Continued Spending on the Home Improves Profitability at Wide-Moat Home Depot | HD Message Board Posts


The Home Depot, Inc.

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Msg  378 of 380  at  8/21/2021 10:56:17 AM  by

jerrykrause


Continued Spending on the Home Improves Profitability at Wide-Moat Home Depot

 Morningstar Investment Research Center
 
 
 
Continued Spending on the Home Improves Profitability at Wide-Moat Home Depot 
 
Jaime M. Katz
Senior Equity Analyst
 
 
Business Strategy and Outlook | by Jaime M. Katz Updated Aug 20, 2021

Home Depot is the world's largest home improvement retailer, on track to deliver more than $140 billion in revenue in 2021. It continues to benefit from a healthy level of housing turnover along with improvements in its merchandising and distribution network. The firm earns a wide economic moat rating because of 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 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 operating margin expansion in 2021, with capital expenditure investments moderating.

Home Depot should continue to capture top-line growth beyond 2021, bolstered by aging housing stock 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 (most recently bolstered by the acquisition of HD Supply). Expansion of newer (like textiles from the Company Store acquisition) and existing (such as appliances) categories could also drive demand.

In our opinion, operational changes to improve the omnichannel experience should support the firm's competitive position, even if 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 13.8% and 30%, respectively, in 2020. 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 reaching above 15% sustainably over the next decade.

Economic Moat | by Jaime M. Katz Updated Aug 20, 2021

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 lower everyday 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 31% 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 has closed 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 individually, saving time and effort.

Fair Value and Profit Drivers | by Jaime M. Katz Updated Aug 20, 2021

We are increasing our fair value estimate to $225 per share from $220 to reflect second-quarter results that were better than we expected, including 4.5% same-store sales growth (versus our 0% estimate) and 16% operating margin performance (against a 15.5% forecast). We have kept our adjusted long-term tax rate at 28% beginning in 2022 to account for the higher corporate tax rate likely to be implemented under the Biden administration.

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 5% average sales growth over the next five years, supported by 4% 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 30 basis points from 2020 levels, to 34.3%) while the SG&A expense ratio leverages by 100 basis points (to 17.5%) and the firm continues to capitalize on its scale and supply chain improvement initiatives. This leads to a terminal operating margin of 15.3%, higher than the 14.6% peak achieved in 2018.

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. Katz Updated Aug 20, 2021

Home Depot's sales are largely driven by greater consumer willingness to spend on category goods, thanks to still-rising existing-home prices and decent turnover. Thanks to the 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. The diversified consumer base helps normalize revenue even in uneven times. Currently, the bulk of consumer sales (about 55% of sales) is for maintenance projects, as pro sales (which represent around 45% of the total) can result in choppy quarter-to-quarter results, particularly in periods of economic uncertainty.

Although new competitors could set up shop on Home Depot's turf, we think a new player in the industry would be hard-pressed to offer similar product prices, as it likely wouldn't have vendor relationships of the same strength. 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 only minimal ESG risk. While there is some exposure from being a publicly traded company, product sourcing, and potential data theft, the biggest issue we foresee is in consumers' shifting preferences to sustainable product offerings. We expect Home Depot to adapt, and as such, we do not see any material financial impact from such exposure.

We believe the biggest risk is a slowdown in the real estate market, which could be indicated by increased home inventories for sale, slower growth in prices, or higher mortgage interest rates.

Capital Allocation | by Jaime M. Katz Updated Aug 20, 2021

Our capital allocation rating for Home Depot is Exemplary. Forecast adjusted returns on invested capital including goodwill (33% on average over the next five years) are set to handily outpace our weighted cost of capital estimate (8%) 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.

Craig Menear has held the CEO position since Frank Blake stepped down in 2014. Menear has followed Blake's strategic suit, and we expect this will continue, with 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 in a similar manner as in the past; 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 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 over the last year. Home Depot has consistently raised its dividend in recent years, and it recently did so again (up 10%, to $1.65 per quarter), further returning excess capital to shareholders.

 
 


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