Investment Thesis
Last time I wrote about Home Depot (NYSE:HD), I talked about how the current macroeconomic climate was putting pressure on the company. In this article, I dissect the company’s Q3 numbers and highlight the key takeaways from what was yet another subdued earnings report.
A Snapshot of Q3 Performance
Home Depot had an unimpressive third quarter despite both the top and bottom lines beating analyst estimates. Revenues came in at $37.71 billion, declining 3% Y/Y. EPS came in at $3.81, which represents a Y/Y decline of 12.2%. Management re-adjusted the guidance on the downside, with revenues now expected to decline between 3 and 4% compared to FY22 and diluted EPS expected to decline, on a Y/Y basis, between 9 and 11%.
Home Depot Switches Focus Towards Pros: Is It Going to be Enough?
One of the major takeaways from the third quarter earnings was that the company is switching its focus from DIY customers to Professionals such as contractors, as the former continues to see increasing pressure in a high-interest rate environment. Management, in their prepared remarks, indicated that they continued to see engagement with smaller projects but demand remained subdued for big-ticket items, a trend very similar to what was observed during the company’s second quarter. This was further reaffirmed by the October retail numbers, which showed that the building materials and garden equipment categories were down 5.6% Y.Y and 0.3% M/M.
According to HD management, the Professionals segment has an addressable market of approximately $475 billion, and with the company having little share in the market, management has planned to focus their innovation towards this segment.
Furthermore, within the Pro segment, the company is planning to release products that cater to those professionals who work on complex projects, who are more likely to “reserve product, use trade credit, and have products delivered to their job site in a staged manner.”
There is a lot of sense in the company switching its focus towards the Professionals. According to UBS, the Pro segment accounts for about half of HD’s revenue and at a time when the Fed has indicated that interest rates are going to stay “higher-for-longer,” the average US consumer is unlikely to spend freely on big-ticket, discretionary items. On the other hand, Professionals should continue to spend, even during this turbulent environment, given how necessity-driven it is.
Having said that, there are factors that could throw cold water on HD’s strategy. For instance, while overall home improvement demand has stayed up, even during this period of higher rates, professionals within the remodelling segment have a preference for smaller projects that cost under $20,000. According to the third quarter numbers of National Association of Home Builders’ remodelling market index, re-modelers were the most pessimistic towards large projects that cost $50,000 or more.
So, while the shifting of focus towards professional segment is the right thing to do in the current market, the strategy, in my opinion, is not going to be either straightforward or guaranteed for HD.
Deployment of Machine Learning Should Allow HD to Be More Efficient
In an environment that remains unfavourable, it is vital, in my opinion, that companies look for moves that make them efficient. And HD is doing just that with some help from machine learning. During the earnings call, recently promoted Senior Vice President Ann-Marie Campbell announced that the company has recently rolled out new tools in the form of Sidekick and Computer Vision. While the former notifies HD employees about areas where on-shelf-availability is low, the latter, which uses machine learning, allows employees to quickly find de-palletized product in the overhead.
The company has deployed both Sidekick and Computer Vision across all U.S. stores and is already seeing significant improvement in on-shelf-availability. This is a positive development, especially during a time when sales are under pressure. The company, therefore, needs to deploy these tools outside the United States at the earliest in order to maximize efficiency. For now, this is a great start.
No Plans to Cut Down Dividends and Repurchases
The environment might be murky, but HD’s management clearly indicated that there were no plans of alter their capital allocation. This should be music to the ears of income-loving investors. The company has already undertaken $6.5 billion worth of repurchases to date and hinted that they have every intention of doing more, especially with respect to repurchases, for the foreseeable future.
Valuation
|
Forward P/E Multiple Approach |
|
|
Price Target |
$314.00 |
|
Projected Forward P/E multiple |
20.5x |
|
Projected Forward PEG Ratio |
5.54 |
|
Projected Earnings Growth Rate |
3.7% |
|
Projected FY24 EPS |
$15.30 |
Sources: Refinitiv, HD’s Q3 Earnings Report, and Author’s Calculations
The company, as I mentioned earlier, now sees FY23 EPS declining between 9 and 11%. I have taken the higher end of the guidance, given that the demand continues to remain under pressure. A decline of 11% would result in an FY23 EPS of $14.75.
The company currently trades at a forward P/E of 18.3x, 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 forward PEG ratio of 5.54, which results in a projected earnings growth rate of 3.7%. At this growth rate, the projected FY24 EPS comes to $15.3.
At a forward P/E of 20.5 and a projected EPS of $15.3, we would get a price target of $314, which represents an upside of only about 3% from Tuesday’s closing price.
Risk Factors
The main risk factor affecting HD is if the weakening seen in the professional segment accelerates. This would cause a major problem for the company, especially since the DIY segment is unlikely to see any improvements for the foreseeable future.
In the quarter gone by, the company saw its SG&A expenses jump 17% and the stock-based compensation expenses saw an increase of 5%. These figures might not be worrying yet, but it is vital that the company keeps a check on these expenses in the current environment.
Concluding Thoughts
To conclude, Q3 earnings showed that the company is facing major headwinds, especially in the DIY segment, as the US consumer continues to put off spending on big-ticket items in a high-interest rate environment. The company has made the right call in deciding to switch focus towards the Professional segment, although this segment has also started to experience some weakness as well. The positive development is that the company is taking steps to ensure that it remains efficient in this turbulent environment, thanks to tools such as Sidekick.
The company has also no plans to step away from paying dividends or undertaking repurchases, which suggests that the management believes that they have the ability to weather the storm.
From a valuation perspective, however, there is limited upside, in my opinion, from current levels. And as such, it is better to wait for a meaningful pullback and for the dust to settle so that there is some clarity on how the macroenvironment would be for this retail giant.
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