Stock Home Depot: exceptional result and healthy outlook (NYSE:HD)

Investment thesis

Home deposit (NYSE: HD) is the leading home improvement retail company with over 2,300 locations in all 50 states of the United States, Canada and Mexico. Home prices have risen steadily over the past few decades, and The Home Depot’s footprint and revenues have grown. Leveraging their economies of scale and strong supplier relationships, The Home Depot has been able to provide excellent service to homeowners and professional contractors at low prices. Since my last coverage of HD, management offered a weaker-than-expected guidance in the last earnings call, which sent the stock price plummeting. The decline was further exacerbated by recent market volatility. However, I think this is a market overreaction, and Home Depot remains a solid investment for the long-term investor because:

• Results for Q4 2021 and all of 2021 were exceptional, demonstrating the strength of the business and Home Depot’s competitive advantage over its competitors.
• Home Depot’s future outlook remains strong due to rising home prices and strong demand for home improvement projects.
• With strong profit margins and exceptional cash flow, the dividend payout is secure and will continue to increase for the foreseeable future.

Exceptional 2021 result

Home Depot is a core holding in my portfolio and has been outperforming the market for a long time. They released Q4 2021 results at the end of February, and 2021 was another stellar year. For Q4 2021, revenue was $35.7 billion (10.7% YoY increase) and net profit was $3.4 billion (28% YoY increase) . For all of 2021, revenue increased 14.4% ($151.2 billion in 2021 vs. $132.2 billion in 2020) and net income increased 27% ($16.4 billion in 2021 compared to $12.9 billion in 2020). As the CEO said on the earnings call, “Fiscal 2021 was another banner year for Home Depot.” I was certainly happy as a shareholder.

Shareholders might be concerned about inflation and supply chain disruptions, but I think Home Depot is doing a great job of mitigating those issues. Using its vast network, strong supplier relationships, and the pricing power of its economic stronghold, The Home Depot controls its costs and passes on rising costs to consumers. During the latest earnings call, management mentioned that the average compensation ticket increased by 12.3%, citing inflation in several product categories as the main reason. Margins have declined slightly (30-35 basis points), but their profit margins are still in line or above their historical average. So I don’t see any big red flags.

Solid prospects for the future

The main driver of Home Depot’s growth is rising house prices. As long as home prices continue to rise, homeowners will recognize home improvement projects as a great investment and The Home Depot will continue to grow. During the latest earnings call, management mentioned that demand for home improvement projects remained strong at all price points. The average house price rose 14.6% in 2021. Due to rising interest rates, some experts expect prices to rise more slowly in 2022, as low as 2.9%.

I expect house prices to rise at a pace somewhere between the low of 2.9% and the remarkable 2021 level of 14.6%. Continued inflation (above 7%) and rising labor costs are causing new home construction costs to soar. Also, even with the recent increase, the current mortgage rate (4.75% for a 30-year mortgage) is still at a historic low and in line with its 2018-2019 level. Therefore, I expect house prices to rise further around the 5-8% level, which will positively contribute to Home Depot’s growth. Moreover, the United States is still short of more than several million homes. So I expect the price of real estate to continue to rise in the long term.

Excellent profit margins and cash flow

Combining economies of scale, network effect and brand recognition, Home Depot has one of the strongest economic moats in retail. Reflecting this strong economic moat, their profit margins are above the industry median. The 5-year average of EBIT margin (14.7%), EBITDA margin (16.7%) and net margin (9.7%) is above industry medians by 35-60%. Recent inflation and supply chain disruption challenges have slightly reduced the margin by 30 basis points, but I do not expect this trend to continue. Moreover, even with this slight decline, current margins remain above their five-year averages.

Reflecting its strong growth and profit margin, Home Depot generated plenty of cash and rewarded its shareholders. In 2021, they generated $16.6 billion in operating cash flow and returned more than $21 billion to shareholders ($14.8 billion in buyouts and $7 billion in dividends). With a solid future outlook and a solid economic moat, I expect them to continue to generate plenty of cash and reward shareholders for the foreseeable future.

Estimation of intrinsic value

I used the DCF model to estimate the intrinsic value of Home Depot’s business. For the estimate, I used EBITDA ($26,164 million) as the cash indicator and the current WACC of 8.0% as the discount rate. For the base case, I assumed 8% EBITDA growth (management forecast) for the next 5 years and zero growth thereafter (zero terminal growth). For the bullish and very bullish case, I assumed EBITDA growth of 10% and 12%, respectively, for the next 5 years and zero growth thereafter. Given that the historical EBITDA growth rate is 10% and last quarter’s EBITDA growth rate was 13.7%, a 10-12% growth rate is quite reasonable. .

The estimate showed that the current stock price is 20-30% upside from the current level. Given the positive outlook for the housing market and strong demand for home improvement projects, I expect Home Depot to easily realize this upside in the future.

	Price target	Upside down
Base case	$374.73	21%
Bullish case	$404.83	30%
Very bullish case	$437.05	41%

The assumptions and data used for the price target estimation are summarized below:

• WACC: 8.0%
• EBITDA growth rate: 8% (base case), 10% (bullish case), 12% (very bullish case)
• Current EBITDA: $26,164 million
• Current stock price: $310.68 (03/25/2022)
• Tax rate: 30%

Risk

The Federal Reserve has just announced the schedule for interest rate hikes for 2022 and 2023 (nine times in total). Combining rate hikes, ongoing inflation and supply chain disruption, some experts expect the US economy to slow. Additionally, the war between Russia and Ukraine has added a whole new level of tension and uncertainty to the global economy. A slowing economy and uncertainty may negatively impact Home Depot’s growth rate, so investors should monitor macro indicators.

As mentioned earlier, rising mortgage rates could cool the housing market, which will negatively impact Home Depot’s growth rate. However, given the US home shortage and rising construction costs, I don’t expect home prices to slow too much below the 10-year average (~5-8% per year). Even if house prices fall, I don’t expect that to be a long-term scenario.

Conclusion

Home Depot has been an exceptional investment over the past two decades. Riding on rising prices in the US housing market, Home Depot’s revenues and operating cash flow have steadily increased. Given their leading market position and strong economic moat, I expect them to remain a great investment choice for a long time to come. Rising interest rates and a slowing economy may challenge Home Depot, but I don’t expect that to hurt its long-term growth trajectory. Overall, I expect a 20-30% upside from the current level.