We’ve discussed here on The College Investor the belief that the housing market is going to rebound. And one of the top ways to play it is to look at home remodeling companies, specifically Home Depot and Lowes. Today, let’s look at Home Depot (HD).
Home Depot shareholders are undoubtedly enjoying their rollercoaster ride on a coaster that has, so far, only gone up.
The company finds extraordinary success in its brick and mortar, category killer stores that sell everything from screwdrivers to storage sheds. Year-to-date, the stock is up 15%, 5% more than the S&P 500 index.
The Promise in Home Depot
Home Depot is more than just a cyclical play. While the company does best when real estate prices are high and rising, it’s also a go-to place for repairing and upgrading existing homes.
Here’s what I find attractive about Home Depot’s business:
- Home Depot Dominates Distribution – Home Depot’s business model and competitive edge live and die on the company’s distribution. Products you find in a home and hardware store aren’t the kind of thing you’d buy on Amazon and ship to your home. They’re heavy, expensive, and require some kind of in-depth research – the kind of research that requires a hands-on look. Home Depot’s 2,256 stores across North America give it an edge when it comes to scale and shipping products from one geographic area to another.
- Home Depot Lacks Competition – Save for an also-ran, Lowe’s, Home Depot really doesn’t have much competition as a category killer. Even if we give Lowe’s an upgrade and call it a true competitor in the space, Home Depot is at worst competing with one other national chain. A duopoly is good for profits as it limits price competition. Smaller hardware stores have, for the most part, been swallowed up or shuttered in real estate downturns.
- Home Depot Focuses on it’s Strengths – Home Depot recently sold off parts of the business that it didn’t see in its future. It sold the professional supplies business in 2007 and then later closed a retail business that didn’t fit its big-box shape. Home Depot recently decided to close its Chinese operations as well, figuring its opportunity in the developed world – where it had already found incredible success – was the place it should focus its intentions.
The company’s position in big box retail couldn’t be stronger thanks to its distribution network and strength from competitors. While I can see a future where much of Walmart’s products are competitively priced at online stores like Amazon, I find it difficult to believe shoppers will ever want to buy a new kitchen sink or toilet bowl online rather than at a local hardware store.
A Company That Pays Shareholders
All too often companies forget about who they really work for: their shareholders. Home Depot hasn’t forgotten about investors, and has spent much of its history paying out dividends and buying back stock.
Home Depot recently announced an increase to its dividend (now 39 cents per share, per quarter) as well as a repurchase program worth as much as $17 billion by the end of fiscal 2015. Since 2002, the company has repurchased nearly 1 billion shares for a total of $37.5 billion in repurchases.
At the current valuation, Home Depot could shrink its share count by an additional 16% after slashing shares outstanding by roughly 40% in just the past decade. All the while, Home Depot continues to reward investors with more and more cash dividends while shares outstanding shrink rapidly.
The company also said that it expects to seek to maintain a 50% dividend payout ratio. Seeing as the company generates substantially more free cash flow than it does GAAP earnings (thanks to a disconnect between accounting depreciation and capital expenditures) the company should be able to maintain its dividend policy with ease, even after a recent increase in quarterly dividends.
Home Depot: A Good Company at a Fair Price
Good capital allocation isn’t usually met with a low valuation.
Home Depot is a slow grower, adding only 9 new stores in 2013, and expecting only 3% in comparable sales growth. Free cash flow should grow slightly faster than sales thanks to some margin expansion as fixed costs are spread out through higher sales volume.
However, slow growth doesn’t necessarily show in the company’s valuation. Home Depot trades at 17 times forward earnings estimates, and about 16 times expected 2013 cash flow.
This isn’t a super cheap value stock by any means, but as a very obvious leader in the space, with a moat in the form of unmatched distribution, long-term shareholders are unlikely to frown at the company’s performance over the long haul. There’s still upside in a continued improvement in home sales and prices, as one can assume there is still pent-up demand from delayed home improvements and maintenance.
Long term investors will also enjoy the natural lift in the stock price as the company spends heavily to repurchase shares. Assuming a base case of about $5.5 billion in free cash flow and 3% annual growth, Home Depot stands to reward shareholders with roughly 8.5% returns in the long haul – not outstanding by any measure, but its results are likely more reliable than your average ticker symbol.
What are your thoughts on Home Depot and exposure to real estate plays?