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Robert Abbott
Robert Abbott
Articles (899)  | Author's Website |

The Home Depot and the Lumber Shortage

Capital gains and a growing dividend highlight the case for this building supplies giant

Last summer, I went to The Home Depot, Inc (NYSE:HD) to buy some cedar 2 x 4s to finish up a fence replacement. But as the Old Mother Hubbard nursery rhyme told us, the cupboard was bare.

That was part of one of two major trends that determined the fortunes of the building industry in 2020. First, the pandemic affected the lumber industry like many others; loggers, sawmill workers and others went home, and many stayed there. That led to lumber shortages.

Second, the pandemic led to many office workers and other non-essential workers staying home as well, either to work remotely or because they lost their jobs. With the sudden increase in downtime, they decided to renovate or build.

Third, record-low mortgage rates and city flight led to a rush to buy or build new homes, especially in suburban areas.

The result was strong consumer demand for lumber meeting reduced supplies. Prices went up, as indicated in this one-year chart of the iShares Global Timber & Forestry (NASDAQ:WOOD) ETF:

The Home Depot lumber prices

You might suspect that would negatively affect building supply companies such as The Home Depot. However, Chairman and CEO Craig Menear suggested in the third-quarter earnings release that it wasn't much of an issue after all:

"The third quarter was another exceptional quarter for The Home Depot as we saw the continuation of outsized demand for home improvement projects, which has led to sales growth of more than $15 billion through the first nine months of the year. Our ability to effectively adapt to this high-demand environment is a testament to both the investments we have made in the business as well as our associates' focus on customers. We continue to lean into these investments because we believe they are critical in enabling market share growth in any economic environment."

In the 10-K for 2019, Menear reported they had invested heavily in the supply chain over the past decade, and presumably, that enabled the stores to get better, although not necessarily perfect, access to lumber during the shortage.

The company also had another initiative on its side in 2020 called "One Home Depot." The program aimed to "seamlessly blend the digital and physical worlds and was formulated using an entirely customerback approach." According to the company, that is another reason for its successful year.

Investing gurus mostly saw promise in the third quarter, although a significant number also appeared to be taking profits while the prices were high:

The Home Depot guru buys and sells

Regular investors as well as many institutional investors became more cautious after the end of the third quarter, as the share price has begun moving down again:

The Home Depot 1-year price chart

Winding up his shareholders' letter for 2019, Menear summed up the company's strategy:

"We believe that ultimately scale, combined with a low-cost position, will win in retail, and we intend to deploy and leverage our scale in home improvement to win with the customer and deliver exceptional returns to shareholders."

So, what are The Home Depot's, and its shareholders', prospects for the longer term? Let's look at some of its key metrics, starting with revenue per share:

The Home Depot revenue per share

Ebitda per share takes the same upward path:

The Home Depot Ebitda per share chart

We see the same for earnings per share (diluted):

The Home Depot earnings per share chart

However, has the company generated enough free cash flow to keep expanding its operations, paying its dividends and buying back shares? Yes, it would seem it has:

The Home Depot free cash flow chart

The Home Depot carries a serious debt load, but it is still about average for its industry. Its current debt load is also consistent with its own history. As the interest coverage ratio of 13.34 suggests, it is generating more than enough operating income to cover its interest expenses as long as it doesn't suffer a major hit to earnings.

The weighted average cost of capital (WACC) of 6.39% is much lower compared to the return on invested capital of (ROIC) of 35.66%, indicating strong profitability. What's more, the company has healthy margins; the operating margin is 14.01% while the net margin is 9.94%.

Below is the GuruFocus chart for the company on share buybacks and dividends:

The Home Depot dividend and share repurchases

For investors willing to hold for five years, the dividend yield could rise to 6.36%. While the current yield is relatively low, The Home Depot has been increasing it by an average of 25.4% per year over the past three years. That 6.36% assumes it continues to grow the dividend for the next five years as quickly as it has grown in the past five years (and if investors buy now and hold for five years). There's no guarantee that will happen, but the company does generate significant amounts of free cash flow.

The three-year share buyback ratio is positive, at 3.6, showing us the company has been buying back its own shares. Indeed, as this chart below shows us, it has consistently reduced its share count every year for the past 10 years:

The Home Depot shares outstanding chart

While The Home Depot does have the revenue and earnings to take care of its shareholders, there is no shortage of competitors. In its 10-K, it describes its environment as, "highly competitive, very fragmented, and evolving."

GuruFocus lists major competitors as Lowe's Companies Inc (NYSE:LOW), Floor & Décor Holdings Inc (NYSE:FND), Haverty Furniture Companies Inc (NYSE:HVT), GrowGeneration Corporation (NASDAQ:GRWG) and Lumber Liquidator Holdings Inc (NYSE:LL). Haverty, as the name suggests, is not a significant building supplies vendor, nor is GrowGeneration, which describes itself as an operator of specialty retail hydroponic and organic gardening stores. Lumber Liquidators focuses on just hardwood flooring. These competitors are only competing with specific parts of Home Depot.

Essentially, only Lowe's is a full-line competitor, and it too had an exceptional third quarter. According to President and CEO Marvin R. Ellison in the Q3 earnings release:

"Strong execution enabled us to meet continued broad-based demand, as we delivered over 15% growth in all merchandising departments, over 20% growth across all geographic regions. and triple-digit growth online."

The GuruFocus Value chart assesses The Home Depot to be fairly valued. It is backed up by the price-earnings ratio of 22.98, which is close to the 10-year median for the industry and its own 10-year median.

The PEG ratio suggests it is overvalued; dividing the price-earnings ratio by the average five-year Ebitda growth rate produces a PEG ratio of 1.85, almost double the fair valuation level of 1.00.

On the other hand, the discounted cash flow (DCF) calculator, based on a 5 out of 5 business predictability rating, tells us the company is undervalued by almost 20%:

The Home Depot discounted cash flow DCF

Finally, this is not a stock that you watch for a significant pullback. As this 10-year price chart shows, it has only experienced one of those in the past decade:

The Home Depot 10-year price chart

Conclusion

The Home Depot met the lumber shortage in 2020 and prevailed, at least according to the CEO and to quarterly earnings metrics.

You may take whichever valuation perspective best suits your specific criteria, but we can at least say that the company lies somewhere between modestly overvalued and modestly undervalued. A look at the price chart indicates there are not many opportunities for entry on a significant dip.

The lack of a deep discount in the price is likely to send value investors off to search for another stock. It may be an appropriate stock for growth investors willing to get in at any level, but growth likely still wouldn't be stellar.

Disclosure: I do not own shares in any of the companies named in this article and do expect to buy any in the next 72 hours.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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