2 Q Newsletter – July 2023

Home Depot (HD)

In case you haven’t noticed, we are long-term investors. Quarterly earnings are important, but we are not going to sell a core holding because of a single disappointing quarter. One of our core stocks, Home Depot, recently reported disappointing first quarter earnings on May 16th.  Sales were down 4% and earnings down 7% compared to the prior year.  Wall Street was disappointed and the stock dropped $10 (granted, the stock price is trading in the $300 range).

Keep in mind, HD caters to the housing market and when interest rates rise, house prices weaken.  Over the last couple of years, inflation in building materials has been all over the map.  As an example, framing lumber skyrocketed to $1,450 per thousand board-feet in the first quarter of 2022, only to fall to $420 this quarter.  The 4% drop in sales looks pretty good compared to the 71% drop in framing lumber.

15 years ago I was listening to HD’s quarterly earnings call.  The Chief Financial Officer was Carol Tome.  I think she may have been the smartest CFO I have ever heard.  She answered every question with precise statistics and explained to the analysts if there was a better way of looking at something, if their questions were going in the wrong direction.  She truly understood HD.

15 years ago, HD was in the final year of building many new stores, trying to keep up with Lowe’s, who was doing the same.  By the way, these two competitors have only 40% of the building materials market, so there is plenty of the pie still to consume.  Carol Tome then redirected HD’s cash flow from building new stores to purchasing HD’s stock.

The following chart shows HD’s store growth for the last 25 years.  As you can see, the number of stores plateaued in 2008 at a smidge under 2,300.

The next chart shows sales per square foot for the same period.  How impressive is this?  Sales per square foot increased from approximately $300 to over $600.

Instead of using the increased profits to build more stores, Carol repurchased shares of the company’s stock. The chart below shows the company’s cash flow numbers per share in more detail. Cash flow is the cash the company earns from its ongoing business operations. Free cash is cash from operations subtracted by capital expenditures. One possible use of that free cash flow is then to reward shareholders with stock buybacks and dividends. Over the last decade, Home Depot has consistently rewarded shareholders by increasing the dividend and buying back stock.

The figures underneath the chart show Carol’s real genius: she continually bought back stock and reduced the number of shares outstanding by over 40%.

Double the sales per square foot and nearly halve the shares outstanding.  Bottom-line, as a shareholder I am pretty happy, and this is before even mentioning the dividend (which should soon have grown 1,000% from 2008).

The next graph is the stock price for the last 5 years.  In December of 2021 the stock was over $400.  Today it is bouncing around $300.  At $400, you had a 25 P/E ratio and dividend yield of 2%.  Today, the P/E is 18 and the dividend yield is 2.8%.

Source: Bloomberg, Monarch Capital. Data is from June 15th, 2018 – June 15th, 2023.

Undoubtedly, the stock price will continue to bounce around with quarterly earnings and news from the housing market. From a more macro viewpoint, one area that gives us some comfort is the secular demand drivers that should support home improvement spending over the long-term. Home improvement spend has historically had a strong correlation with home price appreciation, age of housing stock, and disposable personal income.

If we look at home price appreciation, we can observe that national home prices increased very quickly during the pandemic (up over 40%), so it would seem likely there may be some broad-based declines in home prices, at least in the near to medium term. With that said, homeowners still currently have a near record amount of equity in their homes, approximately $330,000 on average. Housing represents a primary way in which most Americans build and store wealth. Homeowners oftentimes think of their home as a long-term investment. As consumers see the value of their investment grow, they are inclined to invest more. In addition, consumers with fixed-low interest rate mortgages will look to improve what they own, rather than trade up. Both of these features should be supportive of continued home improvement investment. 

Although it would not be a huge surprise to see home prices decline over the next couple years, there seem to be a number of elements making cascading price declines unlikely. For instance, more than 90% of homeowners either own their home outright or are locked into a low fixed rate mortgage (insulating them from rising rates). In addition, there has been a persistent undersupply of homes the last decade (see chart on next page) and 250,000 first-time millennial homebuyers are also expected per year through 2025. Current Home Depot CEO, Ted Decker, recently stated that, “There is a fundamental shortage [of U.S. houses]…You are looking at 10 years in a best case scenario, to address this supply / demand imbalance in housing.” Furthermore, lending standards have been reasonably solid (mortgage originations credit scores are significantly better than the lead-up to 2008-2009). These all would appear to support the premise we will not see a surge in distressed sales, which would then lead to larger price declines. 

Source: U.S. Consensus Bureau, Lincoln International

The second secular driver that is likely to drive a remodeling wave down the road is the aging of housing stock. The average age of homes in the U.S. is over 40 years old and the additional homes built during the housing boom of the mid-2000s will be entering prime remodeling years around 2025. The average age of U.S. housing stock is one of the key reasons why Marvin Ellison, the current CEO of Lowe’s, believes that approximately 2/3 of home improvement spend is nondiscretionary on repair or maintenance projects that cannot be delayed for long.

Source: U.S. Consensus Bureau, Home Depot Investor Presentation

The last factor that has historically had a strong correlation with home improvement spending is disposable personal income. Disposable personal income has remained strong while consumers were also able to accumulate an estimated $2.1T in excess savings during the pandemic due to unprecedented stimulus coupled with closures of key sectors like travel, entertainment, dining out, etc. Since that time, a large amount of those excess savings have now been drawn down, which has likely supported home improvement demand to some degree. Although the total amount of disposable income and the percentage of it spent on home improvement is certainly up in the air in the near-term, there is a clear trend of real disposable income growing over time. It would seem reasonable that a relatively steady share of this would go into home improvement as a majority of home improvement spend is used on repair and maintenance projects. 

What happens near-term in the home improvement industry is anyone’s guess as there are so many unknown future variables – mortgage rates, the unemployment rate, economic growth, wage growth, uses of disposable income, etc. We are not trying to forecast what happens next, but rather show some of the longer-term drivers that should support Home Depot’s business over time. Carol retired from HD in 2019, but her successor has continued the strategy of increasing productivity and using the funds to reward shareholders. We hope this strategy pays dividends for years to come, even though there are sure to be bumps in the road ahead.   

Written by David Meyer