(Disclaimer: Excel file attached below the post)
Home Depot, Inc. is the largest home improvement retailer in the world based on net sales of $152.7BB for FY '23. The stock has returned +18.95% in 1 year while the S&P 500 returned +22.34%, but the story reverses course if we look at the last 5 year's returns; HD's returns increased +95.35% while the S&P 500, in the same timeframe, returned +81.34%. The stock is currently trading at 27.9x its earnings and at 18.8x EBITDA. Additionally, I was amazed by the company's performance over the last quarter in which HD was expected to post EPS of $3.64 but ended up reporting $3.78, easily beating the estimates. So, is this one of the best dividend paying value stocks? I will begin by looking at the company, its business, past and historical performance, compare the company to some of its contemporaries, and finally end the post with what I think is its fair intrinsic value.
Home Depot
Home Depot is the largest home improvement retailer in the world, and offers customers a wide assortment of building materials, home improvement products, lawn and garden products, decor products, and facilities maintenance, repair and operations products as well as providing a number of related services such as home improvement installation and tool and equipment rental. As of the end of FY '23, HD operates 2,335 stores that are strategically located throughout the U.S., Canada and Mexico. The stores average approximately 104,000 square feet of enclosed space with approximately 24,000 additional square feet of outside garden area. Home Depot also maintains a network of distribution and fulfillment centers along with a number of e-commerce websites in the U.S., Canada and Mexico. Home Depot serves three distinct types of customers: Do It Yourself (DIY), Do It For Me (DIFM), and Professional Customers (Pros).
Historical Performance
Historically speaking, Home Depot has been one of the best performing companies; the company has put up consistent numbers in terms of revenue and revenue growth rate, COGS as a % of net sales or total revenues, operating income and margins and net income and net margins. If we look at the the last five years, HD's top line grew from $110BB in FYE '20 to $153BB by the end of FYE '24. Cost of goods sold, or COGS in wall street parlance, has consistently been around 66% of net sales, which given the growth and the ebbs and flows of net sales, is an amazing operational achievement. Additionally, over the last 5 years, the company reported gross margins in the range of 33% to 34%. SG&A expense has understandably increased from $19.7BB in FYE '20 to $26.5BB by the end of FYE '24 given the top line growth. I believe where the company truly stands out is in its margins; HD has reported consistent margins (gross, operating and net) over the last five years despite issues such as supply bottlenecks, pandemic, inflation, high interest rates, and geo-politics.
As you can see from the image above, historical margins over the last five years have been consistent despite the multitude of micro and macro factors impacting the company, its broader industry, and specifically its subsector. Starting with its gross margins over the last five years, the company reported consistent gross margins in the range of 33% to 34% and this consistency in gross margins implies that the company clearly has a competitive advantage and is vividly able to dictate terms with its suppliers and business partners. Operating margins tell a similar tale where the company has been able to notate margins in the range of 14%-15% clearly solidifying the company's competitive advantage and its position in the industry. Lastly, HD reported 10% net margins over the last five years, and as we know, positive net margins directly translate into dividends and share repurchases. With an understanding of the company's business and its performance, here is a peak at its historical income statement:
Home Depot's income statement highlights why the company is trading at the multiples that it is, but income statements are typically ruined by the fact that companies follow accrual accounting and so the numbers the companies put out in their income statements reflect profitability in terms of GAAP rules and regulations, but give no insight as to the company's ability to generate positive cash flows or its ability to meet is obligations; in order to better understand any given company's liquidity and its ability to meet its near and long-term obligations, we have to look at its cash flow statement as that is the one statement where we can tell exactly how much cash has come in and gone out of the business, so here is a look at HD's cash flow statement over the last three years:
As we can see, not surprisingly, HD has had positive operating cash flows over the last three years (the company reported OCF of $21BB for FYE '24), and this positive cash flow is driven by multiple factors; firstly, the company's growth in its NI and that is the first line item in company's operating activities; secondly, it is further accentuated by the additions of non-cash items such as D&A and stock based compensation; and lastly and perhaps most importantly, HD's grip on its current assets and current liabilities. If I were to dissect the company's working capital items I would see a really impressive inventory turnover, its superior ability to turn its AR into cash, and its bargaining power in the shape of AP among other things.
As is also evident from the image above, the company has reported FCF of $14BB, $11.5BB, and $18BB for FYE '22, FYE '23, and FYE '24, respectively, which also explains the company's ability consistently issue dividends and conduct share repurchases along with meeting its debt obligations. Let's now take a look at the company's balance sheet as it highlights the company's long-term position.
