The markets have been quite chaotic over the last two weeks, due to in large part to the spread of the novel coronavirus (Covid-19). Markets have taken some steep declines during this time, giving investors a chance to purchase stocks that are trading at a lower valuation than they were just a few weeks ago.
One name that I like but don’t yet own is Home Depot HD, which is a leader in the home improvement space and operates 2,290 stores in the U.S., Canada and Mexico.
While the stock isn’t yet at a valuation that I find very attractive, the market’s roller-coaster ride might ultimately give me the buying opportunity that I have been looking for.
Recent earnings results and growth prospects
Home Depot reported fourth quarter and full year earnings results on Feb. 25, 2020. Earnings per share of $2.28 topped estimates by $0.17 and grew 1.3% from the previous year. Revenue declined 2.6% to $25.8 billion, which was in line with estimates. The fourth quarter of 2018 had an extra week, which impacted the year-over-year comparisons. Adjusting for this, EPS improved almost 12% while revenue was higher by 4%.
For full year 2019, net income of $11.2 billion was essentially flat, but thanks to share repurchases, EPS improved 5.3% to $10.25. Revenue was up 1.9% to a record $110.2 billion.
Comparable sales grew 5.2% in the fourth quarter, topping consensus estimates of 4.8%. The U.S. led the way with 5.3% growth. These results were on top on solid results for last year. The fourth quarter of 2018 had comparable sales growth of 3.2% and U.S. sales growth of 3.7%. Home Depot had two-year stacked comparable sales and U.S. sales growth of 8.4% and 8.5%, respectively.
Full year sales improved 3.5% on top of 7.2% sales growth in 2018, for a two-year stacked growth rate of 10.5%. U.S. sales increased 3.8%, which equates to a two-year stacked growth rate of 7.5%.
Showing how well the business is performing company wide, Home Depot had positive comparable sales in all U.S. regions as well as in both Canada and Mexico during the fourth quarter.
Comparable average ticket value improved 4.4%, while transactions were up 0.8% in the quarter. All merchandising departments produced positive comps, with the appliance department leading the way with double-digit growth. Big-ticket purchases of more than $1,000 were higher by double-digits, which is significant given that these purchases represent 20% of all U.S. sales.
Growth was seen across customer types as well. Demand for pneumatics, concrete, hand tools and caulks amongst Pro customers grew faster than the company average. DIY customers spent heavily on window coverings, cleaning, exterior paint and kitchen and bath.
The company expects a midpoint for EPS of $10.45 for 2020, which was slightly below consensus estimates at the time. Home Depot also expects comparable sales to grow 3.5% to 4% for the year.
While the recent quarter and fiscal year were solid, investors should be more concerned with the future of the company instead of its history. Home Depot shareholders aren’t likely to be disappointed, in my opinion, as the company has a bright future ahead of it.
While the retail landscape is littered with companies that have encountered significant headwinds due to the rise of e-commerce, Home Depot is unlikely to be impacted by the change in consumer shopping habits. Home improvement stores have a unique look and feel aspect to them that other retailers don’t. Shopping for products that you need for a home improvement job is different than shopping for shoes or clothes. Many shoppers, including both contractors and individuals, often want a product or tool in a timely fashion. Even next day delivery might not be soon enough for these customers, meaning they will have to visit a physical location to purchase the item.
In addition, Home Depot has invested heavily in its own e-commerce operations. Digital sales increased 21.4% in 2019 following 24.1% growth in 2018. More than 50% of online orders were picked up in a local store. The company plans to make further investments into this area over the course of the next few years, all with the goal of improving the customer experience. Doing so will likely lead to continue loyalty to the Home Depot brand.
Also helping Home Depot is the continuation of the low interest rate environment. The Federal Reserve cut its short-term benchmark rate three times last year. On Tuesday, the Fed made a 50 basis point cut in response to the likely disruptions that the coronavirus epidemic will have on the economies of the world.
These cuts result in a lower cost when borrowing money. The average rate on a 30-year fixed mortgage is now 3.45% according to Freddie Mac. This level hasn’t been seen since late 2016. When its cheaper to borrow money, people are more inclined to spend on home improvements before selling their home or after buying a new home. With interest rates low, Home Depot should be in a position to capture more home improvement dollars.
Home Depot has averaged an EPS growth rate of 14% over the last five years. Some of this growth has been due to share repurchases, as the company has bought back ~2.9% of its share count annually over the last half decade. Last year was no different, as nearly 33 million shares were retired. Home Depot expects to repurchase $5 billion in 2020, or 2% of its current market capitalization.
One potential downside is that the company is susceptible to the impact of a recession. EPS declined 37% from 2007 to 2009. However, Home Depot’s market dominance and ability to thrive in an e-commerce world, as well as the low interest rate environment and share repurchases means that the company likely can grow at a high clip for the remainder of the current bull market. I expect an EPS growth rate of 6% to 8% going forward, though this could prove to be conservative.
Dividend history and valuation
Home Depot paused its dividend growth in 2008 and 2009 as the company dealt with the headwinds of the last recession. The company did increase its dividend for nearly three decades prior to this pause.
After a 10% increase for the upcoming March 26, 2020 payment, Home Depot has now raised its dividend for 11 consecutive years. The company has increased its dividend by an average of:
- 25.4% per year over the past three years.
- 23.7% per year over the past five years.
- 19.4% per year over the past 10 years.
While the most recent increase is well below any of these averages, it is probably because the payout ratio has climbed above the normal range. Using the new annualized dividend of $6.00 and the midpoint for expected EPS for 2020, the expected payout ratio is 57% for 2020. This would be the highest payout ratio in more than a decade.
That said, the dividend payout ratio isn’t to a point where I am worried about another freeze or even a cut. The company paid out $6 billion in dividends last year while generating $11 billion in free cash flow for a payout ratio of 55%. This is above the three-year average free cash flow payout ratio of 43%, but again, not so much so that investors should be concerned about a dividend cut.
Shares currently yield 2.6%, topping the average yield of 1.9% for the S&P 500. Using the most recent closing price of ~$235 and guidance of $10.43 of EPS for 2020, Home Depot shares trade with a price-earnings ratio of 22.5. This is above the stock’s five-year average price-earnings ratio of 21.2. Shares are slightly less expensive than the S&P 500, which has a price-earnings ratio of 22.8.
I am waiting for shares to trade in-line with the five-year average multiple. Using expected EPS for 2020, my price target for Home Depot is $221. This is 6% below the most recent closing price. This target price might be realized considering the market volatility experienced over the past two weeks.
Final thoughts
Markets have seen strong action in recent trading sessions, which has brought the valuations of individual stocks down quite a bit.
Home Depot is one stock that is inching towards a price-earnings ratio where I would consider purchasing. Home Depot continues to generate impressive same-store sales, and the company also saw growth in all merchandise departments and every country in which it has stores. There are few retailers who can say that.
On top of that, Home Depot has several factors working in its favor that should enable future growth. Shares of Home Depot also offer a solid dividend yield and a very reasonable payout ratio. For all of these reasons, Home Depot is at the very top of my watch list for the next market-wide pullback.
Disclosure: The Author is not long Home Depot, but may purchasing the stock within the next 72 hours.
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