The Home Depot, Part 1

Business:


We all sort of know what Home Depot does, since we have all probably been there multiple times. I guess we can go over the business. They are a Home Improvement retailer, something Amazon has not disrupted (and I do not think they really will for the foreseeable future). Something about walking into a Home Depot and going to the aisle you want, not sure if that will change anytime soon. The company sells building materials, lawn and garden, decor, and they provide installation of home maintenance products. The company also has a professional service program to DIY (you will see this pop up multiple times in this report, it stands for do-it-yourself). Who does Home Depot serve? Obviously the public, but a large portion of their business comes from general contractors, handymen, building service contractors, renovators and remodelers. Something I think is very hard to disrupt since they have established themselves in that space.


Recent Q3 2020 Earnings Call Notes & Personal Analysis:


To start, Home Depot acquired HD Supply. HD Supply is a leading national distributor of maintenance, repair and operations products for the multi-family and hospitality markets (MRO). Expanding their dominance in home repairs and pro contractors. The transaction appears to still be under customary regulatory approvals, which makes sense given the pressure on share price. Financials at a glance. Sales in the 3Q grew $6.3b to $33.5b, this is up 23.2% YoY. Comp sales were up 24.1% YoY, and U.S. comps were positive 24.6%. Diluted EPS was $3.18. Home Depot states they saw “outsized demand” for home improvement projects, which actually lines up with what I have seen with working from home, building new projects, and the housing market booming. Strength across the board, all top 40 markets posted double digit comps. Home Depot also saw double digit growth from both the PRO and the DIY customers. One reason I like Home Depot is that management is focused on bringing better product, better service to their customers. Home Depot has leveraged technology, as any company has, with the “One Home Depot” strategy over the last few years. Walk into a Home Depot, you probably notice less workers and cashiers and more self-checkout. Improving the digital experience is important as well, and they have had positive reviews from customers. One area was decorative lighting, enhancing the experience with improved visual imaging and more lifestyle photos. The company actually saw higher customer engagement with this specific category online, which in return drove sales growth above the company average in the quarter.


Let us review some key components of the One Home Depot Strategy, which I suppose could be labelled under catalysts as well. Components include, opening various supply chain facilities, technology investments, and enhancements to the digital experience. These all remain on track. Some of these initiatives were halted due to the pandemic, but as of this quarter, are back on track. Have you noticed when you walk into a Home Depot now, there are more self-checkouts now. They are nice!


One metric, the comp average ticket, increased 10% and comp transactions increased 13%. The growth was primarily driven by the project demand they saw in the second quarter, this leads me to believe with lower rates and more home buying, people are spending more on Home Improvement. DIY customers, Home Depot continues to see amazing engagement from new and existing customers across various home improvement projects. The company saw double digit growth in both the PRO and the DIY, over the next few calls I would like to see this expand more especially as the weather gets better heading into spring.


A few key points I wanted to highlight, gross margins were 34.2%, decrease of 30bps and the reasoning for the negative impact was from product mix / pressure from shrink. Pressure from lumber prices, etc, I have seen that pressure for years covering Home Depot. It does not worry me too much. As you will see in the Financial charts below, Home Depot has kept their margins in the same range for the past 10 years. Return on Invested Capital (ROIC) was down to 41.6% from 45.1% last year, same quarter. The cause of this is because of management's decision to enhance liquidity position, which includes the suspension of their share repurchase program back in March. Lastly, let us discuss management's macro views. I love Home Depot for this reason, they give us a “macro view”, which is another reason I like Zebra Tech following each of their end markets. The Home Depot is seeing strong demand continue, consumer sentiment and consumption trends are showing them that home improvement spend is becoming more than the historical share of consumer spending. Metrics in the housing market continue to be stronger than before we entered the COVID-19 pandemic. Home prices ARE appreciating as inventory in the housing market is near record lows. Customers are basically telling Home Depot that their homes have never been more important, I take this a few ways. This is a positive for sure, but now we have to wonder to what extent they will continue home projects. Does this pose a risk later in 2021? I think it would represent a buying opportunity. I also think people are investing in their houses while the markets are at all time house, I suspect if the stock market corrects, that $50k you spent on your kitchen probably wont correct.. but hold its value.


Headwinds & Risks


Headwinds and why I think the company has been flat / slightly down for weeks. We are in a complex time, with COVID and working from home. Home Depot took the initiative to take care of their people by extending weekly bonuses for hourly employees, they spent approx $1.7b on temporary pay and benefits. To continue, they are transitioning to a temporary weekly bonus program to invest in permanent compensation for frontline hourly employees. This is another $1b (on an annualized basis) expense. “Our orange apron associates are the heartbeat of The Home Depot, and supporting them through this time of uncertainty and beyond continues to be a key priority”. This is a management I can stand behind.


Furthermore, Ryan Conner, the co-contributor of this report and a Fiducia Subscriber, mentioned that he heard Home Depot’s head of training speak at a lecture. Most employees last around 2 months and they have somewhere around 80% annual turnover. (RC NOTES: (1) stable, reliable but might not have explosive growth like tech, biotech (other things out there) (2) competition from Lowe’s (3) overvalued (4) COVID issues - like any retailer, specifically supply chain issues, stocking stores - anecdotes from items not in stock (5) home equity applications decreased, home buying/COVID DIY already hit its peak - steady downtrending (6) Vaccine (7) competitors in DIY space (8) HD SUPPLY HOLDINGS - merger does not work well, synergies don't exist. But back in March, people had more money to work with. As the coronavirus pandemic continues to exact a toll on our country, those collective funds have been negatively impacted.


