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The Home Depot (HD) share price surge reduces its attractiveness. I suspect this surge is likely partially attributed to irrational exuberance!
In my April 4, 2022 Home Depot (HD) post, I disclose the purchase of 200 shares @ ~$303.36 in a 'Side' account within the FFJ Portfolio. At that time, the most current financial information was for Q4 and FY2021.
In hindsight, I should have added to my exposure in mid-June when the share price plunged below $300. However, I deployed funds toward other purchases; it was not until August 2 that I acquired another 50 shares @ ~$301.64.
Now that we have Q2 and YTD2022 results and FY2022 guidance, let's look at why it might be wise to postpone any HD share purchase.
Overview
In late July, I read Built from Scratch: How a Couple of Regular Guys Grew The Home Depot from Nothing to $30 Billion. The book was written by the founders of HD and was published in 1999.
While some information is outdated, it is fascinating to read about the background of the founders, how they came up with the concept, HD's formative years, and how HD reinvented the home improvement retail industry.
It is remarkable to read some of the statistics and to see the extent to which HD has grown in just over 20 years. When the book was published, for example, HD's annual revenue was in the ~$30B range. Compare this with HD's ~$44B Q2 2002 revenue!
At FYE1998, HD had 913 Home Depot stores, of which 43 were in Canada, and 2 were in Chile. In addition, it had 15 EXPO Design Center stores. HD's plans included the opening of a store in Argentina in FY2000. At the time, it employed ~157,000 associates, of whom ~9,420 were salaried, with the remainder compensated on an hourly basis.
Interestingly, in October 2021, HD announced that it had reached an agreement to sell its 9 South American stores. The 5 stores in Chile were purchased by its joint venture partner, Falabella. The 4 stores in Argentina were sold to Hipermercados Jumbo, the owner of Easy Homecenter.
Despite its decision to exit Chile and Argentina, HD stated that the expertise and local business knowledge it developed in South America would help facilitate its growth in Mexico.
Fast forward to FYE2021, and HD operated 2,317 stores located throughout the U.S. (including the Commonwealth of Puerto Rico and the territories of the U.S. Virgin Islands and Guam). It also had 182 stores in Canada and 129 in Mexico. It employed ~490,600 associates, of whom ~42,800 were salaried, with the remainder compensated on an hourly basis.
This is impressive growth!
My previous post includes an overview of the company. Most readers are undoubtedly familiar with HD to some extent. Should you want to learn more about the company, however, a great starting point is Part 1 Item 1 in the FY2021 Form 10-K.
Financials
Q2 and YTD2022 Results
On August 16, 2022, HD released Q2 and YTD2022 results. All material related to this earnings release is accessible here.
In Q2 and the first half of FY2022, HD generated $43.8B and $82.7B in revenue. In comparison, it generated ~$110.2B, ~$132.1B, and ~$151.2B in FY2019 - FY2021.
From a geographical perspective, each of HD's 19 US regions delivered positive comparative results relative to Q2 2021 results; Mexico and Canada posted comparative results above the company average. These solid results have been generated despite global supply chain disruptions, inflation, and a tight labour market.
HD experienced growth with both its Pro and DIY customers in Q2 and it is encouraged that project backlogs remain healthy.
At the end of Q2, inventories were $26.1B, up $7.2B compared to Q2 2021. Inventory turns were 4.5 times, down from 5.7 times last year. Approximately 50% of the YoY increase in inventory reflects product cost inflation. Furthermore, the higher inventory level reflects deliberate investments in response to continued global supply chain disruption, the investment in new supply chain facilities, and the carryover of some spring seasonal inventory.
In Q2, operating expenses as a percent of sales decreased ~50 bps to 16.6% as HD continues to work to offset significant transportation and product cost pressures.
On the capital allocation front, HD invested ~$0.75B back into the business in the form of capital expenditures. It also distributed ~$2B in dividends and it repurchased ~$1.5B of shares.
Computed on the average of beginning and ending long-term debt and equity for the trailing 12 months, HD's return on invested capital was ~45.6%, up from 44.7% in Q2 2021.
FY2022 Outlook
On the Q2 2022 earnings call with analysts, management indicates that:
'While the business performed very well and our consumer remained resilient through the first half of the year, we are navigating a unique environment. We can't predict how the evolving macroeconomic backdrop will impact our customer going forward.'
Assuming there are no material shifts in demand, HD's outlook is as follows:
- Sales growth and comparable sales growth of ~3%;
- Operating margin of approximately 15.4%;
- Net interest expense of approximately $1.6B;
- The tax rate will be ~ 24.6%; and
- Diluted EPS growth will be in the mid-single digits.
In comparison, this was HD's outlook when I wrote my April 4, 2022 post:
- Sales growth and comparable sales growth will be slightly positive;
- Operating margin will be relatively flat with FY2021 ~15.2%;
- Net interest expense will be ~$1.5B;
- The tax rate will be ~24.6%; and
- Diluted EPS growth will be in the low single digits.
Operating Cash Flow (OCF) Free Cash Flow (FCF)
The Condensed Consolidated Statement of Cash Flows in the FY2011 - FY2021 Form 10-Ks reflect OCF of (in $B) 6.65, 6.98, 7.63, 8.24, 9.37, 9.78, 12.03, 13.17, 13.69, 18.84, and 16.57.
Back out capital expenditures (CAPEX) in FY2011 - FY2021 and FCF (in $B) is 5.43, 5.66, 6.24, 6.80, 7.87, 8.16, 10.13, 10.72, 11.01, 16.38, and 14.
YTD2022, HD's OCF is $7.182B. Deduct $1.447B in CAPEX and FCF is ~$5.735B.