To quote every finance and accounting book out there, balance sheet is a snap shot of a company's assets, liabilities and equity at any given point in time, and if we need to assess a company's liquidity, balance sheet probably is as crucial as the cash flow statement. HD has kept a reasonable amount of cash on hand as well as having more current assets than current liabilities which obviously equates to the fact that the company, over the last five years, has been in a comfortable position in terms of liquidity. One off-putting thing that I see here is the amount of debt the company has on its balance sheet; as we can see, for FYE '24, the company has long-term debt in the amount of $43BB, excluding the operating lease liabilities, which explains its high interest expense. I believe that the company has a solid enough credit profile as well as FCFs and liquidity, but raising further debt could impact the company's debt profile and as a result, its margins and profitability. Lastly, we look at the company's financing activities, we can clearly see that the company is using its FCFs to return value to the shareholders in the form of massive buybacks and dividends. With this understanding, I believe we are in a suitable place where we can look at other companies in the sector and compare HD's performance with its peers before we move onto the valuation.
Comparable Companies Analysis
This is not a full blow comparable companies analysis where I try to value/price the company based on its peers and their performance, but rather this is a nuanced approach where I will compare HD to a select few contemporaries and look at a few data points and try and assess if the company is trading at a premium, discount or par. For the purposes of this exercise, I will compare Home Depot to three of its very close peers: Loew's, Floor & Decor, and Arhaus.
Home Depot:
Home Depot has a market value, as of this post, of $407BB, and given its debt and cash and cash equivalents, an enterprise value of $468.6BB, which means that the company is trading at 18.76x EBITDA. The company based on 14.73 diluted earnings per share, is trading at 27.80x times its earnings. The stock has returned 17.32% over the last year. As of this post, the company reported revenues of $152.6BB, operating expenses of $29.2BB, operating income of $21.7BB, and gross profit of $50.96BB. HD has inventory of approximately $23.9BB and AR turnover of 33.72. As stated before, for the last reported fiscal year, the company reported OCF of $21.17BB and FCF of $18BB. Company reported operating, gross, and profit margins of 14.2%, 33.4, and 9.9%, respectively, for the latest reported year. Additionally, the company reported ROA of 16.91% and ROIC of 26.88%.
Lowe's
Lowe's has a market cap, as of this post, of $142BB and an enterprise value of $178.6BB, which means that the company is trading at 14.37x its EBITDA. The company is trading at 20.95x times its earnings and has a diluted earnings per share of 12.02. Over the last one year, the company has returned 12.99%, which is lower than HD which, as stated before, returned 17.32% over the same period. According to the latest numbers, Lowe's reported revenues of $83.7BB with operating expenses of $17.5BB, operating income of $10.3BB, and gross profit of $27.8BB. Lowe's has inventory of $17.6BB, OCF of $9.82BB, and FCF of $7.82BB with capex of $2BB. As of this post, the company reported operating, gross, and profit margins of 12.33%, 33.21, and 8.17%, respectively. Lastly, the company has basic EPS of 12.04, ROA of 15.67% and ROIC of 29.57%.
Floor & Decor
Floor & Decor has a market equity value of $10.47BB and an enterprise value of $11.98BB. The company is trading at 54.22x it earnings and 25.46x its EBITDA, which of course imply that the company is trading at a premium compared to HD or Lowe's. The company, over the last year, has returned -8.01% which is of course lower than both HD and Lowe's. As of this post, the company reported revenues of $4.4BB, operating expenses of $1.6BB, operating income of $288.3MM, and gross profit of $1.89BB. Additionally, the company has approximately $1.05BB and an AR turnover of 43.51 which is higher than that of HD's which has an AR turnover of 33.72, and when it comes to AR turnover, the lower the better, because it means that the company is able to turn its AR over quickly which translates into more cash for the company. Floor & Decor has cash from operations of $606.4MM, capex of $483.3MM, and FCF of $123MM and is trading at 2.40x its sales which is higher than Lowe's but slightly lower than HD's price to sales ratio of 2.63x. Moreover, the company reported operating, gross and profit margins of 6.57%, 42.9% and 4.45%, respectively. The company has basic earnings per share of 1.82, ROA of 4.08% and ROIC of 5.41%.
