Old Homes Don’t Renovate Themselves, according to The Home Depot

Summary

  • The Home Depot is the biggest retailer of home improvement products in the world and is expected to surpass $200 billion in net sales.
  • As more houses age, the market for renovations and repairs will continue to grow.
  • As mortgage rates rise and the housing market weakens, first-time buyers will become more picky. In order to appeal to pickier consumers, sellers will need to make upgrades.
  • The business has strong fundamentals and consistently produces adequate cash flow to sustain investments in expansion and to return to shareholders through double-digit dividend increases.

With a 17% market share in a sector with a more than $900 billion addressable market, The Home Depot (NYSE:HD) is the largest home retailer in the world. They reported +$151 billion in net sales and +$14 billion in free cash flows (FCFs) in 2021. In addition, the dividend was raised by 15%, and it is currently growing at a CAGR of 20% over the course of ten years. The company’s long-term strategic objective is to generate sales of at least $200 billion, which is undoubtedly doable given the company’s fundamentals.

Despite fundamental advantages, shares are declining due to concerns about rising rates and the potential for sluggish economic development. Contrary to popular belief, HD has a bright future in the home improvement sector. The United States’ aging housing stock is conducive to the market for repairs and remodels expanding further. Additionally, households are in a better financial situation overall and have far lower levels of debt than in previous years.

Prospective homebuyers will become more picky as interest rates rise. Older properties require maintenance, therefore sellers will need to make the renovations in order to sell their property. For long-term investors who are confident in the housing market’s continued stability, the recent dip has given a compelling opportunity.

The Lists

At the moment, HD is going for roughly $310. This is roughly 13% higher than their typical values over the past few years, but it is down about 25% from their high of $416.

In the last three months, HD has decreased by 24%, while Lowe’s has decreased by 18% and the market as a whole has decreased by only 3%.

In comparison to their historical performance both versus the larger market and Lowe’s, the decreases in HD seem excessive. On annualized returns, HD has regularly outperformed over the last 10 years. The stock has been declining recently, but it has dropped more than Lowe’s, which has typically underperformed HD or at best been on par with it.

The 50-day moving average of HD just lost ground to the 200-day moving average. This demonstrates a pessimistic attitude and can suggest that further losses are imminent. It will be crucial to keep an eye on whether the stock can hold above its resistance level on days when it advances higher. Deeper losses may result if HD keeps reversing after encountering resistance.

In terms of relative strength, HD seems to be heading toward oversold territory. It also seems that Lowe’s is like that. On the other hand, the S&P is moving upward and nearing overbought territory. Perhaps HD and Lowe’s are serving as early warning systems for the future of the market. These two stocks might perhaps actually be oversold.

Due to the drop in HD, the pricing multiple has been slightly reduced. Its P/E increased to a high of 29x in 2018. But historically, the stock has trended at roughly 23.1x. The multiple is 19.9x at the moment. The stock price would be about $360 if it were to return to its historical average.

Given that HD’s loss has outpaced that of the market as a whole, the company currently has a bearish outlook based on its moving averages. The stock, however, seems to be moving closer to oversold territory. Additionally, compared to historical averages, the current pricing multiple is lower. In previous years, HD routinely outperformed the S&P, and there are few signs that will change in the near future.

the Possibility

Through 2022, rise in expenditures for improvements and repairs is predicted by the leading indicator of remodeling activity. Homeowners are still likely to start more substantial discretionary renovations that had been put off during the epidemic, even though DIY activity is predicted to drop from pandemic-era levels. According to one projection, large projects will have double-digit growth through 2022 and 2023 before slowing down. Any DIY reductions should be countered by a growth in the PRO market, which tends to spend more than the ordinary DIYer because people spend more time away from their homes.

According to a statistic from John Burns Real Estate Consulting (JBREC), people who have previously renovated are 3.7% more likely to do it again, on average paying 11% more. Another study claims that after 15 to 20 years, 80% of a home’s characteristics become outdated. The majority of American homes are more than 20 years old, making them a desirable population for upcoming remodels.

The ability of current homeowners to access their equity to finance significant projects is as strong as it has ever been, with household net worth at all-time highs. Additionally, favorable demographics encourage further expansion of investment on improvements. Due to increasing earnings and expanding families, owners age 35 and beyond tend to spend significantly more money upgrading their homes. Then, until homeowners are close to retirement, spending stays at this high level. This suggests that there will be plenty of improvement initiatives in the years to come.

While the net worth of current homeowners has increased significantly, rising housing prices have kept many Americans from becoming homeowners. Existing property prices increased by 15% in just February. The increases haven’t yet caused a slowdown in home sales, though. According to the Mortgage Bankers Association, applications from prospective homeowners have increased for the last three out of the last four weeks.

