At first look, Home Depot’s (NYSE:HD) Q1 2022 results seem quite robust, especially against a backdrop of poor performance from other retailers like Walmart (WMT) and Target (TGT). The company believes that demand for home improvement products is still strong due to continued home price appreciation we’re seeing in the housing market. Management mentioned that customers were trading up to higher priced merchandise, a trend not being seen by other big-box retailers in the quarter. Revenue, gross margin dollars, and EPS were all up YOY against a very strong 2021. This article drills down into the numbers to help see what’s driving company economics.
Chart 1 shows Home Depot’s breakdown of sales on a per-SQFT basis. I’ve included distribution center square footage in the calculation, as online sales and Pro deliveries supported by DC square footage are included in store sales. The bottom half of the chart shows the inventory sold, and the top half shows the gross margin dollars generated by the product markup. The sum of the top and bottom gets you to sales-per-SQFT.
On a total SQFT basis, sales in Q1 shrank 0.59%, from $118.6 to $117.8. Inventory sold and markup % were both down slightly. The big change this quarter was the ticket vs. transaction volume. In Q1 2021, each square foot of the company transacted 1.41 times selling $55.4 of inventory-per-ticket. In ’22, inventory sold per ticket was up 13.3% to $62.7, but transaction volumes were down 12% to 1.24x on a SQFT basis. Management stated on the Q1 earnings call that much of the sales (and cost) increases were due to inflation.
An optimist might argue that higher prices have simply led to an equivalent decrease in transaction volumes. Adjusting for a late spring and a continued shift from DIY to Pro, sales dollars remain a wash at the end of the day. As long as home improvement demand is still strong – they’d argue – a balanced elasticity response or temporary seasonal effects should leave the investor with little concern. CFO Richard McPhail reinforced this sentiment on the Q1 earnings call by citing recent ‘National Association of Home Builders’ survey data…
This is a survey that goes back to 2001. And the survey, if you’ll bear with me, just sort of says are you optimistic or pessimistic, 50 being kind of the median mark here. So for the 20 years up to 2020, that optimism index never got above a 58. Today, it stands at an 86, so that is the sentiment of the remodeler. With respect to backlog, that is also surveyed. That number over the past 20 years never got above a 64. Today, it stands at an 84. Both of those sentiment numbers are at all-time highs.
Optimism aside, however, there is a more bearish interpretation of Q1 results. It assumes that the decrease in transactions has less to do with inflation and more to do with negative demand trends already in motion. If that’s the case, the high inflation in the near-term could simply be masking a more secular drop in unit demand.
A closer look at the NAHB survey discussed on the call shows that – although sentiment is still very high – it may have peaked last year for projects under $50,000. Additionally – backlog sentiment was up YOY, but backlog leads were down – pushing the “Future Indicator Index” slightly negative. See Table 1 below.
The critical question is whether the decrease in product unit volumes were caused by inflation, or just happened to coincide with it. Asked another way… What would Q1 transactions have been without inflation? Despite the upbeat tone of the call, CEO Ted Decker seemed to imply that it was the macro environment – not elasticity – that’s driving down transactions.
In his prepared remarks he said…
Comp transactions reflected the late start to spring and the anniversarying of stimulus. (Emphasis added.)
In a later response to a question on what’s driving transactions lower, he replied…
We’re seeing obviously much higher than that with 11% in ticket. A lot of that is inflation-driven.But our customers are resilient. We are not seeing the sensitivity to that level of inflation that we would have initially expected…..And then lastly, on transactions, we do always look for a balance of ticket and transactions. But again, with these inflation rates, it’s a very unique year in inflation and ticket is higher than norm for sure. But again, the consumer’s hanging in there. (Emphasis added.)
With SG&A levels near an all-time high of $20 per-SQFT – and showing little correlation with lower Q1 traffic – a drift towards pre-COVID sales levels could spell trouble for operating margins. Given such uncertainty around the macro picture, it’s fair to say that the risks for investors are higher now than they have been in recent history.
