The brick and mortar industry has struggled mightily in the recent past, due to worries about online competition from Amazon and others. Some pockets of the vast brick and mortar industry continue to perform very well, though, which includes the home improvement segment.
The market leader in this industry, Home Depot (HD), is a wide-moat company with excellent fundamentals. The company has performed solidly operationally during early 2019, and the expected returns for Home Depot stock are compelling over the next several years. For these reasons, Home Depot stock is one of our favorite long-term retail plays.
Home Depot, which operates more than 2000 stores across North America, has been generating solid growth rates in the past. One key factor for its rising revenues are growing comparable store sales. These do not only provide the majority of Home Depot’s revenue growth, they also allow the company to continually expand its margins, thanks to the positive impact of operating leverage – fixed costs per store remain unchanged, while the rising revenue generation at its locations allows for growing gross profits, which results in growing operating margins.
Home Depot’s first quarter earnings results were announced in May 2019. The company generated revenues of $26 billion, which was 6% more than the revenues that Home Depot generated during the previous year’s first quarter. This revenue growth was positively impacted by comparable store sales improvements, as comps sales rose by 2.5% year over year. The company managed to grow its earnings-per-share to $2.27, up by 9% year over year, with share repurchases playing a major role for rising profits on a per-share level.
Home Depot Offers Hefty Shareholder Returns That Are Key For Stockholders’ Total Returns
Share repurchases, which played a role for last quarter’s solid earnings-per-share growth rate, have been in play for a long period of time, as Home Depot has a history of rewarding its shareholders handsomely with cash flows.
Home Depot does not open a large amount of new stores, as Home Depot and/or competitor Lowe’s (LOW) own stores in most of the attractive markets already. This is why Home Depot has been opening new stores at a low pace of well below 1% of its existing store count. The company invests significant amounts of money into other assets, such as logistics centers that are aimed at improving productivity or enhancing Home Depot’s ecommerce business, but all in all the company does not have to put a large amount of its cash flows towards capital expenditures. The company’s growth centers around increasing comparable store sales, which do not require large investments, thus Home Depot operates a capital extensive business that throws off large amounts of free cash flows.
During fiscal 2018, Home Depot generated operating cash flows of $13 billion, whereas capital expenditures totaled $2.4 billion during the same time frame. This resulted in free cash flows of $10.6 billion, which compared to free cash flows of $9.8 billion during the previous fiscal year, and $8.2 billion during fiscal 2016.
Source: Home Depot presentation
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During 2018 Home Depot has paid out more than its free cash flows, which was possible due to a net debt issuance of $2 billion and a decline in the company’s cash position. It is likely that shareholder returns will be more in line with free cash generation going forward, per management’s comments.
Home Depot has a history of splitting its free cash flows between dividends and share repurchases when it comes to shareholder returns, which has been a highly successful approach in the past. Dividend growth investors benefit from steadily rising dividend payments, as Home Depot has raised its dividend for many years in a row, and its dividend growth rate has been very compelling: Over the last five years, Home Depot has raised its dividend by 24% annually, the most dividend raise was an even larger hike of 32%. Investors who started investing into Home Depot’s stock early on, benefit from a massive yield on cost.
Share repurchases, at the same time, are beneficial for those that seek share price gains, as the declining share count boosts Home Depot’s earnings-per-share growth rate. Even those that focus on income generation benefit from share repurchases, though, as the declining share count means that Home Depot has to spend a lower amount on dividends in total, which enhances its capability to grow dividends-per-share at an attractive pace.
When we assume that free cash flows will grow slightly during 2019, Home Depot’s shares offer a free cash flow yield of roughly 5% with shares trading for $206. As Home Depot essentially returns all of these free cash flows to its owners via dividends and stock buybacks (which drive EPS growth, thereby leading to share price gains), we can say that Home Depot’s shareholder returns will be responsible for about 5% of total returns going forward. When we add in comparable store sales growth, some margin improvements, and additional earnings due to capex investments into ecommerce, it is not at all unrealistic to expect total returns of around 10% annually.
Home Depot is not a high-growth company when it comes to the opening of new stores. The company’s excellent fundamentals, high returns on capital, and its ability to drive comparable store sales at a meaningful pace, allow for a highly attractive business model, though.
Due to its strong market position – Home Depot essentially operates a duopoly with peer Lowe’s – it is likely that the trend of rising comparable store sales will be maintained going forward. Declining interest rates could be a tailwind for building activity around the country, which would be positive for Home Depot’s sales going forward.
Home Depot operates a free cash flow heavy business and eagerly returns its huge cash flows to its owners. The combination of an attractive dividend yield, strong dividend growth, and share price gains, which partially rest on earnings-per-share growth that is fueled by share repurchases, should result in an attractive rate of total returns over the coming years, we believe, which is why we deem Home Depot an attractive long-term investment.