The world’s largest home improvement retailer, Home Depot (NYSE:HD), has been one of the shining stars of the pandemic recovery, delivering a return of nearly 40% so far in 2021. But can it keep going now that its stock is hitting new all-time highs?
Home price appreciation has driven much of the gains at Home Depot. When homes soar in value, homeowners eventually tap home equity lines to improve them — and home prices have been soaring. The latest reading on the S&P Corelogic Case-Shiller Index showed an annual home price gain of 19.7% in July.
The average homeowner has more than $150,000 worth of home equity that can be tapped with home equity lines of credit, according to a recent report from Black Knight, a data and analytics firm for the mortgage industry. All told, Americans are sitting on $800 billion worth of tappable home equity, the report said.
“We believe that home price appreciation is a fundamental support of home improvement activity and demand,” Richard McPhail, Home Depot’s chief financial officer, on an Aug. 17 conference call. “As we look forward, not only have we seen that home price appreciation, but the homeowner balance sheet is incredibly healthy.”
When homes soar in value, homeowners eventually tap home equity lines to improve them — and not only in the do-it-yourself market. In its most recent quarter, Home Depot reported that 45% of its sales came from contractors.
Still not overpriced
Despite Home Depot’s impressive gains this year, it trades at a lower multiple than the Standard & Poor’s 500 Index, with a 12-month trailing price-to-earnings ratio of 26 compared to 28 for the S&P.
Rival home improvement retailer Lowe’s (NYSE:LOW) has a PE of about 24, but it’s less profitable than Home Depot. In its most recent quarter, Lowe’s reported has a net margin of 7.41%, compared to 10.55% for Home Depot in the comparable period.
Home Depot outperforms Lowe’s on several fronts, in part because it benefits from larger economies of scale, and because it has a larger percentage of professional contractors as customers. Its net margin has grown consistently each year from about 3.5% in 2009. Lowe’s has also grown its net margin from about that same level in 2009,but Home Depot has proven over these years to be a more profitable operator.
Risks for Home Depot include continued inflation, commodity shortages and supply chain disruptions, as well as the ever-present competition from the No. 2 player in its market category, Lowes. But Home Depot has a wide and defensible economic moat; its size provides a low-cost advantage, giving it bargaining power with suppliers, vendors, advertisers, landlords and others. It’s also protected from e-commerce threats, given the weight and specialization of many of its offerings.
Home Depot, of course, faces the same pandemic-era logistics disruptions as every other mass retailer, but the company has taken extraordinary steps to ensure its supply chain. On its most-recent conference call, company executives said they had secured container ships for their exclusive use and noted that their inventory levels were 40% higher than last year. Stores remain well-stocked. A larger inventory, the dedicated container ships, and the largest economies of scale in its retail category will likely help to brace Home Depot for whatever disruptive or inflationary pressures lie ahead.
It seems most things have gone just right for Home Depot, but the biggest risks it faces would be a downturn in the housing market or steep decline in consumer spending. For now, the surge in home prices appears to be leveling off. Existing home sales fell 2% and in September. Part of the reason is that inventories remain tight and prices remain high, keeping many potential buyers out of the market, according to a report from the National Association of Realtors. The group expects the housing market to rebalance — but not fall sharply — over the next year.
But if home prices tank or consumers stop spending, home improvement projects would get pushed to homeowners’ back burners, the sales they generate for Home Depot would dwindle, and many other bets in the stock market might suffer as well.
Why it’s still a buy
Home Depot is a cash cow that has consistently deployed its excess profits to hike dividends and boost share repurchase plans, enriching its shareholders. Over the past five years, it has returned to shareholders the equivalent of more than 15% of its market cap — or $56 billion — in the form of dividends and share repurchases. On Home Depot’s most recent conference call, executives reiterated their commitment to continue this trend.
It’s also important to remember that the trend of rising home equity prices has a long tail. When homeowners find they’re sitting on lots of equity in what remains a low mortgage-rate environment, they eventually turn to lenders for refinancings and home equity loans. Even if home price appreciation were to slow, but prices remained stable near their recent highs, this trend would likely continue for several quarters to come.
For this reason alone, investors can expect more from Home Depot. The company has enjoyed a surge in sales, accelerated by the pandemic and the ensuing recovery. Its next earnings report will show whether the retailer can continue growing as the economy continues to normalize. In Home Depot’s next earnings call on Nov. 16, watch the company’s sales per square foot, which have grown from $343 in 2011 to $663 in its last reported quarter — a 58.5% total increase even after you adjust for inflation. If this stalwart retailer continues increasing sales faster than it expands its footprint, it’s a clear sign that Home Depot could keep delivering for investors.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.