Home Depot (HD) reported superb total sales ($24.829B vs estimate $24.7B) as well as comp store sales up 4.2% and U.S. comp store sales up 5.7%. Home Depot also raised full year sales, comp store sales and earnings guidance. This report confirms the strength in the U.S. housing construction, retrofitting, and remodeling market. Read the full report at this link:
Home Depot 2Q earnings report press release
The conference call starts at 9am ET
Looking at the details, Home Depot seems to have some margin pressure at the gross margin line. There were a couple one-timers in the numbers which I took out. I believe the $92M charge for the data breach is in the COGS line. Even after adding the $92M back in, I still see gross margin down by 19 bps. I don't think there is a lot of discounting going on in home supply retailers, so I am guessing it's coming from the COGS, maybe some wage pressure. Home Depot should have raised prices to offset this wage pressure in order to avoid this margin compression.
Home Depot has a debt-to-EBITDA ratio of 1.1x, and this is expected to increase roughly 0.1x per quarter. The reason for this is the $7B share buyback which Home Depot is executing during calendar 2015. Home Depot has repurchased $3.085B of stock in the first 2 quarters. I am usually a fan of share buybacks, but I don't think it's a great idea to lever up the balance sheet too much to buy back stock, particularly at the beginning of a Fed tightening cycle.
At yesterday's closing price of $119.70, Home Depot is trading at 25x FCF. I think Home Depot is benefitting from a construction market which is quite firm and expected to continue to strengthen, but I don't see the stock as a great investment opportunity.
The strength in the Home Depot sales makes me think of Lowe's (LOW) and Tractor Supply (TSCO), both of which should also benefit from the strong construction market. Lowe's reports tomorrow, and Tractor Supply reports in October. This is an interesting comparison, because the valuation difference between these companies is quite significant. Lowe's trades at 18x FCF, but does have lower operating margins than Home Depot and Tractor Supply. Lowe's is also more highly financial levered than Home Depot at 1.5x debt-to-EBITDA. Tractor Supply has no net debt.
Tractor Supply trades at the highest multiple at 40x FCF, but is also growing sales at around twice the rate of Home Depot and Lowe's. The comp store sales of these three is pretty comparable. The growth from Tractor Supply is coming from geographic expansion. Home Depot and Lowe's are pretty saturated. As of the end of the first quarter, a total of 293 stores, or 12.9% of the total store count of 2,270, were located in Canada & Mexico. This leaves little room for geographic expansion in the U.S., and the U.S. construction market is what I want to get exposure to. This is just me talking, but if Home Depot started a new smaller store format, maybe they could further penetrate the home supplies market. The existing warehouse-style format is probably pretty close to saturation in the U.S., so store growth is going to approximate population growth which is below 1%. Lowe's has a similar saturation problem. Lowe's has some upside in making their operation more efficient, and Lowe's is buying back even more stock than Home Depot.
I like the growth story of Tractor Supply. They are in a non-competitive space where Home Depot and Lowe's have decided not to focus. This is a great advantage for Tractor Supply, and could help them expand their operating margins above Home Depot's 13%. I see Tractor Supply with the highest PEG ratio at 2.6 versus 2.0 & 1.4 for Home Depot and Lowe's. I am hoping for a strong report out of Lowe's, but I think their strategy to lever up the balance sheet and buy back stock is not a good fit with me. Let's wait to see what Lowe's report looks like tomorrow to make a final decision.
Michael Grove, CFA