Aptus Musings: Stock Highlight – Home Depot, Inc. (HD)

Who-Dey Fans-

I am writing this with a smile on my face. The Cincinnati Bengals are going to the Superbowl – something I never thought I’d say – I’ve re-watched the game thrice. I keep my “Joey Burrow Prayer Candle” next to my laptop, as I don’t want to let it out of my sight – Joey Burrow has never been injured during a game while it has been lit. This isn’t superstitious – just a little ‘stitious.

Two years ago, the Bengals won only two games. Last year, they won 4. The Cincinnati Bengals have started to build, from the ground up, quite a franchise around young players – Joe Mixon, Ja’Marr Chase, Joey Burrow.

So, on our stock highlight of the month, I chose a company that focuses on building from the ground up. A company that sports a large orange sign – Home Depot, Inc. (HD).

Please note – at the bottom of this email, I’ll provide some commentary on a few idiosyncratic stock earnings reports – y’all can probably guess the culprits.

Home Depot, Inc. (HD)

What Do They Do?

Many homeowners know the Home Depot brand, as they can attest to their continued shopping at national hardware store for home remodeling, but what they may not be aware of is that only about half of the company is dedicated to serving “Do It Yourself” homeowners. The other half of the business is acting as a key supplier to small contractors – which the company calls “Pros” – who depend on Home Depot as a mission critical business partner.

Why is the Business Structure Appealing?

This Pro segment accounts for just 4% of their customer base, but about 45% of revenue. Basic math implies that this means the average contractor customer spends about 20x the amount that the average homeowner customer spends. In an industry where you want to drive high levels of sales per store, the contractor customer profile is super attractive. It is why Home Depot spends so much focus on serving contractors (Pros), and it has led to a great success as HD generates about 30% more revenue per store than its main competitor, Lowe’s – which has far fewer professional contractor customers. Given this statistic, its no surprise that Lowe’s has tried to enter this market – we don’t see this as a significant risk in the NT.

We largely believe that Lowe’s (LOW) is behind the eight-ball regarding their rollout because HD has heavily invested in this program, especially online. For instance, their Pro Online interface allows for the exporting of order history to Quickbooks, the accounting software used by most small contractors, making it easy to manage delivery options to a large number of active job sites. This technology creates sticky and loyal business customers.

Bull Case:

• Strong US Consumer & An Aging Housing Supply: Record low unemployment, improving wage growth, and 50% of US homes are older than 40 years of age all bode well for HD. The low interest rate environment and a strong housing sector stimulates home buying/selling activity which directly benefits sales. Looser credit gives consumers more ability to do bigger scale projects. This has resulted in a continual Increase in sales per square foot and increased customer productivity.
• Pressing the PRO Advantage – While already ~45% of sales, HD’s Pro business represents one of the most significant growth opportunities over the next several years. Specifically, the addition of enhanced delivery capabilities, improved data analytics, a personalized B2B website, and enhanced capabilities around services such as tool rental represent key levers that should help HD tap into new Pro customers and expand its wallet share with existing Pros in the years ahead. We also believe the acquisition of HD Supply will allow HD to accelerate market share in the highly fragmented MRO space.
• Post-Pandemic Beneficiaries – As Americans emerge from the pandemic, they will be reevaluating their housing needs. Remote work options may cause more homeowners to consider moving, with home improvement projects being common in preparation for sale as well as when a new family first moves into a house. Many people who do not move will still plan to work from home with some regularity, driving demand to create office space in their house with associated remodeling expenditures.
• Vertical Integration on the Supply-Chain = Control Your Own Destiny – HD is in the midst of a multi-year journey to transform/redesign its “downstream” supply chain, with the goal of creating the fastest, most efficient delivery offering. In short, HD is significantly expanding its direct fulfillment center network and is adding cross-dock facilities to facilitate same/next-day delivery in the top 40 markets. While stores will still play a large role in secondary markets, HD is consolidating delivery into fewer locations to drive efficiencies.

Bear Case:

• Housing Market Deterioration – Renewed  deterioration  in  the  housing  market  could  negatively impact demand for HD’s products/services, particularly those driven by housing turnover activity. In addition, home price depreciation could cause weakness in bigger-ticket home improvement projects/renovations.
• Economic Conditions – A contraction in consumer spending resulting from macroeconomic factors such as higher interest rates, rising fuel and energy costs, prolonged weakness in the housing market, and increased unemployment levels could negatively impact sales.
• Irrational Pricing – Industry players could become more aggressive with price in an attempt to drive traffic and market share gains. Any price war would adversely impact both sales and profit margins.
• Increased Restrictions in Credit Availability –  Increased  restrictions  in  credit  availability  could negatively impact sales, as big-ticket home improvement projects are often financed.

 

Q3 2021 Earnings – Nailed it !