Arhaus
As of this post, Arhaus has a market equity value of $1.77BB and an enterprise value of $2.11BB, and the stock is trading at 22.50x its earnings which is significantly lower than Floor & Decor and HD, but higher than Lowe's. The stock has returned 6.70% over the last year which is lower than HD's one year return, which as stated above was 17.32%. According to the latest numbers, the company reported revenues of $1.27BB, operating expenses of $404MM, operating income of $99.4MM, and gross profit of $503.7MM and the company has roughly $294.6MM worth inventory. As of this post, the company reported OCF of $139.8MM, capex of $126.9MM and FCF of 12.92MM. Additionally, the company is trading at 1.40x its sales and has operating, gross and profit margins of 7.84%, 39.72%, and 6.19%, respectively. Lastly, the company has basic earnings per share of 0.57 and ROA of 6.75% along with ROIC of 9.76%.
Comparable Companies takeaway:
I think the next logical question on anyone's mind would be, "What do all the numbers mean?" Before I answer that question, I believe it is paramount to understand what multiples are and what they signify. multiples, broadly speaking, are functions of ROE/ROIC, growth rates, cost of equity/ cost of capital, reinvestment, dividend payout and retention, tax rate, operating margins and D&A, and to try and explain why companies trade at the multiples that they trade at is a futile exercise; the most we can do try and explain it, because it is more an art than science. Having said that, what can we say about HD and where it is currently trading at, is it at premium, discount or par? I believe that the stock is currently trading at par in that the company has higher ROA compared to LOW, FND and ARHS as well as a higher ROIC than FND and ARHS but lower than LOW. Moreover, the company has basic earnings per shares (NI divided by basic shares outstanding) of 14.77 which is higher than other three companies that I looked at. HD's price can be further justified when we look at the company's margins; compared to its contemporaries, the company has higher operating and profit margins while gross margins are amongst the lowest when compared to the other three companies.
The company is trading at 18.76x its EBTIDA which is the second highest among the four companies. The company also has significantly higher FCF than its competitors as well as revenues and gross profit. Based on the comp analysis, I'd say the company is trading at par, but what about its value based on its own cash flows, expected growth, cost of capital and risk? Next we look at the company's price per share based on its discounted cash flows.
DCF Valuation
I think I am in a better position now to talk about the company's future, or my version of it.
Home Depot (HD) has been around for a minute now, and I think it is in a position in its corporate cycle where it is more concerned with returning value to shareholders rather than growth. Logically speaking, I believe what should transpire in the future is the management's intention to continue to return value for its shareholders through dividends and share repurchases, and not spend an obscene amount on its growth. I am not comfortable with the amount of debt the company has, but at the same time, it is not surprising at all because the company has a good credit profile and a storied history of operations which make the company's access to capital easy, but I believe they should now be more focused on repaying debt rather than raising more as they have done in the past; and this is because I believe the company's healthy amount of interest expense is eating away its profitability and value. I also believe that the company's double digit growth days are in the rears now, and going forward, the company should grow at a modest growth rate of 3% to 5%, with this in mind lets look over my base case assumptions.
Base Case Assumptions
Revenues: Going forward, as I stated above, I do not expect double digit growth for HD, and as such, I expect Home Depot's top line to grow from $152BB in FYE '24 to $221BB by the end FY '34. I expect the revenues to grow at a constant pace due to the company's brand and its solid position as the biggest home improvement retailer in the world among other factors. I believe the company will have to traverse the harsh waters of geo-politics as well as the current administration's efforts to re-shore everything through incentives, tariffs and import taxes.
Cost of Sales (COGS): As mentioned before elsewhere in this post, the company reported consistent numbers in terms of COGS as a % of total sales; over the last five years, HD's COGS margins (COGS divided by total sales) have hovered around 65% to 66%, and going forward, I have no reason to believe that these costs will reduce thereby improving the company's margins, and so I am estimating cost of sales somewhat in the same range for the next ten years.
Gross Profit and Margins: Given my assumptions for total revenue growth and cost of sales, I expect the company to continue to post gross profit and gross margins in line with its historical range of 33% to 35%. I believe that, for my base case, this is a conservative enough approach to assume that the numbers will not change that much from historical trends and that the management will continue to perform the way it has been up to this point.
Operating Income and Margins: As we saw in the comparable companies analysis section, HD has the highest operating margins amongst the four (HD included) companies that I looked at, and I believe this trend will continue into the future. I believe the company's operating income will increase from $21.7BB in FYE '24 to $36.3BB by the end of FY '34, and margins to improve from 14% in FYE '24 to roughly around 16% by the end of the projection period. I believe that the company has a competitive advantage and very clearly has a bargaining and purchasing power, and that coupled with its brand name, investment in technology and sophisticated supply chain should help the company improve its margins in the future.