Inventory levels in the quarter were also noteworthy, as they were higher than usual. Chart 1 shows that inventory levels from Q1 ’17-’19 remained stable around 83-85% of COGS, resulting in annualized inventory turns of 4.8-4.7. During the pandemic, demand went up and supply shortages brought inventory levels way down. Fiscal year inventory turns shot up to a record 5.8 in 2020 and were still elevated in Q1 of 2021, with an inventory-to-COGS ratio of only 72%. However, that situation reversed itself this year and average inventory now sits around 92% of COGS. Interestingly, management suggested on the call that they’re still not satisfied with their in-stock levels, implying that they would feel more comfortable at even higher levels.
It’s likely that part of the increase in inventories is simply the result of management using store shelves as a buffer during a time when supply chains are unpredictable. Add that to a slow start to spring and it’s possible that the levels make sense if demand stays strong. If demand falls faster than expected, the high inventory levels could lead to gross margin degradation resulting from increased promotional activity – compounding the hit to operating margins you’d expect in a downturn. Investors in Lowe’s (LOW) saw inventory issues wreak havoc in 2018, leading to a massive drop in operating income and the ouster of long-time CEO Robert Niblock. Target reported similar problems with inventory just this past week, and their stock was down almost 30% by Friday. I’m not predicting the same for Home Depot, but it should give shareholders pause.
Chart 2 below isolates the pre-tax earnings from Chart 1 and deducts tax. On a per-SQFT basis, net income is down 2.2% YOY. As you could see from the left of the chart, investors in Home Depot have seen a sizable increase to their cut of operating earnings since the Trump tax reforms of 2017.
Chart 2 raises an obvious question… If net income didn’t increase on a SQFT basis, where did the earnings and EPS growth come from if the company hasn’t been adding new stores?
Firstly, the company is still expanding its distribution center footprint. Sales supported by DC’s either flow through a retail store for pickup or are delivered to the home or jobsite. The additional square footage is supporting additional sales in the same way a new store would. The company increased its average total footprint by 4.4% YOY, and the vast majority of that growth was in distribution centers. Retail square footage actually shrank in Q1 by 500k due in-part to a store fire in San Jose, California. (It’s not clear to me where the other 400k went. I’m still waiting for a callback from IR.) Combining the 2.2% drop in earnings/SQFT and the 4.4% growth in total square feet gets you to the 2.07% YOY growth in net income reported for the quarter. The calculation looks similar for sales.
We can get from earnings/SQFT to EPS by multiplying Chart 2 by SQFT/share (Chart 3 below). SQFT/share will tell you the percentage of 1 square foot acquired from purchasing 1 share of stock. Increasing the company’s physical footprint and/or repurchasing shares will have a positive impact on the SQFT/share value. The company has been doing both over time. Two decades ago you needed 14 shares of stock to own 1 square foot of the company. Today it’s just 3.1.
Chart 2 x Chart 3 yields…
By combining the 2.07% benefit from footprint growth with a 4% benefit from share repurchases over the year, diluted EPS was up 6.12% YOY. Whatever the macro environment, you can expect future share repurchases to be a continued tailwind for company EPS. That said, HD allocates a smaller portion of earnings to buybacks than Lowe’s, opting for a higher dividend payout instead. In effect, Lowe’s has traded dividend payments for higher EPS growth… and the more favorable optics that come with it. It means that EPS comparisons between the two companies are not apples-to-apples and should be taken with a grain of salt. In my humble opinion, you’re much better off looking at the core business drivers when comparing companies. If you’re short on time, follow me on Seeking Alpha and I’ll do the work for you.
Also… if you’d like to learn more about Home Depot, my previous article looks at the past 21 years of annual performance on a SQFT basis. It’s a dense read, so refill your coffee before you start it. Access it here.