Credit Ratings
There is no change to HD's senior unsecured domestic currency credit ratings after my April 4, 2022 post. The ratings and outlook remain:
- Moody's: A2 and stable;
- S&P Global: A and stable; and
- Fitch: A and stable.
These ratings are the middle tier of the upper-medium grade category and define HD as having a STRONG capacity to meet its financial commitments. However, it is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.
These investment-grade ratings are acceptable for my purposes.
Dividend and Dividend Yield
When I wrote my June 7, 2021 post, shares were trading at ~$311 and the annual $6.60 dividend yielded ~2.1% (see HD's dividend history); the $1.65 quarterly dividend was increased to $1.90 in early 2022.
At the time of my April 4, 2022 post, HD was trading at ~$303 and the $1.90 quarterly dividend yielded ~2.5%. The dividend yield was similar when I purchased more shares on August 2 @ ~$301.64.
HD's share price is now ~$330.50 and the dividend yield is ~2.3%.
During FY2016 - FY2021, HD has distributed $3.404B, $4.212B, $4.704B, $5.958B, $6.451B, and $6.985B for a total of ~$31.7B. HD has distributed $3.91B YTD2022.
There is nothing foreseeable to raise a concern about HD's ability to extend its track record of consecutive quarters of dividend payments.
In FY2016 - FY2021, HD repurchased $6.88B, $8B, $9.963B, $6.965B, $0.791B, and $14.809B of issued and outstanding shares for a total of ~$47.41B. The dramatic drop in the value of shares repurchased in FY2020 is because HD suspended share repurchases in March 2020 when COVID-19 hit North America. HD resumed share repurchases in Q1 2021.
The diluted weighted average common shares outstanding for the 3 months ended July 31, 2022 is 1,025 million. In comparison, the diluted weighted average common shares outstanding in FY2019 - FY2021 (in millions) are 1,097, 1,078, and 1,058.
YTD2022, HD has repurchased $3.962B. This is offset by only $196 million in stock-based compensation expenses.
Valuation
HD's FY2011 - FY2021 historical PE levels based on diluted EPS are 18.04, 21.93, 22.25, 23.86, 24.77, 21.73, 26.29, 18.76, 21.71, 22.96, and 19.27.
At the time of my June 7, 2021 post, HD had generated $11.94 of diluted EPS in FY2020 and $3.86 in Q1 2021. Management provided no guidance but I felt that FY2021 diluted EPS of ~$13.50 - ~$14 was not unreasonable. Using the current ~$311 share price, the forward diluted PE range was ~22.2 - ~23 and ~22.6 using the $13.75 midpoint.
Using the $13.75 midpoint and a forward diluted PE of 20 that I deemed to be a reasonable earnings multiple, I considered ~$275 to be a level at which I would consider initiating a position.
HD's adjusted diluted EPS guidance from 32 brokers was a mean of $14.16 and a range of $13.44 - $15.37 when I wrote my June 7, 2021 post. With shares trading at ~$311, the forward adjusted diluted PE range was ~20 - ~23 and ~22 using the mean guidance.
When I wrote my April 4 post, HD had reported $15.53 of diluted EPS in FY2021. Using a 20 PE, a ~$310 share price seems like a reasonable level at which to initiate a position. Shares, however, were trading at ~$303 so the PE was ~19.5 based on FY2021's diluted EPS of $15.53.
On an adjusted earnings basis, the valuation based on the current ~$303 share price and adjusted diluted EPS broker estimates were:
- FY2023 - 31 brokers - mean of $16.10 and low/high of $15.65 - $16.85. Using the mean estimate, the forward adjusted diluted PE is ~18.8.
- FY2024 - 30 brokers - mean of $17.32 and low/high of $16.50 - $18.50. Using the mean estimate, the forward adjusted diluted PE is ~18.4.
- FY2025 - 12 brokers - mean of $18.54 and low/high of $17.73 - $19.21. Using the mean estimate, the forward adjusted diluted PE is ~16.34.
HD has now reported YTD2022 diluted EPS of $9.13 and shares are trading at ~$330.50. If we expect similar results in the remainder of the current fiscal year, HD should generate dilute EPS of ~$18.26. This gives us a forward diluted PE of ~18.1.
- FY2023 - 34 brokers - mean of $16.46 and low/high of $16.05 - $16.85. Using the mean estimate, the forward adjusted diluted PE is ~20.1.
- FY2024 - 34 brokers - mean of $17.33 and low/high of $16.29 - $18.66. Using the mean estimate, the forward adjusted diluted PE is ~19.1.
- FY2025 - 17 brokers - mean of $18.34 and low/high of $16.30 - $19.93. Using the mean estimate, the forward adjusted diluted PE is ~18.
HD's valuation using adjusted earnings estimates has deteriorated somewhat following my April review. However, analysts will likely be updating their earnings estimates over the coming days but significant revisions are unlikely.
Final Thoughts
My final thoughts are unchanged from those in my April 4 post; I continue to like HD's long-term outlook. This is why I added to my exposure when shares were trading @ ~$301.64 in early August.
In recent years, HD's share price has exhibited wild swings and I anticipate this will continue. The share price has now surged ~$29 following that purchase yet the forward earnings estimates are not much different from early April. While nobody can predict short-term stock price behaviour, the sudden increase in HD's share price is likely partially attributed to irrational exuberance.
I intend to increase my HD exposure. However, I am in no rush to acquire additional shares. Should HD's valuation retrace to a level somewhat similar to when I acquired shares in early August, I will look to acquire additional shares.
I wish you much success on your journey to financial freedom!
Note: Please send any feedback, corrections, or questions to [email protected].
Disclosure: I am long HD.
Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your research and due diligence. Consult your financial advisor about your specific situation.