Capital Expenditures: HD's capex is the highest in the sector and that is not surprising when we look at its top-line, its global presence, and its margins. The company has historically invested about 2% of its total revenues in capital expenditures and going forward, I believe this trend will continue. I have assumed a decent top-line growth rate and to support that growth, the company will have to continue to invest in capex; going forward, I believe the company's capex should be around 2% of its total sales for the project period.
Dividends and Share Repurchases: As I mentioned at the beginning of this section, HD is in a stage in its corporate lifecycle where it should be concerned with returning value to its shareholders, and based on that belief and assumption, I believe the company will continue to pay dividends and buy-back its own shares in line with its historical numbers.
WACC: At the time of this analysis, the company had a beta of 1.02, the market equity risk premium was 4%, and the risk free rate was 4.53% which means that the cost of equity for HD is 8.61%. This DCF is based on FCFF and not FCFE, and so I looked at the company's footnotes to try and finesse my way around its true cost of debt. I came across the company's disclosure for its outstanding debt issuances and their respective yields, and so I decided to take the weighted average of all of its outstanding debt and use that yield as my pre-tax cost of debt, which was 3.64%, giving me a WACC of 8%.
With my assumptions on the side, let's look at the company's going forward income statement:
As stated in my assumptions above, I expect the company's revenues to be around $221BB by the end of the projection period as well as gross, operating and profit margins that are in line with historical trends with slight improvements as the company moves into the future. I have also made some assumptions about the company's capex and by extension its PP&E along with its share repurchases and dividends, so let's see what the going forward balance sheet looks like.
If we were to believe my version of the future, I believe the company will continue to perform the way it has in the past; I expect a decent amount of cash balance along with current assets that are more than its current liabilities as well as consistent share buybacks and dividends in order to return value to the company's shareholders. Balance sheet is considered by many to show a company's strength as it is long-term compared to income statement which is short-term, and based on my assumptions, I believe the company will be in a solid position over my projection period. Let's now look at the company's pro forma cash flow statement.
As expected, I suspect the company's OCF will increase from $21BB in FYE '24 to $31BB by the end of FY '34, and I expect this increase to come from the company's growth in its NI as well as effective management of its working capital items. I have assumed capex of about 2% for the next 10 years and so I am expecting only modest growth in the company's FCF as shown in the image above.
With an understanding of the company's statements, I think we can finally move onto DCF. Here is a snapshot of my DCF analysis:
Based on my assumptions about the company's future top-line growth, capex, margins and its WACC, I am getting a price per share of $308.29 through perpetuity growth method and $373.04 if I were to assume an exit EBITDA multiple of 15x. The stock at the time of analysis is trading at $416.36, and based on my analysis of the company and my version of the future, I believe that the company is overvalued. In order to give some credence to my analysis, I will next try and look at the changes in price per share given variations in some of the factors that I believe impact a DCF analysis.
Sensitivity
Image 1 shows us the changes in the company's implied price per share given the changes in its WACC and long-term growth rate, and as we can see, the market is assuming that the stock is either trading at lower cost of capital and low long-term growth rate or lower cost of capital and a higher long-term growth rate, and looking at the data table, I believe that the price per share of $308.29 seems justified to me. Image 2 looks at the changes in the implied price per share given variations in terminal year EBITDA and WACC, and as we can see, if I were to assume the same WACC, the company is trading at around 17x to 18x its exit EBITDA. Let's now look at the company's price per share given changes in revenues and margins by the end of the projection period.
As we can see, given my assumptions around the company's operating margins of 16% and revenues of $221BB by the end of FYE '34, I do not even see the company's current stock price of $416.36 in the data table which means that the markets are attributing either higher revenues in the next ten years, higher margins or both, and I, frankly, am not comfortable with either of those scenarios. Image 4 shows changes in the price per share given variations in the company's WACC and its exit EBITDA.
Conclusion
In short, I believe that the company is overvalued and the markets are assigning it growth that I do not see in its future, but I guess only time will tell. As for this analysis, this is purely to satiate my own hunger for this kind of work and not a recommendation for you to buy or sell the stock; that decision I believe should only be done after you have conducted your own analysis, and to that end, I am sharing the excel file for you to play around with, and change the numbers based on what you think about the company and its sector's future, growth and risk.
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