Once you buy a home and move in that’s it for spending. All major appliances work at 100% efficiency. Your significant other doesn’t think anything needs to be upgraded or replaced. The landscape is immaculate and doesn’t require any redesigning. Plus, you have all the tools and materials you’ll ever need to maintain your perfect immaculate house.
To quote Tommy Boy.
Gas Station Employee: I’m picking up your sarcasm.
Richard Hayden (David Spade): Well, I should hope so, I’m laying it on pretty thick.
Homeownership is expensive. The average homeowner spent around $9,325 per year on maintenance and upgrades. If you’re a capable DIYer or you need to hire a professional, The Home Depot is there to help you spend your money.
Dividend History
Home Depot is a dividend stalwart. They have paid and grown their dividend since 1987.
Over the last 10 years, Home Depot grew its annual dividend at a 19.62% compound annual growth rate.
We expect Home Depot to continue to grow its dividend at least 8% per year for at least the next 5 years.
Dividend Safety
Home Depot fails our debt-to-equity ratio requirement. But it’s not because it’s over leveraged. Home Depot’s interest coverage ratio is very high signifying that its debt load is reasonable. Home Depot fails the Debt-to-Equity ratio because its Shareholder Equity is low.
Home Depot is a massive acquirer of its own shares. These shares are held on its books as Treasury Stock which is a contra item on the balance sheet. Home Depot owns so much of its own shares that its Treasury Stock line item surpasses positive items like Retained Earnings and Additional Paid-in Capital.
Catalysts for Price Appreciation and Dividend Growth
Expanding Market Share
Global Market Insights puts the global DIY Home improvement industry at $762 billion and they expect it to grow over $1 trillion by 2027.
Home Depot and its closest competitor Lowe’s only command 30% of the Home Improvement market. Lowe’s has over 12% of the market and Home Depot has just over 17%.
Home Depot has two avenues of growth. The first is riding the general overall growth of the global home improvement sector. The second is taking market share.
Home Depot is aggressively pursuing market share gains with its blend of e-commerce, physical stores, fulfillment warehouses, and online sales fulfilled through stores. Last year Home Depot stated that they gained 275 basis points in market share.
Since we started the program in fiscal 2017 through '18 to '20 and market share is a little elusive in our market. But based on the best data we can get, we believe that we've captured about 275 basis points of share growth during that time frame. [Emphasis added] -Craig Menear, CEO, Q4 2020 Earnings Call
Demographics
Bill McBride at Calculated Risk recently identified two major U.S. housing trends that benefit Home Depot.
The first is a large cohort of people are aging into their prime home buying years, 30-39 years. This trend should last for about 10 years.
A new home purchase leads to other home improvement spending which, as a new home buyer, Glenn has painfully learned this year.
The second demographic trend is aging Baby Boomers downsizing, moving to retirement communities, or hitting the road.
These homes will tend to be older and in need of updating and modernizing. The spend to update these older homes should flow through to Home Depot too.
Repaired Balance Sheets
The mid-2000s housing bubble was the culmination of a decades long trend of rising home prices and increased consumer borrowing. When the bubble popped, the decline in home prices and the stock market decimated household balance sheets.
U.S Households Total Assets/Total Liabilities
The recent stock market and housing market recovery have propelled household balance sheets to new highs. With interest rates so low and housing prices soaring, we expect more home owners to refinance and use some of their cash to reinvest in their homes.
Pros
Two key metrics in retail are sales per square meter and inventory turnover. The Home Depot has higher sales per square meter and higher inventory turns than its closest competitor, Lowe’s.
Home Depot generates higher sales per square meter and higher inventory turns because of its small contractor business which it labels “Pros”. Home Depot is a critical supplier to contractors. As vaccine rates increase and homeowners become more comfortable with outsiders coming into their homes, we expect small contractor remodeling to increase too. The NAHB remodeling Index continues to show increased demand for contractor lead remodels.
Risks
Nardelli 2.0
One of the strengths of The Home Depot is the knowledgeable staff. Which was part of the original business plan created by Arthur Blank and Bernie Marcus.
But the heart of Home Depot was the expertly trained floor associates who could teach customers how to handle a power tool, change a fill valve or lay tile. It wasn’t enough to sell or even tell — associates also had to be able to show. Soon, The Home Depot began offering DIY clinics, customer workshops and one-on-one sessions with customers.
Nardelli, a GE Alum and a Six Sigma devotee, alienated the knowledgeable employees with ruthless streamlining, cost cutting, and increasing the number of unknowledgeable part-time employees. This in turn alienated customers who now had a second choice for their DIY dollars, Lowe’s. Home Depot’s stock and its business languished during this period and then the housing crisis came along.
Home Depot is a great business, but it lacks a self-reinforcing business moat like network effects. It relies on a CEO that understands and cultivates its culture. Another Robert Nardelli can wreck everything that has been regained since the housing crisis.
Housing Bubble 2.0
People are more likely to spend more on their houses and tap equity lines of credit when home prices are rising because of the wealth effect. Spending dries up quickly when the cycle turns.
The rapid rise in home prices is invoking comparisons to the housing bubble of the early 2000s. If it is another bubble and it pops the declining wealth effect will reduce money spent at the Home Depot.
We see several key differences between now and the housing bubble of early 2000s.
First, it is much harder to get a mortgage now.
From the Wall Street Journal.
Mortgage credit availability, a measure of lenders’ willingness to issue mortgages, is near its lowest level since 2014, according to the Mortgage Bankers Association, or MBA.
The tight lending environment illustrates a growing cleavage in the mortgage market: More home loans are being made than almost ever before, but they are going almost exclusively to borrowers with pristine credit histories and sizable down payments. Borrowers with credit qualifications that fall just outside the stellar category are finding fewer lenders willing to approve their applications.
Chart via A Wealth of Commons Sense
N.I.N.J.A loans and no money down deals are not artificially boosting demand like we saw in the housing bubble.
Second, home supply is tight.
According to Greenlight Capital’s Q2 2021 letter, from 1960 to 2002 the U.S. averaged 1.1 million homes being built per year. From 2003 to 2007 it increased to 1.5 million homes per year but since the GFC that rate dropped to 700,000 homes per year. There are not enough homes to meet the rising demand.
2020 pulled forward a lot of demand causing the large spike in prices. We’ll probably see a short-term slowdown in housing demand as prices and demand readjust, but the long-term set-up remains in place for a positive real estate cycle.
Valuation
Home Depot’s return on invested capital (ROIC) is currently 40.69%. Estimates have Home Depot growing its earnings at 10% per year over the next few years. If we use 7%. We can arrive at this using the expected growth of the home improvement retail industry, 4.5%, plus continued gains in market share of 200 bps. With a 10% required rate of return, our justified P/E ratio comes to 28x and a fair value of $384 per share.
This matches our discounted cash flow model that generates a fair value estimate of around $384 per share using the perpetuity method.
With such high returns on invested capital, Home Depot doesn’t need a lot of growth to create excess value. But given the underlying positive real estate trends and Home Depot’s gain in market share, we might get the best of both worlds. Higher growth plus high returns on invested capital.
