Many companies have taken advantage of rock bottom rates in the past several years to load up on cheap debt. This has allowed large companies in particular to finance record stock buybacks as well as acquisitions in ways that wouldn't have been possible otherwise. Some have used debt more than others but Home Depot (NYSE:HD) has certainly taken on its fair share in the past several years and in this article, I'll take a look at its implications.
I'll be using data from Seeking Alpha for this exercise.
We'll begin by taking a look at HD's long term debt balances as well as annual interest expense for the past five years to get a baseline of where it has come from.
We can see HD has added fairly significant levels of LT debt every year since 2012 and over that time frame, its total LT debt balance is about 2.4X what it was at the start. That's pretty substantial and at the end of last year, HD's LT debt was better than $22B. That by itself isn't necessarily a bad thing as debt can be an extremely useful tool used to take advantage of an attractive acquisition or even share buybacks. In addition, HD's tremendously robust earnings growth over this time frame would suggest this level of debt growth isn't a burden to service.
Indeed, that is exactly what we see below as I've plotted HD's interest expense as a percentage of operating income. This allows us to see how much of HD's operating earnings are consumed with servicing its debt to see if it is unduly stressing the company's finances. In short, the answer is a resounding 'no'.
In fact, what we see instead is that even though HD's interest expense has grown right alongside LT debt, its servicing costs as a percentage of operating income has actually fallen over this time frame. The decline is very slight but given that interest expense in 2016 was 1.5X what it was in 2012, you'd expect it would have risen by a significant margin. However, HD's operating income growth has been quite staggering over this period and thus, it has taken on debt that is virtually no burden at all to service.
HD's tremendously high rate of operating income growth is a big factor here as that has allowed it to finance more than double the amount of debt it had five years ago with a reduction in its costs against operating income. But HD has also taken advantage of very low rates and its average cost of debt is down as well (remember debt is 2.4X what it was while interest expense is just 1.5X 2012 levels).
HD has used this extra capital to fund a highly successful buyback, juicing EPS growth over and above what it would have been able to produce without it, which would have been strong in its own right. This is the power of low rates and HD has taken full advantage to be sure. Indeed, HD shareholders have low rates and HD's successful use of debt to thank for a meaningful portion of the rally the stock has enjoyed over the past few years.
The upshot of this is that HD can continue to fund increases in debt like this for the foreseeable future. With costs still under 8% of operating income, HD can afford to drastically increase the amount of debt it has and this assumes no further growth in operating profits, something that sounds clinically insane to even suggest. Thus, as HD continues to grow operating earnings it can either increase its debt load and reap the benefits of that extra capital, or it can enjoy higher margins as its relative cost of debt decreases. Both of these are very favorable outcomes and given HD's astute use of debt to date, I'd honestly vote for the first option. HD's shares are nowhere near as cheap as they were when the buyback was huge so that's a more difficult route to take, but its low leverage means that the bar for choosing additional debt against a lower share count is pretty low. Names that are highly leveraged already face a tougher test but HD certainly does not fall into that category.
The bottom line here is that HD has done extremely well borrowing in the past few years. It has done so at very reasonable costs and at levels that place no undue burden on its finances. Further, the buyback that was funded with this debt has seen shareholders reap sizable benefits and thus, the return on HD's borrowings has been enormous. Going forward, HD can afford to take on much more debt if it so chooses and that can help juice EPS growth as well. Whether that will happen depends upon many factors but HD's balance sheet and strong operating earnings growth mean that we should either see more debt - and whatever benefits HD can reap - or higher margins as its current debt cost is leveraged down via higher operating earnings. Either way, HD shareholders are sitting pretty.
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.