We now See a Steeper Housing Market Downturn in 2023 but Our Long-Term Outlook Is Unc
We now See a Steeper Housing Market Downturn in 2023 but Our Long-Term Outlook Is Unchanged
Analyst Note| by Brian BernardUpdated Nov 23, 2022
After analyzing recent United States housing market data and industry commentary, we've made downward revisions to our near-term outlook for new residential construction, home prices, and repair and remodel spending.
We now project housing starts to decrease 18% year over year in 2023 to 1.275 million—down from our prior projection of 1.420 million units—which is about in line with the level of residential construction activity in 2018-19. However, we expect starts will begin to rebound in 2024 as lower mortgage rates and home prices improve affordability and entice buyers back into the market. Specifically, we project the average 30-year fixed mortgage rate will decline from 6.25% in 2023 to 4.5% in 2024, and we see new and existing home prices decreasing 15% and 5% between 2022-24, respectively.
Repair and remodel spending has historically been less cyclical than new residential construction, and we see that trend continuing in 2023. Nevertheless, we now expect owner-occupied improvement spending will decrease about 1% in 2023—down from 0% growth previously—amid a weakening housing market and a challenging prior-year comparison.
Our long-term housing market outlook remains intact. We project housing starts will rebound 8% in 2024 to 1.375 million units and continue to expand through 2027, reaching approximately 1.550 million units. Over a longer horizon, we think about a 1.4-million-unit annual production pace is a reasonable assumption. After a challenging 2023-24, we see home price appreciation returning to the long-run trajectory of 3%-4% and repair and remodel spending growth normalizing at about a 5% annual rate.
We expect our revised forecasts will result in negligible fair value estimate reductions across our U.S.-housing related coverage because we had already been assuming a near-term downturn and our long-term outlook, which sees rebounding residential construction and repair and remodel spending, remains unchanged.
Business Strategy and Outlook| by Jaime M. KatzUpdated Nov 23, 2022
Home Depot is the world's largest home improvement retailer, on track to deliver $157 billion in revenue in 2022. It continues to benefit from a healthy long-term housing dynamics and improvements in its merchandising and distribution network. The firm earns a wide economic moat rating due to its economies of scale and brand equity. While Home Depot has produced strong historical returns as a result of its scale, operational excellence and concise merchandising remain key tenets underlying our modest margin expansion forecast. Its flexible distribution network will help elevate the firm's brand intangible asset, with faster time to delivery improving the do-it-yourself experience and market delivery centers catering to the pro business. The success of ongoing initiatives should allow for modest operating margin expansion above prepandemic levels longer term, despite inflationary pressures.
Home Depot should continue to capture sales growth, bolstered by an aging housing stock, a shortage in home inventory, and rising home prices, even when lapping robust COVID-19 demand. Other internal catalysts for top-line growth could come from the firm’s efficient supply chain, improved merchandising technology, and penetration of adjacent customer product segments (through the acquisition of HD Supply). Expansion of newer categories (like textiles from the Company Store acquisition) as well as existing ones (such as appliances) could also drive demand.
In our opinion, perpetual improvements in the omnichannel experience should support the firm's competitive position, even as existing-home sales and turnover become more volatile. The commitment to better merchandising and an efficient supply chain has led the firm to achieve operating margins and adjusted returns on invested capital, including goodwill, of 15.2% and 34.9%, respectively, in 2021 (both quantitative peaks). Additionally, Home Depot's focus on cross-selling products in both its DIY and its maintenance, repair, and operations channel should support stable pricing and volatility in the sales base, helping achieve further operating margin lift, with the metric remaining above 15% on average over the next decade.
Economic Moat| by Jaime M. KatzUpdated Nov 23, 2022
Home Depot's size creates a low-cost advantage that is the foundation of our wide economic moat rating. The firm's scale generates significant bargaining power with vendors when it comes to products, advertisement, and rent, among other things. The company provides value and instills customer loyalty by passing along a portion of savings to consumers in the form of everyday low pricing. We also believe the specialized nature of Home Depot's offerings provides some protection from mass merchants and large online retailers. Home improvement retailers remain one of the best-insulated sectors from e-commerce threats, as the high weight/value ratio of many products prohibit cost-effective shipping and the specialized knowledge base employees offer is difficult to replicate. These strengths have helped Home Depot deliver adjusted average returns on invested capital, including goodwill, of 33% during the past five years, benefiting from operational excellence at its core namesake business.
In our opinion, the company has also been able to capture economic rents from its brand, offering an important intangible asset. The business has been built on a culture obsessed with customer service, knowledge, and innovation, which are best-of-breed in the home improvement business--Home Depot has worked hard to ensure the appropriate staff is on hand to solve any problems its customers may have. The reliability of information that consumers can draw upon is unlikely to be replicated easily; Lowe's is the only other company that comes close, and Tractor Supply is closing the gap in a number of categories. We think consumers would be unlikely to switch if a new competitor entered the market, given the long history of consistent service. Home Depot has also found new ways to innovate through product launches, private label (about 20% penetration), exclusive offerings, and services that we would suspect many vendors might be wary of duplicating with smaller competitors, who might not be able to move the same volume of product or predict demand as accurately as Home Depot does. We believe that the familiarity of the brand and knowledge of the employee base keep the business in the forefront of consumers' minds as the premier choice for home improvement needs.