There are worries that overall activity may slow as a result of rising rates that are expected to continue rising. For instance, the Freddie Mac weekly data indicates that average mortgage rates recently reached 4.67%. Since December 2018, this reading was at its greatest level. Rates were 3.22% at the start of the year. That would result in a yearly increase in the household mortgage payment of about $4,000 on a $400K home. Despite the rise, however, the proportion of discretionary personal income devoted to mortgage debt service payments is still at an all-time low, accounting for less than 4% in 2021.

The total amount paid to repay household debt is likewise at an all-time low. The percentage of debt is still low by historical standards even though the overall debt is on an upward trend from the lows. Prior to 2010, households were paying their debt payment with more than 12% of their disposable personal income. Since then, that has decreased to just about 9%.

HD has benefited from the rise in Do-It-Yourself home remodeling projects brought on by lockdowns linked to COVID. There is a belief that the number of people working on home renovation projects will gradually drop as more people engage in other activities outside of their homes. Increased uncertainty is being brought on by rising rates. Despite the worries, things are looking up. Consumers’ financial sheets have a solid foundation, and many of them have access to significant equity in their homes. In the United States, the number of older homes is always growing, and the majority will need modernisation to keep their value, particularly in a time of rising prices. These structural tendencies will keep working in HD’s favor.

The Foundation

Inventory dominates the balance sheet of the corporation, making up 75% of all current assets as of the end of 2021. Due to increased purchases in 2021, inventories did rise significantly. As a result of the transactions, the cash balance decreased from $7.9 billion at the end of January 2021 to $2.3 billion at the end of January 2022.

The organization consistently turns over the inventory it buys in a timely manner. The average time to sell off goods is 65 to 70 days. Inventory turnover is essential because inventories make up the majority of the company’s current assets, especially given that the low quick ratio suggests that there aren’t enough liquid assets to satisfy the company’s total current obligations.

The number of days the company needs additional funding after taking into account short-term financing from suppliers gives a good indication of the efficiency of the company’s working capital management. Cash conversion from the sale of inventories and the collection of A/R was delayed for 78 days in 2021. The business put off paying its suppliers during this time by 43 days. Thus, HD had only 35 days to cover its present working capital requirements by using cash on hand or other financing options.

From a long-term perspective, HD relies heavily on debt relative to its assets and equity. But this is not a problem. Their interest coverage ratio of 17.7x demonstrates a solid ability to satisfy their interest obligations, while their net debt/EBITDA ratio at the end of 2021 was 1.3x. Furthermore, the Z-Score of 8 indicates a 0% likelihood of bankruptcy.

The corporation has a low risk of repayment and can easily afford its interest expenses. The sums payable before thereto are evenly distributed across each fiscal year, and about 80% of the Company’s total liabilities are due after the 2026 fiscal year.

The capacity of the company to consistently produce good returns and cash flows adds to the soundness of its balance sheet. Revenue growth fell in 2021 compared to 2020 but was still double-digit. Additionally, both their net income and EBITDA margins were higher than those seen during the previous five years. Growth is anticipated to slow down going forward, although margins will still be very robust.

FCF margins decreased, however a portion of that might be attributed to the increase in inventory this year. FCF nevertheless came in at +$14B, which was lower than 2020 but 27% more than in 2019, despite the increase in inventories. Approximately +$18 billion in FCF, or 10% more than 2020 and 64% more than 2019, would have been achieved if inventory purchases had been at more normalized levels.

Significant shareholder distributions are being made possible by strong cash flow creation. Over the previous five years, dividend growth has averaged 18%, and the business still has roughly $10 billion in authorized share repurchases. The payout is less than 50% of net income and both free cash flow and operating cash flow more than two times cover the dividends, suggesting high coverage. There are currently no signs that the payouts in the future are in jeopardy.

HD has solid fundamentals overall. The company manages its working capital well, and they have enough cash on hand to meet their working capital requirements. its long-term viability is also strong, with no substantial near-term debt deadlines and little chance of failing to meet its interim interest payments. Strong earnings and large free cash flow (FCF) generation in the past serve as the foundation of the balance sheet. In addition, shareholders receive fully covered dividend payments and share buybacks from the company’s unused funds.

Optimal Share Price

To determine the intrinsic share price of HD, a number of approaches were used. The graph below presents the findings. The simplest approaches simply required multiplying the current price by the historical multiples. Target prices with a low of $292 and a high of $342 were obtained by doing this.

The results of applying models considering future cash flows ranged from $317 to $371. These models allow for the 10-Year U.S. A crucial factor in the calculations is Treasuries. The current rate, which was 2.5% at the time of research and was reported in The Wall Street Journal, was taken into account by the model because rates are expected to rise. And the analysis also used a rate of 3% for fictitious purposes.

