Home Depot: Wait Until Home Sales Are Picking Up

Summary:

• The quarterly results and 2023 forecast released by Home Depot were below expectations.
• Particularly discouraging was the fall in comparable sales, which also occurred after the financial crisis in 2008.
• For the long term, Home Depot remains an attractive investment because of its low stock volatility and high return compared to the S&P 500.
• The stock price is currently quoting very attractively, but uncertainty keeps me on the sidelines before making an investment.

Introduction

Home Depot (NYSE:HD) expected 2023 to be a year of headwinds in consumer discretionary sales. The recent quarterly numbers show this strongly; the sales decline was much higher than what analysts predicted.

I previously gave Home Depot a hold rating in my September 2022 coverage because of the soft housing market. Home Depot is the largest player in the U.S. home improvement market, while Lowe’s (LOW) is a smaller competitor. Both have benefited greatly from the housing boom since the COVID-19 pandemic. Between fiscal year 2019 and now, Home Depot’s sales are up as much as 45%. It remains to be seen how the Federal Reserve’s interest rate hike and the housing market’s headwinds will affect Home Depot’s sales growth for the coming years. I expect further headwinds in 2023 and perhaps in 2024.

If we zoom out to the big picture and just look at the stock price, I see many positives. The combination of low volatility (beta = 0.93, low risk) and high returns compared to the S&P500 are very favorable.

The recent drop in stock prices has made its stock valuation attractive. But the uncertainty surrounding the housing market keeps me from taking a position. For now, the stock is a hold.

First Quarter 2023 Earnings

Earlier, CEO Ted Decker indicated that 2023 will be a year with headwinds. In the fourth quarter of 2022, sales were virtually flat year-on-year. Notable was the 0.3% year-on-year decline in comparable sales, the first since the third quarter of 2009.

First-quarter earnings came in very weak and the outlook for 2023 has also been revised downward. Figures for the first quarter of 2023 were below par with a sharp 4.2% year-on-year sales decline, quarterly sales came in at $37.3 billion. Comparable sales fell 4.5% and U.S. stores had negative comparable sales of 4.6%. Adjusted earnings per share fell 6% to $4.09 per share.

The sharp decline in sales was primarily due to lumber deflation and unfavorable weather conditions. Where the weather was good, Home Depot saw strength in key spring-related categories such as live goods and other garden-related categories. Home Depot saw strength in project-related categories such as building materials, plumbing and hardware, but many departments had negative comparable sales in the quarter. Home Depot expects pressure in a number of key discretionary categories to continue in the coming period. For 2023, therefore, it expects comparable sales to decline between 2% and 5%, and operating margin between 14.3% and 14% with which earnings per share are expected to decline between 7% and 13% year-on-year.

For the long term, CEO Ted Decker remains positive:

While the near-term environment is uncertain, we remain bullish on the medium to long-term outlook for home improvement and our ability to grow share in this large and fragmented market. We look forward to sharing our perspective on the many opportunities ahead when we meet at our Investor and Analyst Conference coming up on June 13. Our team continues to focus on what is most important, our associates and customers. Our merchants, store met teams, supplier partners and supply chain teams did an outstanding job delivering value and service to our customers throughout the quarter.

Housing Market

Home improvement stores like Home Depot and Lowe’s rely heavily on the housing market. Many new homeowners renovate their homes and that boosts Home Depot’s sales. The opposite is true when home sales are falling, as they were during the financial crisis of 2008; Home Depot reported a drop in sales of more than 7%.

After the COVID-19 pandemic, interest rates dropped, which boosted home sales and the home furnishings industry. Home sales have dropped significantly as interest rates have risen recently.

As the following chart shows, home sales are at historically low levels, similar during the Great Recession. Since February of this year, home sales have been picking up, but I don’t expect this to return to pre-2019 levels anytime soon because of sharply increased interest rates.

But now, for the first time in two years, inflation has dropped below 5%. Officials raised the Federal Funds Rate by 0.25% in May to a new target range of 5% to 5.25%. They expect borrowing costs to peak at this point, suggesting that rate hikes will stop soon. This is good news for home sales because interest rates will fall as we enter another recession.

Dividends and share repurchases

Home Depot’s dividend payments have increased over the years, in line with the company’s earnings per share growth. Currently, the dividend yield is about 2.9%, and dividends have risen an average of 11.8% over the past 3 years. For 2024, analysts expect an increase of about 7%.

In addition to paying dividends, Home Depot also repurchases shares for an amount greater than the distribution of dividends. Share repurchases are a tax-efficient way to distribute cash to shareholders compared to the distribution of dividends. The free cash flow generated by Home Depot is 11% lower than the total amount received by shareholders in the form of dividends and share repurchases. This indicates that cash and/or debt is being used to partially finance the company’s dividends and share repurchases.

Net debt has increased significantly from $27.4 billion in 2019 to $40.3 billion currently. However, interest coverage is still at a safe level of 14.9. The $15 billion share repurchase program is still ongoing and the company has repurchased about $2.8 billion over the past 2 quarters. So the remaining buyback yield is 4.2%.

Valuation

Investors were already aware of the lower expectations for 2023, the share price has fallen significantly as a result of which the valuation of the stock seems attractive.

Because of the significant amount of debt, I prefer to include cash and debt in the stock valuation. The EV/EBIT ratio thus seems an appropriate ratio to map to the stock valuation. With the current EV/EBIT ratio of only 13.8, the stock is undervalued by about 22% compared to the 3-year average.

Another well-known ratio to chart stock valuation is the PE ratio. However, this ratio does not include debt and cash in the valuation. The PE ratio is currently quoted at a small discount compared to the 3-year average. Despite the subdued outlook, analysts expect average earnings per share growth in the coming years beyond 2023. The PE ratio for 2026 looks attractive at 17 compared to the 3-year historical averages. Still, investors should be cautious now that Home Depot further downgraded earnings expectations last quarter. In my opinion, the best time to make an investment in Home Depot is when home sales are on the upswing, which should happen after the Federal Reserve lowers interest rates.

Conclusion

The quarterly results and 2023 forecast released by Home Depot were below expectations. Particularly discouraging was the fall in comparable sales, which also occurred after the financial crisis in 2008. The disappointing home sales caused lower spending in consumer discretionary sales. Home Depot expects this trend to continue in 2023 and assumes a decline in sales and adjusted earnings per share. The stock price is currently quoting very attractively, but uncertainty keeps me on the sidelines before making an investment. The ideal buying moment is when home sales are rising. Therefore, it is important to keep a close eye on interest rates over the next few years. We expect an increase in home sales when interest rates fall. For the long term, Home Depot remains an attractive investment because of its low stock volatility and high return compared to the S&P500. But for now, I will wait until there is more certainty about the company’s future growth.

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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.

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