- Home Depot is a great company that I've owned stock in since the pandemic drop of a little over a year ago. I've extended my position, but not that much.
- I missed buying more at significant undervaluation, and the position has appreciated in the high double digits since my time of purchase.
- A combination of growth, confidence in premium multiples/valuations and a strong history makes this company, if not significantly undervalued, a decent "BUY".
The Home Depot (NYSE:HD) is a company I've written about a few times in the past, most notably in my undervaluation article. Since my Corona discount article, the company has outperformed the relevant index by quite a bit. In retrospect, my Home Depot article was probably my best-timed COVID-19 discount article ever.
(Source: Seeking Alpha, Home Depot article)
But what sort of upside can the company possibly offer in this particular situation? That, my friends, is the question that we'll look at in today's article.
Let's get going.
Home Depot - How Has The Company Been Doing?
Unsurprisingly, and much like I've guided for in previous articles, Home Depot performed excellently despite, and because of, COVID-19. The company managed to increase FY20 sales to $132.1B, marking an increase of over $20B in annual sales, but also - in part due to COVID-19 - saw its operating margin reduced by about 60 bps during the same time, as well as an almost 5% reduction in RoIC.
Quarterly sales for the past quarter of 4Q20 were excellent.
(Source: Home Depot)
Unlike some of its competitors, HD has stores outside of the US market, and all of these were positive as well. In particular, and as we might have expected, digital sales grew significantly YoY, with 55% of all online Home Depot orders being fulfilled through a store. Customers are still driving to the stores, and the holidays saw a record-level of sell-through for Christmas.
The transition for HD is complete, with 100% of its workshop content now live online. In terms of customers, because we talk a lot about pro and non-pro customers, both of these customer groups grew in double digits during the pandemic and during 4Q20.
Home Depot's 2,296 stores performed admirably, and I remind you once again that the number of stores as well as their performance, makes Home Depot the largest home improvement retailer in the entire world.
So, much of the company's negatives in terms of margins and returns came from the company focusing on its employees and people - which of course doesn't make it a negative, necessarily. HD has invested over $2B in enhanced compensation of benefits and has added permanent benefits and compensations to frontline associates. There are also some benefits from the political/relief side of things if you're the sort of investor who cares about things such as that.
(Source: Home Depot)
Despite COVID-19, Home Depot managed to open several new stores, and the company communicates that they never thought it possible to grow their business by over $21B in 2020, given that it took them nearly 19 years as a company to reach their first $20B in sales. The company's investments in its own organization and processes, now including a seamless online experience, is key to what made this performance possible.
Delivering EPS growth of 16.5% YoY didn't mean that the company allocated its capital differently. While it comes to what the company has done, it includes the M&A of an MRO product company - HD Supply Holdings - as well as increasing and paying out the company's attractive, growing dividend or returning cash to shareholders in the form of dividends.
Now, it's true that the company has actually lagged the S&P Retail composite index for the past few years...
(Source: Home Depot)
... however, it has still beat the S&P500, and few stocks in the index itself can show the sort of fundamentals, dividend growth, and future potential from now on that Home Depot can.
If we dig deeper into the fundamentals and numbers, we can see a few interesting trends. First of all, the earnings growth wasn't necessarily due to volume increases alone in sales - what really stood out was the average purchase or average ticket size, which grew from $67 per ticket to around $74.3 per ticket, an increase in ticket size that by far outstrips the usual 1-3% ticket size increase of, for instance, between 2018 and 2019. People are shopping for more of their things at the Home Depot.
Any sort of risks or negatives for the year? While sales have increased, a portion of around $1B of the cost increases are not non-recurring, but permanent cost increases, so these need to be included in future margin calculations. These include the permanent wage increase, ramping up capacity in the company's supply chain network, and so forth. So while there are some non-recurring cost increases for HD –such as COVID-19 operational expenses, understaffing and staffing adjustments, some non-recurring transportation expenses – some of these cost increases are going to be permanent, which puts higher demands on the company's earnings ability.
If you recall my original article on Home Depot, the company speaks quite a bit about its years-long investment plan, which has been ongoing for some time. HD believes it has captured around 2.75% of market growth thanks to these investments (of around $11.1B), which have resulted in annual sales of $10B incrementally since 2017. As a low-cost provider of goods and some services, scale is key to HD, and the company's investments over these past few years have all targeted that scale.
