Stay At Home Trade Intensifies
The Home Depot (HD) again blew away the sales estimates in their Q2 results, reporting 23.4% growth in the quarter and 15.9% for the half year. For comparison, recall that the original full-year guidance issued on February 25 before the COVID-19 pandemic got serious was 3.5%-4.0%. Even analyst estimates heading into the quarter averaged only 10.9% sales growth. This was achieved even as the retailer took precautions against COVID-19 especially earlier in the quarter such as reducing store hours, limiting customer occupancy, and cancelling seasonal promotions. Investments in the online sales channel including fulfillment options such as delivery from stores and adding curbside pickup continued to pay off, with triple-digit sales growth numbers for the online channel. Management noted on the earnings call that overall sales growth was strong with both Pro and DIY customers and across nearly all product categories.
The strong sales growth enabled Home Depot to continue rewarding their employees for their efforts in the pandemic. Added benefits including weekly bonuses for hourly associates at stores and distribution centers cost $480 million in the quarter, bringing the first half total to $1.3 billion. The increase in SG&A on a percentage basis was in line with the growth in sales, leaving operating margin little changed compared to last year. Interest expense was also up due to higher debt levels and tax rates were similar. Overall, there was little positive operating leverage from the added sales, but at least the strong sales growth translated into similarly strong net income growth.
Source: Home Depot 2Q 2020 Infographic
Recall that when the pandemic hit, Home Depot made some conservative moves to ensure liquidity. This included net debt issuance of around $4 billion in Q1 as well as stopping share buybacks after completing only about $800 million worth of purchases, a lower amount than prior years. The company also generated strong cash flow from working capital so far this year including a $1 billion reduction in inventory, almost $4 billion growth in payables, and $1 billion growth in accrued salaries. Free cash flow year to date is $13.8 billion, more than double net income. The retailer now has $14.1 billion of cash on the balance sheet compared to just $2.5 billion a year ago. Home Depot’s cash flows are typically seasonal, with stronger FCF in the first half of the year. The current cash balance will come down somewhat in 3Q as working capital builds again. Still, the company will have ample cash to pay down $2.5 billion of debt due in the next year as well as resume buybacks.
Management was emphatic that sales would be hard to forecast for the rest of the year due to the unknown path of the COVID-19 pandemic. Still, sales growth in August is in line with the 2Q average. Even with this strong growth, the stock’s run from the $245 area to the current $285 which began in mid-July more than prices in an improved forecast. Assuming a sales growth of 15% in the back half of 2020, only about one percentage point below the 1H 2020 actual growth, results in an EPS estimate of $11.64 and a forward P/E of 24.5x. That represents multiple expansion from the 22.4x the estimate of $10.65 and price of $238.19 that existed at the time of my last article in May.
Home Depot could be entering a new growth phase driven by “de-urbanization” of the Millennial generation as the work from anywhere trend grows in the aftermath of the pandemic. The experience that customers gained with DIY projects during lockdowns may also translate into demand growth going forward. Nevertheless, 2H 2020 estimates are already uncertain before factoring in more uncertain longer term growth assumptions. While I could have been more bullish last quarter, shares look like they need to take a breather here until the forecast becomes clearer. I am staying long HD but maintaining my Neutral rating.
Growth Forecast Improves
I updated the earnings model that I used in my last two articles with 1H 2020 actuals and assuming 15% sales growth in 2H 2020 compared to the prior year. This would be a modest reduction from the 15.9% sales growth seen in 1H 2020. It is not a management forecast but a projection that allows for some slowing from the 23.4% growth in 2Q. It assumes demand patterns start to normalize as other uses of disposable income become available as they slowly reopen from the pandemic. I assumed gross margin and operating margin in line with 1H 2020. Note that this would require an absolute reduction in SG&A of about $1 billion compared to 1H 2020. The company would likely have to phase out the enhanced employee benefits it has been paying since the start of the pandemic in order to deliver that savings. Interest expense and tax rate are assumed in line with 1H 2020 and no buybacks are assumed. These assumptions result in an EPS estimate of $11.64 for FY 2020, a 13.6% improvement over 2019 actuals.
This 2020 estimate is also 9.5% better than the $10.65 base case from my May article. Since that time, the stock is up more than double the EPS estimate: 19.7% growth from $238 to $285. This implies some multiple expansion in addition to the earnings increase. The multiple expansion suggests that the market sees the potential for earnings growth to remain strong coming out of the pandemic. One thesis supporting this was discussed by management on the call that customer engagement increased, especially with the online channel. Newly acquired customers have also been coming back for another purchase.
“During the second quarter, new and existing customers set record levels of engagement across our new capabilities. The rate at which our existing customers are adopting new channels to engage with The Home Depot more than doubled here today. And we also saw a third of recently acquired customers reengaged with The Home Depot for another purchase in a different department.”
Source: EVP of Merchandising Ted Decker, Home Depot 2Q 2020 Earnings Call
Another thesis is linked to more general demographic trends. Millennials have been aging and moving into larger homes in the suburbs. This trend may be accelerated by COVID-19 as city dwellers, freed up by technology to work from anywhere, look to escape the crowding and social unrest of dense urban areas. More time spent at home also leads to remodeling projects for home offices, exercise and play areas, and gardening and landscaping.
Even with these favorable trends, the 23.4% 2Q sales growth seems unsustainable. Even 15% growth would be remarkably better than the mid-single digits seen before the pandemic. Given the recent run in the stock price, it is not surprising that HD was down about 1% on the day it reported and further consolidation of recent gains is possible. On the upside, the cash boost from 2Q alone could fund resumed buybacks or a generous dividend increase in 2021. I considered the shares above fairly valued in May before seeing how much the stay-at-home trend would help the company. With the stock up 20% since then, a higher earnings estimate and growth rate is still built into the price. For that reason, the stock is still a hold. For some margin of safety, I would use a buy target of $245, or about 21 times my latest base case earnings estimate. The stock needs to demonstrate continued high growth after the pandemic to warrant even higher multiples.
Home Depot performed impressively during the pandemic using improvements in the online channel to help meet surprisingly high demand. This strong sales growth helped to cover higher employee costs while maintaining margins. The company will need to get costs back down as working conditions and demand normalize after the pandemic. It is too early to say if longer term demographic trends can put Home Depot back on the path of double-digit sales growth. Current market pricing seems to reflect too much confidence where there is actually still uncertainty.
Home Depot shares blew through their all-time high in late July. Some consolidation is in order as uncertainty still remains about the path out of the COVID-19 pandemic. As a long-term holder from a lower basis, I am happy to hold the stock and continue collecting the safe and growing dividend. While I am raising my fair value estimate considerably, I rate the shares at Neutral and would not add above $245.
Disclosure: I am/we are long HD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.