Investment Thesis
Home Depot (NYSE:HD) had a poor quarter and the management’s guidance for FY23 wasn’t rosy either, in my opinion. In this article, I argue why, despite having some strong catalysts for long-term growth, the current macroeconomic climate together with its valuation doesn’t suit well for the company.
A Snapshot of Q1 Performance
The company had a subdued first quarter, with revenues coming in at $37.36 billion, declining 4.24% year-over-year, and missing estimates by $1.09 billion. EPS came in at $3.82, which represents a year-over-year decline of 6.6%, albeit being largely in line with analyst estimates. Management, as a result of the poor Q1 performance and uncertain macro conditions, now expects FY23 sales and comparable sales to decline between 2% and 5% respectively. They also guided to a 7 to 13% decline in FY23 EPS.
The poor performance in the first quarter and the reduced guidance could be primarily attributed to the moderating demand being witnessed in the home improvement market, driven by Fed’s interest rate cycle and dampening consumer demand. Management, however, did reiterate that the long-term health of their customers continues to remain intact, which, in my opinion, was insignificant and looked like a reassuring message to existing investors.
Falling Lumber Prices: Short-Term Blip or Long-Term Headache?
One of the key factors that adversely impacted the company’s Q1 performance was falling lumber prices. Management, during the earnings call, mentioned how framing lumber prices had fallen to $420 per 1000 board feet during the first quarter, a precipitous fall from $1,170 per 1000 board feet, where it was trading during the first quarter of FY22. Prices have further fallen to the sub-$350 levels since then, and according to Trading Economics, are expected to fall even further to approximately $290 in the next twelve months. While this is an element that was factored by the management in their updated guidance, given that they see a further pressure from lumber deflation to the tune of 120 bps in Q2, the forecast for lumber prices in the next twelve months do not look good for Home Depot.
The other factor, which was detrimental to HD, was the bad weather experienced in the West, especially in California. This element appears to be a blip rather than anything structural, as despite the company’s Pro business being a victim to the bad weather, the developments initiated by the company combined with the growing levels of spending seen in this category should more than make up for the lost sales in the long-term.
Reluctance of Homeowners to Move: Is there a Silver Lining for Home Depot?
In the week gone by, there were some positive developments for Home Builders, a category crucial to HD. The National Associate of Home Builders/Wells Fargo Housing Market Index rose 5 points, the fifth straight monthly increase. Despite the improvements seen in the housing sector, it continues to remain under pressure as a result of elevated mortgage rates.
There might be a silver lining for HD amidst all the negativity. Given the high mortgage rates, homeowners who bought homes during the period of low mortgage rates, are reluctant to move. According to Realtor.com, the number of new listings in April fell 21% year-over-year. With consumers continuing to spend more time in their homes, albeit not as much as they did during the pandemic, and their reluctance to sell, together would suggest that remodelling opportunities are set to increase.
An increase in remodelling/repurposing activity is more than likely to aid both the Pro and DIY segments of HD, which further bodes well for the long term.
Home Depot Continues to Remain Generous with Respect to Dividends
Despite the negative catalysts in the form of macroeconomic uncertainties, the company continues to return capital to shareholders in the form of dividends and buybacks. During the quarter, the company paid approximately $2.1 billion in dividends and initiated $3 billion of buybacks.
The company recently announced a quarterly dividend of $2.09 per share, which translates to a forward yield of 2.83%, in line with the likes of Dick’s Sporting Goods and Target. The healthy yield should, to an extent, cushion the short-term pressures arising from macro headwinds.
Valuation
|
Forward P/E Multiple Approach |
|
|
Price Target |
$314.00 |
|
Projected Forward P/E multiple |
20.5x |
|
Projected Forward PEG Ratio |
9.33 |
|
Projected Earnings Growth Rate |
2.20% |
|
Projected FY24 EPS |
$15.33 |
Sources: Refinitiv, HD’s Q1 Earnings Report, and Author’s Calculations
The company, as I mentioned earlier, now sees FY23 EPS declining from 7 to 13%. I have taken the midpoint of the guidance, which implies a decline of 10%, thereby resulting in an FY23 EPS of $15.07.
The company currently trades at a forward P/E of 19.1, according to Refinitiv. Historically, the company has been trading at a forward P/E of 20.5, which is the multiple I have assumed.
The company has a PEG ratio of 9.33, which results in a projected earnings growth rate of 2.2%. At this growth rate, the projected FY24 EPS comes to $15.33.
At a forward P/E of 20.5 and a projected EPS of $15.33, we would get a price target of $314, which represents an upside of only 6.4% to the closing price on 18th May 2023.
Risk Factors
In addition to falling lumber prices and bad weather, there’s also a greater risk of the economy entering a period of strong slowdown, if not a recession.
Furthermore, layoffs continue to be a recurring theme, especially in the tech sector, which would further restrain consumers from spending on big-ticket items.
Finally, there’s always the threat of the Federal Reserve surprising the market with more rate hikes, which could further push up the already elevated mortgage rates.
Concluding Thoughts
There are far too many uncertainties when it comes to Home Depot. While long-term fundamentals remain intact, and while the dividend yield is healthy, in the medium-term, the elevated mortgage rates together with continued macro uncertainties (threat of a recession, falling lumber prices, etc.) makes me uncomfortable to invest in the stock.
Add to it the limited upside from current levels, and HD falls in the category of “wait-and-watch.” If the U.S. homeowners are doing this at present, then I see no reason why potential HD investors shouldn’t either.
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