(RC) The bears say that weaker consumer spending due to the economic downtown might delay home improvement spending, and the limited footprint growth domestically could drive increased competitive pricing pressures between Home Depot and Lowe’s. (9) continued high costs taking care of employees/associates. Home Depot’s biggest risk: The health of the U.S. economy. We wrote, “During a recession — whether caused by a collapse in the housing market or a global pandemic — consumers stop buying houses, homeowners foreclose on properties that sit vacant, and home improvement projects are delayed or scaled back:the 2008-09 financial crisis was a completely different animal. During the three-year period from January 2007 to January 2010, revenue and EPS declined steadily and the share price took a 50% haircut from peak to trough. Competition is another risk, with numerous independent home improvement stores scattered across the country and Lowe’s, a worthy national rival. In addition, companies such as Amazon.com (NASDAQ:AMZN) and Best Buy (NYSE:BBY) sell several products (e.g. appliances) that overlap Home Depot’s inventory. While logistics challenges and high costs provide real barriers to entry for a new national competitor to emerge, it doesn’t mean it’s impossible, especially for companies with deep pockets such as Amazon.


(RC) Finally, a risk we failed to mention last time is the possibility that Home Depot’s continued focus on the Pro Customer could eventually cost it to lose DIY customers. To be sure, there is no evidence this is taking place as Home Depot is seeing rising sales from both types of customers. Yet this is a potential risk Menear acknowledged at a recent analyst conference, saying: “At the end of the day, if we end up with an 80-20 Pro [80% Pro to 20% DIY sales mix], we haven’t really done our job because we want to grow the DIY business at the same time we’re growing the Pro business, and that’s been our focus all along.”

Catalysts:


What are the catalysts for The Home Depot, a $290b+ Market Cap company? Comps may be difficult in 2022, I mean, Home Depot did just post a 23.2% increase in revenue YoY for a large-cap company. I think an opportunity in Home Depot will be this sort of scenario: Travel & Leisure will pick up in 2021+, maybe making home improvements less attractive, therefore hurting Home Depot in the short-term. This may put the stock “out of favor”, but I would love to accumulate shares. Everyone points to low rates as being the biggest catalyst, I think that is just one. One thing I like about Home Depot is where are the threats? Amazon? I think Home Depot & Lowe’s have established themselves as the clear players. In 2018, the company invested $11b to better their technology, store improvements, as well as the supply chain. This is a dominant company, in an ever-evolving market because home building and construction will most likely always be here.


The company is still on their dividend increase and share repurchase program (which they suspended because of covid, but will resume), this is also a catalyst to attractive passive money for income as well as bottom line appreciation. Now we can talk about the HD Supply acquisition, because that is obviously a catalyst as well. The company states that this acquisition positions them to drive sales in a “highly fragmented” MRO space, MRO = Maintenance, Repair, Operations. Honestly, paying $8b for the company does not seem like a bad deal. I am looking forward to the synergistic opportunities HD Supply will. bring in the future. Home Depot plans to finance the acquisition with cash on hand and new debt. Rates are low, why not? Makes sense to me. The acquisition will also be accretive to EPS in Fiscal 2021, and more shareholder value over the long-run. I also want to make note that Home Depot has consistently raised their dividends over the years as well. We will take a further look in the segment below. From what I have personally seen this year, M&A activity has dampened short-term performance in stocks I have seen. For instance, Teladoc and Livongo. Teladoc has traded down since the deal. Yes, comps will be hard for Home Depot to beat in 2021, but that does not worry me.


Brief Financial Overview & Strategy (Data from FinBox API linked into excel)


Below is a simplistic financial overview of The Home Depot and key metrics that I analyze. One strong reason I want to add Home Depot to my portfolio is the consistent shareholder return in the form of share repurchases, and dividends. The Home Depot has a strong history of bottom line compounding over time.


Below, is a 10 year period of Return on Invested Capital. Essentially tells me they are very efficient capital allocators, I put them against Lowes for reference. (Source: FinBox).



Summary:


Overall, I am a strong believer in Home Depot and their strategy over time. Any portfolio, where you are Growth or Value, I think Home Depot deserves a spot based on their ability to return capital to shareholders and their impressive Return on Invested Capital. Given the current market addiction to Growth, in a low rate environment, I think HD is a great addition to a dividend portfolio as well. I believe I will be accumulating shares through 2021 in Home Depot as I restructure the portfolio. I am going to be holding CloudFlare, BlackLine, Lemonade, Zebra, Anaplan, Home Depot and Lam Research in my Growth Fund maxing myself at 7 names. I will continue to research and write reports that are easy to understand and grab your attention over time on these names.


I think Home Depot over the next 5 years has more secular tailwinds to run on, and will provide investors stability in their portfolios. I am a buyer and will be adding. Below is a photo from Portfolio Visualizer which is a website I utilize to strategize sometimes. Obviously, past performance is NO guarantee of future performance, but is incredible to note the compounding this business has done.. my jaw dropped with a 23.51% CAGR since 1986.. cannot wait to own this stock again. Now that I am a dad, and maybe buy a house soon, I guess I will be here more often with my white New Balances.


Yours Truly,

Fiducia B



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