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Stock Analyst Update

Safe Work Environment Costs Hinder Home Depot Profits

We are maintaining our fair value estimate and long-term outlook for the wide-moat essential business.

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Wide-moat Home Depot (HD) was able to grow its top line nicely in its fiscal first quarter, as one of the few retail operators that remained open. Sales grew 7%, with total same-store sales printing a 6.4% uptick, and the average ticket up a whopping 11%, as consumers stocked up on cleaning products as well as do-it-yourself products (as installment services was limited in some locations). However, Home Depot couldn’t escape the incremental costs associated with ensuring a safe work environment amid the coronavirus pandemic though, digesting $640 million in after-tax expenses ($0.60 per share) to support its front-line employees, expanding time off, offering weekly bonuses and extending certain benefits. These costs increased the selling general and administrative expense ratio to 20.6%, marking a 190-basis-point expansion versus last year’s first quarter. This led to an operating margin of 11.6%, which was the lowest first-quarter performance since 2014, but evidence exists that the underlying business remains strong. Excluding COVID-19 expenses, Home Depot could have posted earnings per share growth of 14%, and the selling general and administrative ratio would have leveraged, indicating prior investment was stimulating demand.

In our opinion, these employee benefit expenses are expected to be transitory as retailers implement initial safety protocols and COVID-19 cases begin to wane. Thus, costs should normalize over time restoring operating margin growth. We don’t plan to alter our long-term outlook for the business, which includes between 3%-4% top-line growth and mid-teen operating margins. In the near term, we anticipate higher expenses will be partially offset by the lower cadence of promotions, potentially yielding an improved gross margin profile. In this vein, we don’t anticipate a material change to our $179 fair value estimate and view shares as rich.

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Jaime M. Katz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.