Home Depot, unlike other companies, has elected not to provide any sort of guidance for the year 2021. The reasons for this include inventory buildups that the company has made due to COVID-19. The company's products don't exactly have a short shelf-life, meaning the company can overstock quite a bit. They have, and they intend to do even more of this. (Source: Earnings Call 4Q20, Ted Decker)
The last communication puts Home Depot in for preparing for the spring period, and working to work inventory more, and capture that spring demand, which Home Depot views itself as being in a good position to do. The company's focus is driving the gross margin numbers and operational expenses down in relation to profit, but as of now, we have no guidance from Home Depot where things may go in the future.
My view is this.
Home Depot is a fundamentally and in ways, almost ridiculously conservative, well-established company. Due to the products it sells, it can't be muscled out by any new entrant to the market. Doing so would require investments, probably in the hundreds of billions. The company's conservative fundamentals also means that Home Depot actually has plenty of room to run and go from here. COVID-19 was proof that not even a pandemic will dent this company - it will in fact work to increase this company's numbers year-over-year, and not even I expected the outperformance we've seen from this business.
To say that a company can't fail is wrong - any company can fail. However, barring a management shake-up into someone/a completely incompetent team or something truly fundamentally changing in the way people do business like this with these sorts of products, Home Depot is here to stay.
That forms the basis for an excellent investment.
Home Depot - What Is The Valuation?
While the basis for an excellent investment is quality and fundamentals - all of which HD has - other things which are as important before you put that stock order in at your broker is looking at a company's valuation.
It's here that we start to run into some rubs - not trouble - but a bit of question.
You know that we want to outperform the overall market and historicals, based on earnings growth forecasts, and if possible, a mean reversion in terms of valuation multiples. While one of these variables is entirely possible here, the second really is not.
Home Depot trades at around 25.51X, which is an insane, 10X premium above a 15X fair value P/E. While this company certainly deserves a premium for what it offers, such as a 10-year average EPS growth of 16%, we need to realize just where Home Depot trades today in terms of its historicals.
(Source: F.A.S.T. Graphs)
Upside here is complex. While the company carries a negative future forecast if we're looking at a 15X P/E, I view the likelihood of this company going down to a 15X P/E without outside interference as extremely low. If it did, I would probably be cracking open capital to push it to work here.
The company did trade at around 15X 2021E earnings at the time of COVID-19, but has since then massively outperformed. However, we can see in the company's 5-year trends that volatility is actually quite inherent to this stock.
When forecasting, we need to forecast to premiums.
The positive is that the upside exists, if you look far enough in the future.
However, 30% returns in 5 years aren't exactly something I would normally be looking for. The same rates of return to a 22.4X P/E to 2023 earnings, which is where I typically look today, is less than 6%, and this is mostly due to valuation.
The fact is, historically, Home Depot has always gone back down from valuation levels such as this - and they have done so fairly quickly. The difference between a fair premium and the current valuations is short- to medium-term return differences of over 15-20% RoR in 2-3 years time. That is significant.
For that reason, and that reason alone, I view Home Depot as tricky here. Look, the company has appreciated massively in less than 2 months. My own position has gone up ridiculously, making 19.2% RoR since late February of 2021, which comes to annualized returns of over 500%. But such a spike, or climb, is something that can result in only one thing.
Sure, it can continue for another month, and I won't be selling HD at an overvaluation of 7-8%, which is where we currently are, but I certainly won't be adding at an upside of 30% over 5 years and a yield of 2.1%
And neither, I believe, should you.
We're entering a market where I believe that sub-par rates of return are going to be the norm rather than the exception. It makes it crucial that we position ourselves at appealing valuations in great companies to generate nice RoR. Unfortunately, this also means that current opportunities on the market are going to be relatively sub-par, as things go.
Analysts guide for the following targets for Home Depot.
(Source: Author's Data, S&P Global)
Whenever I see a change like this one in less than a year, I always get suspicious. Perhaps the analysts expected COVID-19 to be far more serious for Home Depot, but it also reflects analysts' exuberance on the part of the company at this particular time. I view this as quite risky - because history shows us, HD is no stranger to dropping to below $250/share at a relatively quick pace, despite its long-term outperformance.
