Near-Term Macro Headwinds Are Unlikely to Erode Home Depotís Robust Selling Apparatus
Near-Term Macro Headwinds Are Unlikely to Erode Home Depot’s Robust Selling Apparatus and Scale
Jaime M. Katz
Senior Equity Analyst
Business Strategy and Outlook| by Jaime M. KatzUpdated May 19, 2023
Home Depot is the world's largest home improvement retailer, set to deliver $153 billion in revenue in 2023. The firm earns a wide economic moat rating due to its economies of scale and brand equity. While Home Depot has realized 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 should help elevate the firm's brand intangible asset, with faster time to delivery improving the do-it-yourself (DIY) 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 and near-term economic turbulence.
Over time, Home Depot should continue to capture sales growth, bolstered by an aging housing stock, a shortage in home inventory, and rising home prices, despite lapping robust COVID-19 demand. Other internal catalysts for top-line growth could stem from the firm’s efficient supply chain, improved merchandising technology, and penetration of adjacent customer product segments (such as the maintenance, repair, and operations, or MRO, market that Home Depot expanded its exposure to 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% and 34%, respectively, in 2022. Additionally, Home Depot's focus on cross-selling products in both its DIY and its MRO channel should support stable pricing and volatility in the sales base, helping achieve modest operating margin lift, with the metric remaining above 15% on average over the next decade.
Economic Moat| by Jaime M. KatzUpdated May 19, 2023
We assign Home Depot a wide economic moat. As the largest global home improvement retailer, we believe Home Depot possesses a competitive edge owing to its brand intangible asset and cost advantage. Over the past 10 years, Home Depot’s sales growth has outpaced the building materials and garden equipment and supplies dealer industry’s average growth of 6.2% by 160 basis points annually (based on the U.S. Census Bureau data), an indication of the brand’s ongoing relevance. We surmise Home Depot’s strong brand equity and extensive scale should enable incremental market share gains in a highly fragmented $1 trillion North American home improvement market, on top of the high-teens market share it has amassed thus far (given roughly $157 billion in sales in 2022).
Dissecting the components of its competitive prowess, we think Home Depot’s impressive same-store sales growth, which has averaged 7% over the past 10 years, suggests a brand intangible asset exists. For one, we think Home Depot’s extensive product offerings and services have fostered brand loyalty. In fact, Home Depot moves 30,000-40,000 stock keeping units in store and 1 million units online, allowing consumers to save time and effort by visiting one shop for all a project’s needs. To continue to engage its consumers and keep up with changing customer demand (for localization and personalization, for instance), Home Depot leverages consumer data, collaborates with its suppliers, and conducts periodic merchandising resets to better refine its assortments. Apart from its trusted national brands, Home Depot holds eight private-label brands that primarily cater to its DIY customers, who tend to be brand agnostic; we think those brands not only allow broader product selection and brand positioning but also provide margin benefits (while not disclosed, we estimate private-label gross margins to be a few hundred basis points above national brands). Additionally, Home Depot’s value-added services (including tools and trucks rental, installation, and remodeling) allow smooth undertaking of projects for its wide range of consumers, which further elevates the customer experience, in our view.
An important aspect of Home Depot’s brand intangible asset lies in its omnichannel capabilities; we think these protect the firm’s competitive position and prevent customer attrition by enabling customers to buy what they want how they want. While Home Depot maintains an extensive brick-and-mortar presence, it has been investing heavily in its digital and omnichannel capabilities for decades, which has allowed the firm to remain relevant in the market, in our view. For Home Depot, nearly half of e-commerce transactions (which we estimate represented around 15% of 2022 sales) were ordered online and picked-up in store, implying more than $10 billion worth of goods stemmed from an omnichannel transaction. For perspective, online penetration was just around 7% in 2017, but we expect it can continue to remain around a midteens rate in the near term as buy online pickup in store and other omnichannel efforts continue to be adopted across the overall consumer base. We expect omnichannel will continue to evolve based on customer-led demands, which will help protect brand position.
Moreover, with consumers increasingly favoring retailers with a robust omnichannel presence, retailers without capabilities to offer a seamless multichannel shopping experience could struggle to attract customers, in our view. We surmise operators that were less equipped to compete with the online incumbents and omnichannel retailers likely ceded share to Home Depot and Lowe’s during the pandemic, as consumers acclimated to different transaction preferences. Home Depot’s omnichannel footprint combined with continued improvements in merchandising strategy and product offerings should support the brand, in our opinion, driving same-store sales growth of 3% on average through 2032. In addition, we think these efforts should prompt further market share gains, albeit at a slower cadence than historically, given a mature home improvement market and where Home Depot sits in its business lifecycle.
Beyond its product offerings, we think Home Depot’s emphasis on topnotch customer service and associate knowledge further supports its brand intangible asset. And we attribute Home Depot’s superior service levels to the firm’s commitment to invest in its talent through various training and career development opportunities, competitive benefits, and a wellness package, to name a few. The net promoter score (which we use as a proxy for customer satisfaction) at Home Depot is ahead of that at wide-moats Lowe’s and Walmart according to comparably.com, and employee surveys, which gauge worker satisfaction, have been positive. We think Home Depot’s continued investment in its people (most recently, the firm announced $1 billion in investment for frontline, hourly workers) should help the retailer deliver reliable services to its customers and remain on top of customers’ minds for any home improvement needs.