Home Depot reports Q4 2021 earnings on February 22^nd. So, let’s take a quick look at their Q3 earnings. HD had better-than-expected Q3 results, which reinforced our positive view on the name. Specifically, Home Depot is flexing its considerable scale and operating capabilities to navigate unprecedented supply chain friction, secure inventory and capitalize on still healthy sector demand trends. When combined with a portfolio approach to handling product cost inflation and renewed emphasis on expense management, HD’s P&L agility was fully on display during the quarter. This is why we love the stock – their dynamic nature to adapt in a difficult supply chain environment, i.e., great management leadership with a strong business structure in place.

Is Amazon a Threat?

Despite the rise of Amazon, Home Depot has generated outstanding results for shareholders during the rise of eCommerce, even as Home Depot’s end market in housing suffered the worst collapse in a century. Of course, when competing with Amazon, having a strong eCommerce or Omnichannel strategy is just table stakes. But due to the nature of home improvement spending, where parts are often needed the same day and in many cases are heavy, bulky objects, the fact that well over 50% of Home Depot’s online orders are picked up in store, despite offering 2-day delivery to 90% of US households, speaks to the unique nature of this category and why we do not view Amazon as a meaningful threat.

Growth:

Who doesn’t like growth? Because HD has scalability. The best way to think about companies like Home Depot that generate high returns on invested capital (“ROIC”) is that these businesses can grow without needing to invest as much in their business to generate any given level of growth compared to companies with lower returns on capital – it’s the beauty of owning companies with inelastic pricing and a competitive moat. For HD, their success in growing the business without needing to invest that much capital is well illustrated by their fundamental growth over the last decade – the number of stores they operate has only increased by 2%, even while revenue has more than doubled. Economies of scale at its finest.

Technicals:

HD dropped to its 2021 May highs and the 200-SMA at the same time during this year’s pullback, pointing to a great long-term entry with a long-term trend. The company reports earnings on 2/22 and the next steps for HD is to maintain the 200-day moving average lows and look to take out the 50-SMA, which is turning negative from above near $400. Support should be near the 400-SMA and the lows from June last year near $300 on any drop further.

Source: Bloomberg, Data as of 2/2/2022

Overall Thesis:

While Home Depot has executed extremely well over the last decade, it did so in the context of a weak overall economy, the worst housing crash in a century, an existing base of homes that had more new homes (needing less home improvement work) than the historical average, and low or even negative equity restricting homeowners’ ability to finance home improvement projects. But we believe the housing end market is in the midst of a Great Reshuffling, especially given the current “post-COVID” world.

We believe HD remains a strong story in the retail sector given company-specific sales and margin initiatives, the duopoly/AMZN resistant nature of the industry, and significant financial and operating leverage that amplifies EPS growth in better sales environments. With internal momentum building, we expect HD to benefit from its refocused branding and value proposition, which has driven favorable traffic and ticket trends at the retailer. In addition, internal initiatives enable HD to gain share vs. its competitors. These efforts should yield accelerating incremental margins, good cash flow, and EBITDA growth that will necessitate more leverage (thus buybacks and dividends). HD has a proven track record of a deep focus on the culture with a strong customer/employee experience while also historically proving strong shareholder returns. In our opinion HD makes a relatively boring business innovative and fun by engaging the customer whether it be in the store or its growing online business.

 

Updated Yield + Growth Framework

Yield + Growth = Total Return

1.77% + 9.75% = 11.52%

 

Sales Growth + Margin Growth + Inorganic Growth + Repurchases = Growth Rates

7.75% + 0.50% + 0.00% + 1.50% = 9.75%

 

Idiosyncratic Earnings Reports:

1. Meta (FB) – It was a perfect storm to hit Facebook Meta as they guided poorly regarding their FY Q1 2022 earnings – but, at its core, I guess it’s better to invest in growth than to stay stagnant?
   1. Earnings: While Q4 revenues were in-line, pressure on Q1 growth was more pronounced than anticipated, as Meta deliberately shifts towards lower-monetizing video content compounding impacts from tougher comps, FX translation and Apple’s privacy changes. Obviously ad spending was the black eye of the guidance. Looking further ahead, we see Q2 trends somewhat similar to Q1 before 2H growth benefits from easier comps, more tools to combat privacy headwinds, and presumably improving video monetization. With Q1 guidance out of the way, we continue to see a brighter path for shares once investors focus on re-accelerating double-digit growth in 2H.
   2. Valuation: We believe after hours valuation is attractive at ~13x 2022E Core EPS  vs. mid-teens LT EPS growth.
2. PayPal Holdings (PYPL) – Long Road to Redemption Here In My Opinion, as PYPL’s Strategy Pivots Away from User Growth
   1. Earnings: The call shed more light on the startlingly low Net New Active Account guide for FY22, as management has pivoted towards driving more engagement from high-value customers, & pulled the target of 750M active users by FY25. We view the market’s reaction to this report as justified. At Aptus, we think that PYPL needs a new direction, thinking that to drive growth they need more physical POS processing, something which may require M&A – which is not likely under the current management team.
   2. Valuation: We believe that valuation remains the biggest worry here, outside that the market may be too optimistic on LT growth now. Given our POS comments and the company needing a new direction, PYPL shares could trade at a discount to Visa (V) and Mastercard (MA).

 

 

 

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