Why Home Depot Should Be on Your Watchlist
Its massive scale creates a low-cost advantage that is the basis of its wide moat.
Home Depot (HD) is the world’s largest home improvement retailer, on track to deliver more than $115 billion in revenue in 2020. It continues to benefit from a stable housing market and improvements in its merchandising and distribution network. The company 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 of our long-term margin expansion assumptions. Its evolving distribution network will help elevate the company’s brand intangible asset, with faster time to delivery improving the do-it-yourself experience and market delivery centers catering to the professional business. The success of ongoing initiatives should set the operating margin back on a rising trajectory in 2021.
Home Depot should continue to capture top-line growth, bolstered by macroeconomic factors including low unemployment, wage growth, and an aging housing stock. Other internal catalysts for top-line growth could come from the company’s efficient supply chain, improved merchandising technology, and penetration of adjacent customer product segments (like commercial). Expansion of both new (like textiles from the Company Store acquisition) and existing (appliances could still grow after the Sears bankruptcy) categories could also drive demand.
In our opinion, operational changes to improve the omnichannel experience should strengthen Home Depot’s competitive position, even if existing-home sales and turnover decelerate modestly. The commitment to better merchandising and an efficient supply chain has led to an operating margin of 14.4% and adjusted return on invested capital, excluding goodwill, of 34% in 2019. 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 16% over the next decade.
Brand Is an Important Intangible Asset
Home Depot’s size creates a low-cost advantage that is the foundation of our wide economic moat rating. The company’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, excluding goodwill, of 33% during the past five years, benefiting from operational excellence at its core orange box 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 (LOW) is the only other company that comes close, and Tractor Supply (TSCO) is closing the gap in certain categories), and 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, which 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 at 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 manufacturer individually, saving time and effort.
We believe Home Depot’s moat trend is stable. We expect the company to continue to gain an incremental share in the home improvement retail category, given its extensive economies of scale and brand recognition, bolstered by the respect of its private-label offerings. As ongoing operational improvements bear fruit, Home Depot’s competitive position should strengthen. We believe there is ample opportunity for both Lowe’s and Home Depot to expand sales and profitability in the large, fragmented U.S. home improvement market, of which we believe Home Depot captures less than 20%.
In our opinion, it would be difficult for another retailer to enter the market and threaten Home Depot’s position, as smaller retailers would probably have a hard time building vendor relationships that would be strong enough to undermine the company’s pricing prowess, or a supply chain that was as responsive. We don’t fear large international companies with deep pockets entering the domestic market either, as a lack of infrastructure would make distributing inventory prohibitively expensive from overseas and the lack of real estate in the right location and price range could be difficult to acquire on a large scale. The lack of a rapid location growth trajectory for Home Depot prevents the business from gaining a wider global market share quickly, which could offer a positive trend in the longer term.
Consumer Spending Is Key
Home Depot’s sales are largely driven by improved consumer willingness to spend thanks to rising home prices and decent turnover. Sales from the professional side of the business can perform more cyclically, but sales from the retail segment should provide stability through the business cycle. Also, with the addition of Interline Brands, pro revenue could be less cyclical, as the maintenance side of the business proves more consistent. In weak 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 home sales, reinvigorating professional sales. 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 new-home construction (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 probably 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 competitor in a precarious position when it comes to acquiring enough of the most sought-out products to satisfy demand.
We believe risk lies in competition from the e-commerce channel, particularly in categories that have been commodified. In our opinion, 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 (which have fallen about 83 basis points between April 2019 and April 2020, a potential factor that could bolster interest in home purchases).
Home Depot raised an additional $5 billion in long-term debt in April 2020 to ensure it weathers the coronavirus storm without disruption. This puts the company in place to end 2020 with a debt/capital ratio of 0.99. We aren’t concerned about near-term cash constraints as forward debt maturities are staggered, with just $2.35 billion of the $32 billion total long-term debt coming due in 2021. EBIT is forecast to cover interest expense more than 11 times at the end of 2020.
Given Home Depot’s ability to generate tremendous excess free cash flow (we forecast more than $10 billion in 2020), we expect management to have no problem facilitating dividend payments and remaining near its long-term dividend payout ratio target of 55%. However, in light of the uncertainty surrounding COVID-19, we believe share repurchases will remain paused over the next few quarters. This should free up incremental cash as the company spent nearly $7 billion on repurchases in 2019.
Jaime M. Katz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.