Sundry Photography
In the spring of 2021 I concluded that Home Depot (NYSE:HD) continued to construct shareholder value, being a prime beneficiary of the pandemic. The company has done extremely well, having leveraged sales growth into earnings growth, allowing for additional M&A and shareholder returns in the meantime.
Being deeply impressed with the quality of the business, I found the valuation a bit rich around $315 per share, with good operating conditions being extrapolated into the future, all while interest rates were still quite low.
Establishing A Base Case
While the pandemic has started about thirty months ago, I still find it quite useful to go back to 2019 to establish a base case, as activity levels might have been distorted ever since, especially for businesses which were impacted (for good or for worse) by the pandemic.
Home Depot posted revenues of $110 billion that year on which it posted operating earnings in excess of $15 billion and net earnings of $11 billion, equal to just over $10 per share. Ahead of the pandemic, shares traded around the $230 mark, translating into a 22-23 times earnings multiple. A $28 billion net debt load was substantial, but very manageable given the profitability and size of the company.
The pandemic was a real driver for the business as Home Depot grew first quarter sales in 2021 by 6%, yet sales growth exploded to 23% in the second quarter, resulting in a profit boom and giving management confidence to pursue an $8 billion deal for HD Supply later that year. In the end, Home Depot grew full year sales by 20% to $132 billion in 2020 as net earnings rose just to levels just shy of $13 billion, or about $12 per share. Net debt of $29 billion was pretty flat, despite the deal for HD Supply.
Through May of last year, the company had just reported first quarter results with comparable sales up 31% as strong cost management resulted in a profit explosion with first quarter earnings up 85% to $3.86 per share! With the company easily on track to post record profits again, I saw real potential for earnings to come in around $15 per share, or higher, resulting in a 21 times earnings multiple.
That said, I believed that these earnings were not representative through the cycle after the big boost provided to the business. Pegging normalized earnings at $11-$12 per share, valuation was a bit demanding at 26-28 times earnings.
As I believe that investing in quality is key (certainly in the long haul), and Home Depot certainly is top-notch quality, I was looking for a dip in the $250-$300 range before getting onboard.
What Happened?
Fast forwarding from spring of 2021 to today we have seen shares hit a high around the low $400s late in 2021 and earlier this year, as higher interest rates and cooling housing market triggered a reset to $275 per share at the moment. This makes that shares are down some 15% over the time frame of about 18 months, which looks interesting.
Share price momentum in 2021 kept on going as second quarter sales rose another 8% versus a very strong second quarter in 2020, with third quarter sales rising another 10%. In February of this year, Home Depot reported a 14% increase in full year sales in 2021 with revenues topping $151 billion. The company posted net earnings of $16.4 billion, or $15.53 per share, (largely in line with my estimates). A solid performance, but moreover the guidance, which called for slightly positive (comparable) sales growth and similar growth in earnings per share, implied that the company expected to maintain this profitability.
The company has been incurring net debt to the tune of $38 billion, yet with EBITDA reported around $25 billion in 2021, that resulted in a very manageable leverage ratio.
First quarter sales for 2022 ended up rising 4%, amidst flattish margins and earnings per share increasing a bit quicker on the back of share buybacks. The company hiked the full year sales guidance to 3% in response to the results, despite the challenges in the macroeconomic environment.
In August, Home Depot posted a 6% increase in second quarter sales, albeit aided by inflationary trends, as the company maintained the full year guidance. While the growth looks comforting, the composition of growth reveals softer market conditions with the number of transactions down 3% and average ticket prices up 9% on the back of inflationary trends. Net debt is inching up towards the $40 billion mark, but with EBITDA set to rise in a modest fashion from the $25 billion number in 2021, this all seems manageable.
With earnings likely seen at $16 per share this year, valuation multiples have fallen to a roughly 17 times earnings, the lowest multiple at which Home Depot has been trading for years now.
And Now?
Obviously, the macro conditions and inflationary trends might cause some havoc on the business and earnings might come down for some time. On the positive side is that the business continues to do well, is heavily focused on innovation and despite high shareholder payouts, its leverage ratios remain very manageable.
While the downturn in housing will certainly hurt the business, with the impact already seen in the volume trends in the second quarter, there might be a silver lining as well amidst the current state of events. Higher energy prices are arriving in North America as well, driving the need for insulation and some improvements on that end, which actually drives some demand even after the big housing and remodeling boom in recent years following the pandemic.
Perhaps the current downturn hurts Home Depot a bit more given its exposure to the highly successful professional segment, but on the other hand, shares held up quite well during the 2009 recession as well.
Hence, we might see some pressure on earnings going forward, yet I feel much more comfortable now compared to early 2021. Earnings have risen in a definitive fashion, despite the harsh current circumstances and shares are down $50 to $275 per share here as well. This makes me relatively upbeat here, as we can buy a high quality company at a fair market multiple and while there certainly are some risks for some declines in earnings per share, there is solid cash flow generation to allow for earnings per share growth going forward.
Be the first to comment