The average target price came out to be $335 when the findings of all techniques were combined.

An additional explanation of the DDM process is given below for example purposes.

The model’s first step was to choose the discount rate that would be used. The capital asset pricing model (CAPM) was recommended for this. The risk premium—the difference between the projected return on the market and the risk-free rate—and the stock beta both affect the model’s performance. The stock’s beta, according to Morningstar, is 1.06. According to The Wall Street Journal, the risk-free rate for 10-Year US Treasuries was 2.50%. 5.5% is the historical risk premium. As a result, the market’s predicted return is 8.00%. This information was entered into the CAPM, which produced a discount rate of 8.33%.

The data pertaining to revenue and the balance sheet from the previous five years was then entered. The outcomes are listed below. Observations were made once the results were analyzed.

  • Net profit margins are around 10%.
  • Total liabilities exceed total assets by more than 100%.
  • Negative total shareholders’ equity
  • Asset turnover is 2.12 percent.

The projection for the next five years was created using the observations stated above. The relevant percentages were calculated by forecasting total revenues, total assets, net income, total liabilities, and shareholders’ equity.

The projected revenues are displayed below. The model makes the assumption that the business will achieve its target of +$200B in total net sales within five years.

The asset turnover rate of 2.12 was utilized to forecast total future assets in order to directly correlate asset growth with sales growth. The outcomes are displayed below.

One will observe that the suggested% change in total assets varies from year to year, but sales were anticipated to expand steadily each year for the purposes of this model. The CAGR of all assets was estimated to even out these asset variations. According to the model above, total assets should increase from $71,876 to $97,725 over time. This entails a CAGR of 6.34 percent. Below is a summary of the ultimate expected totals based on this growth rate.

The five-year model below was updated with the aforementioned totals. The crucial inputs needed for the continuing value calculation were the total equity and net income in year five.

One of the model’s last steps was entering historical data from the previous five years about share issuance and shareholder distributions in order to create a projection based on those averages. The conclusions of this analysis are presented in the summary below. Under their present share repurchase program, HD had around $10 billion left. According to this strategy, the remaining repurchases will take place gradually over the following five years. Additionally, HD has paid out dividends at a rate of roughly 4.5% of sales while issuing stock at a rate of around 0.2% of revenues. Both are expected to hold the same share in the future. The forecasts were created using these averages, and they were then discounted at a rate of 8.33%.

The total of the above net shareholder payouts was added to the continuing value, which was computed using a 4% expected growth rate.

The model’s output, as can be seen above, produced a result of $357. An average price objective of $335 is fair when combined with the multiples technique.

Principal Risks

The stability of the housing and home improvement markets, as well as overall economic conditions, have a substantial impact on HD’s financial performance. A consumer’s confidence or financial situation may be negatively impacted by unfavorable or uncertain conditions in the housing market or the broader economy, which may lead them to decide not to buy products and services for home improvement or reduce their ability to pay for those products and services.

Lumber and other raw materials are among the commodities with variable prices that are influenced by a variety of external factors, including supply and demand, inflationary pressures, rivalry, and market speculation. If the company is unable to pass on the increases to their customers, significant rises in the cost of these inputs could have a detrimental effect on the business.

Supply chain interruptions could negatively impact HD’s capacity to receive and distribute their product in a timely way in addition to increased input costs. If the business decides to use expedited delivery, this could lead to higher transportation costs. It could also lead to unhappy consumers if their orders are not delivered promptly or if the items they require are frequently out of stock. This could lead to a loss of future business with both current and potential clients.

Conclusion

The current HD decreases seem exaggerated. The stock has historically outperformed the other markets, but during the last three months it has fallen 24%. Credible worries include the prospect of rising rates and a deteriorating economy. Another likely reality is the slowdown in DIY projects following the boom in activity over the previous two years. Despite the dissatisfaction, things are looking up.

For the next two years, the home renovation industry is expected to stay stable. Additionally, the majority of American homes are now of an age that supports the market for repairs and remodeling. Homeowners will have access to record equity in existing homes as a source of funding for larger repairs that were postponed owing to COVID. The PRO market, which will spend more than the typical DIYer, will be hired to complete these projects. Additionally, as younger generations age and move into their later years, there will be a corresponding rise in housing demand.

HD’s basics are solid enough to seize fresh possibilities or overcome any obstacles that may come up in the near or far future. The business is good at managing and allocating its working capital, and it routinely produces positive free cash flows, which has been a strength that has benefited shareholders for a long time. For new and existing shareholders, the recent large share price decrease has provided an opportunity to anchor their portfolios with this market leader in home improvement.

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