AGB 2021.5 - The Home Depot (HD)
Few New Stores, Mostly Efficiency Gains
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The Home Depot
Home Depot is the largest home improvement retailer serving customers in the U.S., Canada and Mexico. A typical store averages 100k in sq. ft. with an additional 25k in an outside garden area. These are massive retail locations that house more than 35k SKUs and over 1M SKUs are available online. The company employs almost 500k associates, most of which are part time hourly workers.
Home Depot operates almost 2,300 stores, a number that’s increased only 0.2% annually over the past 8 years. Because the company isn’t increasing its retail footprint by much or doing many relocations, the average store is over 20 years old while the company is just 43 years old. Interestingly over the past decade, Home Depot has grown its sales almost all through efficiency gains from its existing stores, while expanding its supply chain/distribution network and its online business. So in contrast to the lack of retail square footage growth, the company’s warehouse and distribution centers have grown at 6.2% annually over the same time period.
Currently, there are two main growth initiatives at the company, the One Home Depot and the Home Depot Pro. One Home Depot is a 3 year capex and opex investment plan started in 2017 to interconnect the online and in-store shopping experience for the DIY (do it yourself) customer. Investments are ongoing for both the stores (self-checkout, lockers, storage, electronic labels, store layout improvements, etc.) and the supply chain (delivery network, flatbed distribution centers, appliance delivery, etc.). The company is also investing in the backend technology as well, to support both online and in-store shopping.
The Home Depot Pro initiative (started in 2018) is a series of new offerings that helps the professional manage their work projects and make orders and shipments as easy as possible through an online portal. Some of the main features include inventory management, enhanced credit programs, delivery directly to the job sites and even custom designed products. These two initiatives should result in continued efficiency gains at the company and Home Depot has been good about coming up with new investment areas to fuel growth.
Because home improvement is generally tied to the housing market (which is viewed as cyclical in nature), there may be some concerns around where we are in the latest cycle. Looking at the gross and operating margins of home improvement retail vs. building products and homebuilders suggests that home improvement is much more predictable and less volatile than the other two segments tied to the housing market.
Drivers of home improvement demand remain strong and the four key indicators to look out for are:
Household formation – LT average of 1.2M formed annually, recently higher
Home price appreciation – LT average 2%-3%, recently higher
Housing turnover – LT average 4.2% - lower since the great recession
Age of housing stock – Homes older than 40+ years has gone from 30% in 1996 to almost 50% in 2018
These driver have been neutral to positive in recent years (with the exception of housing turnover) and have helped contribute to Home Depot achieving consistent mid-single digit comparable sales growth annually (with the exception of FY20) over the past 10 years. Since the company has been reporting comparable transaction and comparable average ticket, both have seen steady low-single digit growth since FY15.
The home improvement market in the U.S. is estimated to be $680B (2019) with it broken down by DIY 35% (where Home Depot and its largest competitor Lowe’s command 50% share), Pro products 24%, (Home Depot has been gaining share here), Services 33% and MRO 8% (Home Depot commands 10% of this market with the recent acquisition of HD Supply). Home Depot has roughly 19%-20% market share after the share gains in FY20 and the acquisition of HD Supply. The CEO has recently stated that Home Depot has gained 2.75% market share from 2018-2020 due to the One Home Depot initiative.
In terms of capital allocation, the company re-invests back into the business first, as evidenced by the One Home Depot and Home Depot Pro initiatives. After these opportunities are well funded, the company pays a dividend targeting 55% of earnings, makes strategic acquisitions and lastly conducts share repurchases with the remaining capital. It can be argued that the company is over capitalized, consistently ranging between 1x-1.5x net debt/EBITDA.
Why is it a good business?
Home Depot benefits from scale economies, which helps the company when negotiating with suppliers. Similar to other big box retailers, the company leverages its scale to be able to offer everyday low prices to its customers. With 70% of its suppliers based in the U.S., the company can quickly adjust and recalibrate its product offerings if necessary.
The company’s scale advantages are best evidenced by the growth of its online business. The company leveraged its existing retail footprint to provide a seamless shopping experience both online and in-store. Because home improvement goods are on average low value/weight ratio items, the online penetration of the category is low at 5% vs. other categories such as media (81%) and consumer electronics (44%).
