Home Depot - Even Quality Has Its Price

| About: Home Depot, (HD)
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Home Depot continues to deliver on impressive operational and shareholder returns, driven by its three-legged stool strategy.

While investors have enjoyed great returns from this high-quality name, even quality has its price.

Even if Home Depot might be Amazon.com proof, its multiples have only risen despite an increase in margins, which makes any retracement or even stagnation in margins potentially painful.

Home Depot's (HD) three-legged stool strategy continues to create a solid foundation for shareholder returns. Investors welcome very strong organic sales growth, ever increasing margins, and a very low capital intensity of growth. All these factors drive cash flow generation which Home Depot is eagerly distributing to investors, who award the company an ever increasing multiple on the back of these great cash flow yields being forked over to them.

While the housing market remains strong, Home Depot might be able to effectively compete with Amazon.com (NASDAQ:AMZN), and leverage ratios remain very modest; even quality companies have their price limits.

While I would not dare to bet against a quality name like Home Depot, today's valuation is too rich to create a margin of safety for long-term investors. Unless shares see a big retreat from current highs to the point at which equity trades at market multiples, I have no interest to buy into this valuation.

Execution On All Fronts

Unlike many retailers, Home Depot aims to grow by better running its stores and business rather than expanding its store base. The company has famously not expanded the store base for years but has driven same-store sales growth in a big way, while boosting margins in the process.

These improved returns on the existing asset base have been the outcome of the three-legged stool framework. This is based on a focus on consumer experience, product authority, and capital allocation.

The company believes that customer service needs to be flawless both in-store and online. The company furthermore focuses on strong brands and innovative products at best value, as capital allocation continues to be driven by areas in which it generates the highest returns for investors. Unlike most companies, the company has relied heavily on growing through becoming more productive, rather than growing the store footprint which is much more capital-intensive, of course, and has the potential to result in cannibalized sales.

A Home Improvement Giant

Home Depot has seen its sales plunge from $77 billion in 2007 to $66 billion two years later as home improvement projects were delayed or cancelled in the midst of the crisis. Sales have gradually recovered to $95 billion in 2016. All in all, sales have grown at an average rate of nearly 2% per year over the past decade.

The real achievement has been made in terms of margins. Operating margins have risen five points to a very impressive 14% of sales over this time period. The cash flow being generated has largely been returned to investors in the form of share repurchases as the company did not need to spend huge sums on expanding the business, as it relied on organic growth. Consistent buybacks allowed the company to buy back a third of its shares over this time period. The combination of all these three factors: topline sales growth, margin expansion, and share buybacks, have created an earnings per share boom, as earnings have roughly tripled over this period of time.

2017 is setting up to be more of the same. Sales growth is seen at 4.6%, entirely driven by comparable sales growth, as the company aims to open just six stores this year. This is a negligible number given that Home Depot ended 2016 with 2,278 stores. Focus on online initiatives, including direct fulfillment centers and direct shipments from stores, has created a $5 billion online business for a 5.9% penetration rate.

Growth of the online business and lack of store openings create incredible capital efficiency. Capital spending totaled just $1.6 billion in 2016, running at roughly $400 million less than depreciation and amortization charges. This $400 million in cash flow being generated came on top of earnings of $8 billion per year. The company used all of this $8.4 billion in cash being generated, and some more, to please investors. Home Depot bought back $6.9 billion worth of shares and paid out $3.4 billion in dividends on top of that.

What About The Valuation?

Home Depot started the year on a strong note as sales rose by 4.9% on the back of a 5.5% increase in comparable sales. Traffic was up a healthy 1.6% as inflation, and increased spending per trip boosted average ticket prices by 3.9% to $62.39 on average.

On the back of the solid organic operational performance and continued multi-billion share repurchases, earnings per share are seen at $7.15 per share this year.

As has been the case for a while, Home Depot is quite aggressive to "return" money to investors. Not only is it distributing its earnings to investors, it is distributing more cash and thereby is incurring some debt. Net debt has risen to $19.4 billion, and while this number continues to increase in absolute terms, leverage remains relatively limited. EBITDA came in at $15.5 billion last year and could rise by a billion or so this year for a very modest 1.2 times leverage ratio.

The Perfect Model?

Investors in Home Depot really like the strategy of the company which has delivered on great returns for investors. The company is driving comparable sales growth and its margins, and requires relatively low capital investments into the business. By focusing on same store sales growth and online sales, capital spending requirements actually trail depreciation charges.

No wonder why investors pay 22 times earnings for this leader, as shares are up +300% over the past decade, driving the dividend yield down to 2.3%. Valuation multiples have only risen over time as the company has delivered on margin gains and impressive comparable growth numbers, as many wonder how long the good days can last.

While sales can certainly creep higher over time, certainly, if the housing market continues to perform well, I have concerns about margins which are approaching 15%. That is a very high margin number given the relative high average ticket price. While I am not worried that Amazon.com is going to steal a lot of sales from Home Depot, it might pressure margins in the longer run. For now, it should be said that Home Depot's scale, product expertise, and early entry into online sales provides it with a real competitive advantage versus the Seattle-based competitor at this time.

The company furthermore benefits from the fact that many items are bulky and expansive to ship, as the fact that a purchase at Home Depot is not ordinary, (unlike apparel or food) which makes a shopping trip even an experience for many consumers. Great service and good education and knowledge of its associates create a distinguished experience as well for many consumers.

Even Quality Companies Can Be Risky

Let me put it this way. Home Depot is a very well run business as I would not dare to bet against the company and its shares. On the other hand, a 22 times multiple is rich, especially if I consider the fact that margins are very strong. Even if sales are sustainable at this level, which I think might very well be the case, as they can continue to grow, I think that margins might retreat.

If operating margins fall back to 10% of sales, following a potential successful focus of Amazon.com on the category, the retreat in margins could reduce earnings by $2.00-2.50 per share even if sales would be unaffected. That would reduce the earnings power of the business to roughly $5 per share, for a +31 times multiple at these levels, as that earnings multiple would not be sustainable in that case.

You get the point, even as Home Depot is a great business, I see no margin of safety at these levels, which makes it very easy to avoid the shares at this price. Paying too steep of a price/multiple for a quality company can be a dangerous thing, just like truly long-term investors in Home Depot know. After shares increased by a factor of roughly five times between 1995 and 2000, it took more than a decade before investors enjoyed any capital gains. As shares have risen four times coming out of the crisis, I would be cautious for subdued returns in the years to come, even if underlying growth remains positive.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.