dow Jones Industrial Average. You can see the entire list of Dow 30 stocks here.

This article will discuss Home Depot’s recent events as well as the value proposition the stock offers, as determined by our Sure Analysis Research Database, where we rank stocks based upon total expected returns.

Home Depot’s expected total returns have come down in recent weeks simply due to the rally in the stock. However, we still find the company to be very attractive over the long-term and think investors should consider buying the stock on the next pullback.

Business Overview & Recent Events

The first Home Depot store opened in 1979 after founders Bernie Marcus and Arthur Blank were fired from their jobs at a local hardware store. The plan was to create a superstore that would offer a larger assortment than what was available at the time, with highly trained staff that could help customers with their varying needs.

Home Depot went public in 1981, raising just over $4 million in capital from the offering, which was listed on the NASDAQ stock exchange. Nearly 40 years after the IPO, Home Depot has grown to almost 2,300 stores in three countries.

Source: Investor presentation, page 4

Home Depot employs more than 400,000 people. Its store base is highly concentrated in the U.S., but it has just over 100 stores in Mexico, and nearly 200 stores in Canada as well. Annual revenue is in excess of $111 billion, and the stock’s market capitalization is $226 billion, making Home Depot one of the largest retailers in the world.

Home Depot reported Q1 earnings on 5/21/19 and results were strong once again. Sales were up 5.7% year-over-year to $26.4 billion. Comparable sales rose 2.5% overall and 3% in the US. Online sales contributed strongly to top line growth, moving 23% higher against the year-ago period as Home Depot continues to capitalize on consumers’ willingness to buy out of store. Comparable transactions rose 0.5% in Q1 while average ticket boosted comparable sales by 2%.

Net income came to $2.5 billion in Q1, up slightly from the $2.4 billion in last year’s Q1. However, thanks to a much lower share count, earnings-per-share was $2.27, up 9.1% from the $2.08 earned last year in the comparable period. Home Depot’s formula of strong sales growth and buybacks continues to work despite no material improvements in margins. The company’s float is down 4.5% year-over-year.

The company reaffirmed its guidance for 2019, including 5% comparable sales growth, 3.3% total sales growth, and diluted earnings-per-share of $10.03. That would be a 3.1% gain from fiscal 2018, but keep in mind the company’s tax rate will be marginally higher this year than last, and that last year contained an extra operating week. That extra week that is missing this year is good for a ~2% headwind this year.

Home Depot continues to struggle with boosting margins, particularly with respect to gross margins. This has been true for years as gross margins have oscillated around the 34% mark, but haven’t really shown any improvement.

HD Margins

Source: Investor presentation, page 5

Part of that is by design, as seen in the slide above from a recent investor presentation. Home Depot has been investing in its store capabilities and in grabbing market share from the likes of Lowe’s Companies (LOW) and others by investing in price. Essentially, that means Home Depot is reducing prices on certain items to become more competitive. This drives traffic and comparable sales, but at the expense of margins.

We don’t expect gross margins to drive any sort of meaningful gains in the coming years as the company’s strategy specifically limits margin expansion. While a lack of gross margin growth can be a headwind to earnings growth, it is clearly working for Home Depot, as the company continues to drive high rates of profit growth, in part thanks to this strategy.

Growth Prospects

The company’s stated goal for gross margins is 34.1% for fiscal 2020, and that number came in at 34.2% for Q1 of 2019, implying margins are expected to remain relatively flat going forward.

Home Depot attempts to make up for this lack of gross margin expansion via expense leverage, wherein it looks to grow revenue more quickly than expenses, which helps drive profit gains. In Q1, SG&A costs, which includes things like back office support and store labor costs, increased 3.4%, which is lower than the 5.7% gain in revenue.

Home Depot believes it can achieve between 20bps and 80bps of expense leverage by the end of 2020, so it would appear there is some slightly margin expansion on the way. Indeed, the company made some progress in Q1 towards this goal, which was an improvement over Q4’s results.

Home Depot’s share count was also 4.5% lower year-over-year as measured by its average outstanding diluted shares for the first quarter. Home Depot has been buying back shares on a huge scale for years as it produces far more cash than it can use to invest in the business. This has been a steady tailwind to earnings-per-share growth and we expect that will remain the case for years to come.

Source: Investor presentation, page 8

Home Depot guided for the above for the full year of 2019. Total sales growth is expected to be 3.3% on comparable sales growth of 5.0%. The difference in the two numbers, which are generally very close to each other for this company, is because of the lack of an additional operating week, as mentioned earlier.

Recall that fiscal 2018 contained an additional week that added around 2% to total revenue growth, so that simply gets backed out of fiscal 2019 results. The number investors should focus on is the 5% comparable sales guidance, which is once again very strong.

The five net new stores will not be meaningful as that will represent a small fraction of the store base, but the company sees 14.4% operating margin for 2019. That compares to 13.6% operating margins for the first quarter. The gain for Q1 was due to expense leverage as SG&A costs rose less quickly than revenue; gross margins were essentially flat.