Buying now, while generating long-term returns of 30% over 5 years, also includes a risk of short-term performance the like you might not want to see, and that's the reason I consider Home Depot overvalued despite these lofty price targets. And let's be clear, more overvalued than 0.9%.
How to Invest in Home Depot
Option 1 - Long-Term Investment
As I mentioned, investing in Home Depot's common share can only be considered risky at this particular juncture. While you can generate 5-year returns of 30%, such returns would barely track the overall market, begging the question of why you'd want to go in at such a valuation, unless you're looking for a very safe place to store your cash. This is something that Home Depot certainly is - but I'd still look elsewhere first.
I say "No" to the common shares here.
Option 2 - Selling Cash-Secured Puts
Selling cash-covered put options is another good way to make money off a company while waiting for it to drop further and making money until then. Because of the company's position, and a lower price being even more appealing, this could make it perfect for a nice put.
As of writing this article, I was able to find the following put.
(Source: Author's Data, Google Sheets, Option data from IBKR/Yahoo Finance)
No. Just no. The capital outlay is massive here, at nearly an annual salary, with a potential annualized yield of less than 5% in a 73-day period at a strike that's not even where I would consider Home Depot to be significantly undervalued.
I understand the reasons why options aren't appealing here, and these reasons are unfortunately good. I don't see writing puts here as a good strategy. There are better investments and better option possibilities on the market.
Again, I say "No" to this.
Option 3 - Selling Covered Calls
I could find the following covered call for Home Depot here.
(Source: Author's Data, Google Sheets, Option data from IBKR/Yahoo Finance)
Once again, a big "No". Look at this. 20% overvaluation for a premium stock like this, which is not necessarily something you'd want to sell at strike, for an options yield on an annualized basis to the expiration of less than 2%. Above all, you'd need to have over $30,000 worth of Home Depot to begin with, which I don't believe many of you actually do. I certainly don't.
The lack of appeal here to me is clear. I don't want this, neither should you. There are better ways to work your capital than this.
So, Home Depot is an amazing business. At the right valuation, I would quite literally put 20-30% of my capital into the business today. However, that time isn't now.
In the end, company quality is "only" the first and most important of the requirements for investment.
Let's go through them.
1. This company is overall qualitative.
2. This company is fundamentally safe/conservative and is well run.
3. This company pays a well-covered dividend.
4. This company is currently cheap.
5. This company has realistic upside based on earnings growth or multiple expansion/reversion.
Home Depot checks the first three boxes but falls at the fourth. The fifth could have been a saving argument if the earnings growth was high enough to justify higher prices, but even the high earnings growth expectations here don't weigh up the multiple we're looking at here.
The simple fact is there are companies that tick all of these boxes or points, and as long as that is the case and I'm not excessively invested in every single one of them, this means Home Depot comes in as a secondary consideration or investment potential.
My view on Home Depot?
There is an upside in this superb company - 30% in 5 years. However, investors should be careful with this upside, because it's below what other companies may deliver, and what's more, there's also exuberance in it - meaning that in the short term, I would even consider it likely that things will go back down.
Because of this, I consider HD a 7% overvalued "HOLD" here to a conservative PT of $280/share.
Thank you for reading.
This article was written by
Wolf Report is a senior analyst and private portfolio manager with over 10 years generating value ideas in European and North American markets.He is a contributing author for the investing group iREIT on Alpha where in addition to the U.S. market, he covers the markets of Scandinavia, Germany, France, UK, Italy, Spain, Portugal and Eastern Europe in search of reasonably valued stock ideas. Learn more.
Analyst’s Disclosure: I am/we are long HD. 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.
While this article may sound like financial advice, please observe that the author is not a CFA or in any way licensed to give financial advice. It may be structured as such, but it is not financial advice. Investors are required and expected to do their own due diligence and research prior to any investment. Short-term trading, options trading/investment and futures trading are potentially extremely risky investment styles. They generally are not appropriate for someone with limited capital, limited investment experience, or a lack of understanding for the necessary risk tolerance involved. I own the European/Scandinavian tickers (not the ADRs) of all European/Scandinavian companies listed in my articles. Option Disclosure:
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