Additionally, since 2015, acquisitions have helped Home Depot elevate its brand by expanding the product breadth and relevance for its professional segment. Here, key tie ups to Home Depot’s business have been Interline Brands and HD Supply (acquired in 2015 and 2020, respectively), through which it deepened its foothold into the maintenance, repair, and operations, or MRO, market that primarily caters to the pro customers—with a total addressable market size around $500 billion (according to recent estimates from Lowe's). For reference, Interline Brands and HD Supply generated around $1.6 billion and $8 billion in sales, respectively, at the time of the acquisitions (expanding its pro penetration by a high-single-digit level). These deals also struck us as strategically cogent, given Home Depot can leverage these opportunities to cross- and up-sell, through which it can attract new customers and expand engagement from its existing pro base; we partially attribute the firm’s strong average ticket growth (growing from $57 in 2013 to $90 in 2022, up 58% cumulatively) to its ability to successfully grow its pro customers.
From our vantage point, the pro offering is a key differentiator of the brand, as indicated by the frequency (number of transactions) and the wallet share (average ticket in dollar term) that we assume substantially outpace the DIY cohort. To further entrench its standing with the pro cohort, Home Depot has worked to beef up its loyalty rewards program and enhance its service levels, which we believe have resulted in consumer stickiness. For example, the Pro Xtra program allows for rewards, special sales, and discounts on certain categories, leading to meaningful savings for those undertaking sizable projects, nudging pros to stay with one brand. In addition, we think Home Depot’s exclusive services catered to its pros (such as time-saving pro checkout, call-ahead ordering, and delivery to job sites, to name a few) further enhance the shopping experience. Through both organic and inorganic means, Home Depot’s pro mix shifted from 30% in 2013 to nearly half in 2022, with the rest generated from do-it-yourself, or DIY, customers. Assuming no additional MRO acquisitions ahead, we think continued investments should help pros stay engaged with the brand.
Beyond its brand intangible asset, we believe Home Depot’s size (operating more than 2,300 stores throughout the United States, Canada, and Mexico) has allowed it to manage large volumes and disperse merchandise across a geographically diverse network of stores to target specific markets, underpinning a cost advantage. The magnitude of the business enables significant bargaining power with vendors when sourcing products, crafting advertisements, and arranging logistics. We think the symbiotic relationships Home Depot maintains with its vendor partners are unlikely to be replicated easily, considering the current market landscape and the time and capital involved in scaling up to 1,000 locations, a minimum level we think would be required for any competitor to capture similar vendor pricing as Home Depot. As quantitative evidence, Home Depot’s operating margin (15.3% in fiscal 2022) outpaces those of its competitive set by a couple hundred basis points, supporting our argument that the firm can generate a superior level of leverage over a fixed cost base thanks to its scale (despite continued capital investments to improve the business).
Home Depot’s ability to negotiate well with vendors allows the firm to provide value and instill customer loyalty by passing along a portion of these savings in the form of everyday low pricing, or EDLP. The ability to apply EDLP tactics is a result of negotiating clout due to scale as savings from bulk purchases that allow for this pricing mechanism. We think EDLP drives a positive flywheel effect, prompting customers to return as they understand the value proposition offered by the company driving further scale gains. As evidence, total transactions at Home Depot remained at 1.7 billion in 2022, from 1.4 billion in 2013 (up 20%). Additionally, we assess the pricing strategy as successful given the stability of gross margins, which have generally clocked in the 33%-34% range over the past decade —a level we believe will likely persist as any scale benefits gained are likely to be passed directly on to consumers.
In our opinion, it would be difficult for another retailer to enter the market and threaten Home Depot’s position, as smaller retailers would have a hard time building vendor relationships strong enough to undermine the company’s pricing prowess. While the threat of manufacturers creating their own retail network could jeopardize the availability of product in Home Depot’s retail channel, we doubt such an endeavor would be successful in the longer term. In our opinion, manufacturers would be poised to move more products by maintaining a beneficial relationship with a wholesale network like Home Depot, rather than on their own. Thus, we are confident that Home Depot’s competitive position will continue to benefit the business, indicated by our forward ROIC metrics remaining north of our 8% weighted average cost of capital over the next two decades (with ROICs forecast to ultimately reach 33% in 2032), underpinning our wide-moat rating.
Fair Value and Profit Drivers| by Jaime M. KatzUpdated May 19, 2023
We are lowering our Home Depot fair value estimate to $259 per share from $267 to account for slowing top-line momentum and resulting sales deleverage. Nonetheless, Home Depot continues to invest in merchandising, supply chain, and employees, which we contend should support its brand intangible asset. For 2023, we now expect $153 billion in sales, a 14.3% operating margin, and $15.23 in EPS.
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. We project 2% average sales growth over the next five years, supported by 2% 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 10 basis points from 2022 levels, to 33.6%) while the SG&A expense ratio remains flattish (around 17%) 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 15.5%, higher than the 15.3% peak achieved in 2022.
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 May 19, 2023
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, 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 about 110 basis points in the last 12 months).
Capital Allocation| by Jaime M. KatzUpdated May 19, 2023
Our capital allocation rating for Home Depot is Exemplary. Forecast adjusted returns on invested capital including goodwill (30% 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 nearly 16% 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 17% average dividend per share growth over the past five years), and it did so again in 2023, further returning excess capital to shareholders.