Management guided for ~$10.03 in earnings-per-share, based upon another $5 billion being spent on share repurchases. That’s good for just over 2% of the float at today’s share price, so repurchases will once again be a small tailwind to earnings-per-share growth.

Home Depot’s recent growth has been nothing short of outstanding, although investors need to keep in mind this story is about revenue growth primarily.

HD Growth

Source: Investor presentation, page 5

Sales rose 6.7% in 2017 and another 7.2% last year, with total revenue forecast to increase 3.3% in 2019. As mentioned, these results are skewed but if we adjust for the additional operating week in 2018, the company’s sales increases would all be in excess of 5% annually over this time frame.

Operating margins have remained essentially flat in this time period, as mentioned, because of the investments Home Depot has been making in its business to take market share. We expect this will continue in 2019 and beyond as management has been very upfront about its desire to continue building for the future, even if it comes at the expense of margins.

Source: Investor presentation, page 13

This chart shows focus of the investments the company is planning for the 2018 to 2020 period. There are business as usual, or BAU, investments that are always made, but Home Depot is building on that with incremental spending to support future growth. Namely, it is spending $5 billion in a three-year period just on improving the in-store experience.

The company is investing in things like its product assortment to drive traffic and higher average tickets, in-store pickup of online orders, and its associates in terms of training and knowledge building. It also continues to invest in building the Pro business, along with more targeted advertising using the significant customer data it possesses. Finally, Home Depot continues to build out its supply chain to increase speed-to-market, as well as lower unit costs.

Another driver of future growth will be continued spending by homeowners on their properties.

HD Spending

Source: Investor presentation, page 18

Home Depot sees mostly supportive conditions for the housing market in the U.S. in the coming years, meaning that it should continue to see higher revenue numbers, which will drive earnings-per-share growth. Recent years’ revenue growth numbers correspond well to these drivers of home improvement spending, so we believe Home Depot will continue to grow earnings at high rates in the years to come.

Valuation & Expected Returns

We expect 8% earnings-per-share growth each year for Home Depot over the next five years. This is a strong EPS growth rate, but actually represents a slowdown from previous years. For example, from 2014 to 2019 expected earnings-per-share, Home Depot will have compounded earnings at an annual rate of more than 17%. While that high of a growth rate may not be sustainable due to various headwinds including recent trade conflicts, we do think 8% is an attainable goal.

The main driver of Home Depot’s future EPS growth will be revenue growth, achieved through a combination of comparable sales growth (which represents growth at stores open at least one year) along with new store openings. Earnings growth will also receive a boost from share repurchases to help get Home Depot to 8% annual growth.

Dividends will also add to Home Depot’s total returns. The company recently raised its dividend by 32% and the stock offers a 2.6% dividend yield, which is above the S&P 500 Index average. We expect the dividend to continue to grow at strong rates in the coming years given that the payout ratio is just over 50%. Future dividend increases are likely due to the modest payout ratio, as well as the contribution of future EPS growth.

Source: Investor presentation, page 9

Home Depot has been one of the strongest dividend growth stocks in the Dow Jones over the past several years. Its payout rose from $1.16 in 2012 to $5.44 per share currently. Since we expect Home Depot to continue growing EPS at a high rate over the next several years, we also expect the stock to continue growing its dividend at a high rate for many years.

Valuation changes could be a minor offset to Home Depot’s EPS growth and dividends, as the stock trades for a relatively high valuation in the retail industry. Shares trade for a price-to-earnings ratio of 20.5, based on expected EPS for 2019. As a result, our fair value estimate is a price-to-earnings ratio of 19, for a fair value price of $191 per share. That means shareholders could experience a ~1.5% headwind to total returns due to a small decline in the valuation multiple.

Still, Home Depot has total expected returns of approximately 9% annually over the next five years, despite the somewhat elevated valuation. Given all of this, we rate Home Depot a long-term buy, but would suggest investors interested in owning the stock wait for a pullback. The stock trades at a fairly high level, which in many ways should not be surprising given the strong historical EPS growth of the company. Nevertheless, value investors may want to wait for a better buying opportunity.

Final Thoughts

Home Depot is a premier retailer, and has generated superior returns to shareholders in recent years that place it near the top of the entire retail industry. Home Depot has been virtually immune to the erosion facing the broader brick-and-mortar retail industry. There should be plenty of growth left in the tank for Home Depot, particularly if the U.S. economy stays out of recession.

While investors should not expect a significant level of margin expansion for Home Depot, it should generate more than enough EPS growth from revenue growth and share repurchases. In addition, the above-average dividend yield is attractive for income and dividend growth investors. Overall, we expect a strong rate of total returns for Home Depot in the high single-digits each year through 2024.

Putting all of these factors together, we view Home Depot as an attractive long-term holding. As a result, we rate Home Depot a long-term buy today given its strong growth outlook and dividend growth.

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