Some of the recent statistics related to the company’s integrated online and in-store retail offerings are:
85% of online returns are done in-store,
60% of online orders are picked up in store,
95% of US population can be reach with two days or less shipping.
The company’s online business generated almost $19B of revenues in FY20 (14% of company revenues), which makes it the fifth largest e-Commerce operation in the U.S. after Amazon, Walmart, eBay and Apple.
Home Depot’s other competitive advantage lies with its brand. With the over 35k SKUs offered at a store, the customer may associate the quality of the goods more with the Home Depot brand than the actual brand of the items purchased, especially if the brand has an exclusive distribution agreement with the company. The company also has a strong private label program, which commands higher margins than similar branded products. Private label is now 20% of total revenues.
Due to the company’s acquisition of Interline in 2015 and now HD Supply in 2020, Home Depot is better positioned that its competitors. The MRO (maintenance, repair and operations) market is $55B, of which Home Depot commands ~10%.
Home Depot is also leveraging its MRO business to service Pro customers as well. Pro customers tend to have more consistent spending patterns vs. DIY customers. Furthermore, Pro customers spend more at $6K on average per year vs $3k for DIY.
So far the Pro related initiatives are working, with the Pro segment showing higher growth in FY16-FY17 than DIY customers. Digital adoption of its Pro customers is key. The company expects to onboard 1M pros onto its digital platform over the next few years.
Returns on capital?
Over the past 10 years, Home Depot has spent 2/3 of its capital on capex and 1/3 on acquisitions. From the company’s 2018-2020 capex plan of $11B, we can see that capex can be broken further into reinvestments for stores (45%-50%), IT improvements (22%-27%), supply chain (6%-10%) and other (20%-26%). It can also be broken down by “business as usual” and “strategic” investments. It would be nice to be able to calculate returns on capital for each of these investment categories, but there isn’t enough disclosure to estimate that breakdown.
Both of the company’s large acquisitions over the past 10 years has been in the MRO space that services business customers like hotels, hospitals, institutions and government agencies. Interline was acquired in 2015 for $1.7B or 10x trailing EV/EBITDA and HD Supply was acquired in 2020 for $8B or 16x trailing EV/EBITDA. These multiples imply that the returns on capital were low at 6%-10%, however, both were strategic acquisitions that helped Home Depot solidify its lead in the MRO market.
When Interline was acquired in 2015, the distribution network of 90 access points in the U.S. further enhanced the company’s supply chain and fulfillment capabilities. The acquisition also was an easy way for Interline Pro customers to access all of Home Depot’s inventory for purchase or tools for rent.
Typically for a retailer, it’s helpful to understand the unit economics of a new store build (like we did for Starbucks, Dollar General, Domino’s Pizza), but in this case (1) we don’t have the data because it hasn’t been disclosed by the company, and (2) because store growth has been minimal over the past 10 years, it’s not relevant to the current growth story.
We estimate that the company has returned between 35%-85% of its capital over the past 5 years. In the immediate years after the Interline acquisition was made and now the HD Supply acquisition, the returns were lower. However, the reinvestment rate was higher, so the intrinsic value growth is relatively consistent.
Reinvestment potential?
Home Depot’s growth plan is to continue to gain efficiencies by leveraging its existing base of stores in North America. The company is wrapping up its 3 year, $11B investment plan in capex and opex. Most of the investment went to improving the stores, IT investments and supply chain, which we’ve discuss earlier.
Goldman has a nice breakdown of the investment between “business as usual” (what the investments would have been without the growth investments) and “strategic” investments. The breakdown is roughly 50%/50% with the strategic investments ramping up over the three years, while business as usual remains steady. They also estimate the breakdown between capex and opex, which is roughly 75%/25%.
The supply chain improvements related to the One Home Depot initiative will take a bit longer (5 year plan). Most of that investment will go towards improving the distribution efficiency and capabilities for the company. Previously, distribution was more centered around the store as a hub for last mile distribution, but this became less efficient as the online and pro segment grew over time. Instead of loading and reloading from the stores, home depot is investing in expanding its smaller distribution centers called flatbed delivery centers across North America. This will make it easier to deliver bulky items and appliances as well as service the Pro customer at the job sites.