Lastly, while the threat of manufacturers creating their own retail network could jeopardize the availability of products in Home Depot's retail channel, we doubt such an endeavor would be successful in the longer term. In our opinion, manufacturers would probably move more products, maintaining a beneficial relationship with a wholesale network such as Home Depot's rather than on their own, and we expect consumers would prefer to still visit one shop for all of a project's needs, rather than purchase products independently from each OEM, thus saving time and effort.
Fair Value and Profit Drivers| by Jaime M. KatzUpdated Nov 23, 2022
We are increasing our fair value estimate to $270 per share from $267 after incorporating better-than-expected third-quarter results that included 5,6% sales growth (to $38.9 billion), helped by comp average ticket growth of 8.8%, partially offset by transaction count (down 4.3%). For 2022, we now expect $157 billion in sales, a 15.4% operating margin, and $16.65 in EPS, with the tax rate likely to remain around 24.6%.
Given the maturity of the domestic home improvement industry, we expect demand to largely depend on changes in the real estate market, driven by prices, interest rates, turnover, and lending standards once COVID-19 subsides. We project just shy of 4% average sales growth over the next five years, supported by 3.7% average same-store sales increases and helped by offerings like buy online/pickup in store and better merchandising, which drives market share gains. Longer term, we forecast gross margins to expand modestly over the next decade (by 90 basis points from 2021 levels, to 34.3%) while the SG&A expense ratio remains flattish (at 17.1%) as the firm capitalizes on its scale and supply chain improvement initiatives while investing to protect its market leadership perspective. This leads to a terminal operating margin of 15.8%, higher than the 15.2% peak achieved in 2021.
Home Depot's operating margins and ROICs could improve as the firm focuses on the efficiency of the supply chain and the opportunity to better penetrate the pro business with market delivery centers that leverage its delivery capabilities. Additionally, we think Home Depot still has other opportunities to expand the business. It can capitalize on product lines with weak market share leaders, as it has previously done, for example, in appliances (as Sears faltered). Also, having deeper product lines to cross-sell (with brands like Company Store offering exposure to textiles and HD Supply reaching the MRO consumer) could add incremental revenue potential. The service business backed by a major national brand, as well as the commercial business coming from Interline and HD Supply, could build brand loyalty and keep consumers returning to a trusted source, something that could be hard to duplicate for a new entrant.
Risk and Uncertainty| by Jaime M. KatzUpdated Nov 23, 2022
We give the company a Medium Uncertainty Rating owing to its strong brand recognition, which has helped stabilize sales through the cycle. Home Depot's sales are largely driven by greater consumer willingness to spend on category goods, with stable existing-home price growth and decent turnover. Thanks to the maintenance, repair, and operations (MRO) business (Interline Brands and HD Supply), pro revenue could be less cyclical, as the maintenance side of the business can prove more consistent. In uncertain economic times, consumers remain in their homes, embarking on improvement projects, boosting do-it-yourself revenue. Alternatively, when home prices rise, the wealth effect generates a psychological boost to consumers, reinvigorating professional sales thanks to a higher willingness to spend on big projects. A diverse consumer base helps normalize revenue even in uneven times. Currently, about half of sales are in the do-it-yourself arena for maintenance projects, while the rest is generated from the pro customer.
Although new competitors could set up shop on Home Depot's turf, we think new players would be hard-pressed to offer similar product prices, as it likely wouldn't have vendor relationships of the same magnitude. Ultimately, the biggest brands in home retailing will still want the biggest partners for distribution, leaving a new peer in a precarious position when it comes to acquiring enough of the most sought-out products to satisfy demand.
In our opinion, Home Depot has minimal environmental, social, and governance risk. Product sourcing, potential data theft, and consumers' shift in preferences to sustainable product offerings are relevant, but Home Depot should be able to adapt and do not see any material financial impact from these factors.
We believe the biggest risk is a slowdown in the real estate market, signaled by increased home inventories for sale, slower price growth, or higher mortgage rates (up 190 basis points over the last six months).
Capital Allocation| by Jaime M. KatzUpdated Nov 23, 2022
Our capital allocation rating for Home Depot is Exemplary. Forecast adjusted returns on invested capital including goodwill (38% on average over the next five years) are set to handily outpace our weighted cost of capital estimate (8.4%) over our entire outlook, and the balance sheet remains sound, given the company's medium revenue cyclicality and decent operating leverage. A manageable level of debt is coming due over the next few years, and as such, we aren't concerned about capital demands. With net debt/EBITDA that should average around 1 times over the next decade, there is plenty of financial flexibility on the balance sheet.
Ted Decker took the reins from prior CEO Craig Menear as of March 1, 2022. Like Menear, Decker has a long history with the organization, and as such, we suspect he will follow Menear's strategic suit, including a disciplined focus on keeping the brand elevated. In 2019, longtime CFO Carol Tome announced her resignation. Richard McPhail moved into the position in September that year, and thus far the financials have been managed similarly; this is not surprising, given his lengthy tenure working under Tome.
We hold a positive view of Home Depot's investment strategy, as we think the company is spending strategically to maintain its competitive advantages and respond rapidly to evolving consumer demand patterns. Quantitatively, we believe this is supported by robust ROIC and improving operating margins (which reach above 15% over our forecast).
We deem cash distributions as appropriate, with the management team returning capital to shareholders when optimal. It suspended share repurchases early in the COVID-19 cycle but was able to restart opportunistic purchases in the first quarter of 2021 thanks to the strong demand that has persisted throughout the pandemic. Home Depot has consistently raised its dividend in recent years (with 19.4% average dividend per share growth over the past five years), and it did so again in 2022, further returning excess capital to shareholders.