The end goal of enhancing the distribution network is to be capable of offering same day or next day delivery to 90% of the U.S. population by 2022. This seems achievable considering the company can already do that for 2 day delivery.
With returns on capital of 35%-85% and a reinvestment rate between 15%-20%, we estimate that Home Depot has increased its intrinsic value between 9%-11% over the past 5 years. While the returns may fluctuate more than other retailers that are growing by a combination of store count/sq footage growth and same store sales growth, Home Depot is still able to achieve high returns on capital with efficiency gains.
Also, we’d like to point out that the shift to online retail and the focus of the DIY consumer in home improvement means that FY20 returns were much better than the historical average. We estimate that FY20 added about 1% to the 5 year average intrinsic value growth, which implies that Home Depot prior to FY20 increased its intrinsic value by 8%-10%.
What else is important?
Covid Impact
The lockdowns related to the pandemic meant the consumer spent more money on improving their homes. The sales and earnings increases in FY20 for Home Depot and other home improvement retailers were unprecedented. Comparable store sales growth of 19.7% (8.5% comparable transactions, 10.4% comparable average ticket) and online revenue growth of 84% will probably not be repeated in the near future.
It can be argued that most of that growth was a pull forward in demand (at least for the DIY segment) because (1) there will be fewer home projects to complete on average, and (2) a post vaccine world should result in people spending less times in their homes. It can also be argued, however, that some of the increased spending, especially online, may be stickier than anticipated because more people became new customers and will likely comeback for their home improvement needs in the future.
There were also added costs that came from the pandemic. For most of the FY20 second quarter, Home Depot limited its hours and sometimes the number of people that were allowed into the stores. It’s difficult to measure what kind of impact this had over all.
There was also a focus on higher wages and bonus compensation for Home Depot’s front line associates. A weekly bonus program was instituted, which was made permanent. The company anticipates that this program will result in $1B of incremental compensation expense annually. It’s also worth noting that Home Depot has almost 500k associates, most of which earn an hourly wage. In the company’s FY19 annual report, it’s stated that only 7% of its employees were salaried workers. A rise in minimum wage may have an impact on the margins for Home Depot.
Home Depot vs. Lowe’s
Home Depot and Lowe’s are the two largest home improvement retailers. The stores are of a similar format and size, and both stores offer a similar assortment of items. Market shares for the DIY space are almost identical at ~24% but Home Depot has much higher share in Pro at 22% (before the HD Supply acquisition) vs. 7% for Lowe’s. While Home Depot has 15% more locations than Lowe’s, Home Depot’s revenues are 47% larger and the company has 66% more employees.
Lowe’s had been mismanaged for many years under the previous leadership team. This is evidenced by Home Depot’s superior comparable sales growth vs. Lowe’s from FY11 to FY19 by an average of 2%. Another point is that Home Depot is much further along its online retail integration at 14.3% of revenues in FY20 vs. Lowe’s at 8% of its revenues.
The current CEO, Marvin Ellison, has improved Lowe’s operations since joining in 2018 to catch up to Home Depot. Lowe’s had a good FY20, outpacing Home Depot’s growth in both its in-store and online retail operations. Home Depot still benefits from having a much larger presence in the Pro segment and has solidified its lead in MRO with the acquisition of HD Supply. The Pro segment should be much less cyclical vs. DIY and should help Home Depot achieve less volatility in its business.
Optionality
Home Depot’s growth opportunities are still in North America. The company’s view is that there are still more efficiency gains to be had in the U.S. However looking 10–20 years down the line, Home Depot may be better served to look internationally. Obviously there are different housing industry dynamics, supply chain issues and retail competition by region, but Home Depot should explore international expansion to sustain its reinvestment opportunities. The company hasn’t expanded its store base in 10 years, which has kept the reinvestment rate at the lowest of the companies we’ve analyzed in AGB thus far. International store growth could remedy that fact relatively quickly.
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