Saturday, March 2, 2019

Recent Purchase: Home Depot


 
About: 
Long only, long-term horizon, dividend investing, value
Summary
 
After the company's 32% dividend increase, I was a buyer.
It's rare to find stocks that offer safe, 3% yields and double-digit dividend growth prospects.
HD isn't cheap at 18x forward earnings, but I couldn't pass up entry level exposure to this yield.
Home Depot (NYSE:HD) is a name that I've followed for some time now. It's a stock that I've owned in the past, and frankly put, I've got a bit of seller's remorse. Well, it's time to put that remorse to bed. On Thursday, I bought HD shares, giving myself exposure to the name for the first time since June of 2017. I paid $184.52 per share, which, as I will discuss later, isn't exactly a screaming deal. But it does give me exposure to a stock that yields nearly 3% and has double-digit dividend growth potential moving forward. Those opportunities are rare in the market, and I look forward to my future with HD.
For a while now, I've sort of grouped HD up with another top-performing retail name, Costco (NASDAQ:COST). Both of these companies have basically bucked the "Amazoned" trend that many (including myself) expected to see play out in the physical retail space. Because of the strong growth metrics that this success has produced (and the strong dividend growth that comes along with it), both of these companies demand a high premium in the market. I haven't been willing to pay any sort of premium for a physical retail name for years now and, therefore, HD has been relegated to the backburner in terms of my DGI priority list. However, when I saw Home Depot raise its dividend by more than 30%, my eyes lit up. That is truly fantastic. And, whether I liked it or not, I had to essentially admit defeat of my bearish opinion after that result, and once again, partner with the stock as a shareholder.
I'll discuss HD's recent quarter in a moment, but I want to skip the dinner and get right into the dessert here: Home Depot just increased its dividend by 32% from $1.03 to $1.36/share on a quarterly basis. I was expecting a 10-15% increase from HD this year. In short, this 32% increase basically moves up the passive income target from HD up a year. This played a significant role in the rationale behind my recent purchase.


After today's little sell-off, that puts the company's forward yield at 2.96%. Frankly put, any company paying a ~3% yield with this sort of dividend growth prospects deserves a strong premium in the market. And, to make matters better for HD shareholders, the company also announced an authorization of a $15b stock buyback program, which would be good for ~7% of the company's current float. When it comes to shareholder return figures, it doesn't get much better than that.
And, while the shareholder return figures were certainly the highlight of the recent earnings report, the rest of the data focused on the company's operating results was good, too. Sure, HD missed by $90m on the top line, but sales were still up 10.9% y/y. You're never going to hear me complain about double-digit growth, especially when it's coming from a brick-and-mortar retailer.
HD's Q4 was 14 weeks in 2018 compared to the 13-week quarter that it ended 2017 with. This means that certain comparisons are a bit off; however, regarding the EPS results, management noted that the $2.09 Q4FY18 figure was a bit inflated on a relative basis, with ~$0.21 coming during the added week. But, even still, if you subtract that $0.21 from the $2.09 and arrive at $1.88, you still find that Q4FY18's adjusted figure was nearly 24% higher than the $1.52 of earnings that HD generated in the 13-week Q4FY17.
For the full year, sales and EPS results were impressive as well. Home Depot posted total sales of $108.2b on the year, which grew 7.2% y/y. The company's comparable same-store sales rose 5.2% on the year, and comps in the United States were up 5.4%. As great as the top-line growth was in 2018, HD's bottom-line growth was even better. The company posted EPS $9.73 on the year, which represented 33.5% growth compared to 2017's total EPS of $7.29. Both of these results were record annual figures for HD.
It's this strong bottom-line growth that fuels HD's massive dividend growth. HD has made a name for itself in the dividend growth world over the years. The company has an annual dividend increase streak of nine years now. HD froze its dividend in the aftermath of the Great Recession and began raising it annually again in 2010. Since then, the company has given investors a double-digit annual increase in all years but one (the very first increase after the freeze was just 5% annually). Including this 5% increase, HD's dividend growth CAGR since restarting is approximately 20%. The company has increased its dividend from the $0.225 level in November of 2009 to the $1.36 level today. In other words, today's quarterly dividend is more than 6x the size that it was back in 2009. This is how true wealth is created.
I touched on the buyback before, but I wanted to make it clear that not only is HD generous with its buyback, but it is also very successful at shrinking its outstanding share count. During the past five years alone, HD's management has reduced its outstanding share count by more than 14%. Not only does this help to bolster the bottom line, but it also makes large dividend increases like the one that we saw today more sustainable long-term. If Home Depot hadn't bought back nearly 190 million shares during the last five years, it'd be facing a much larger dividend burden today. I oftentimes talk about the benefits of a company that increases the dividend while reducing the share count. Well, Home Depot is a perfect example of this.
The company provided the following guidance for fiscal 2019, a 52-week year compared to fiscal 2018, a 53-week year:
  • Comparable sales growth of approximately 5.0 percent for the comparable 52-week period
  • Sales growth of approximately 3.3 percent
  • Five net new stores
  • Gross margin of approximately 34.0 percent
  • Operating margin of approximately 14.4 percent
  • Net interest expense of approximately $1.2 billion
  • Tax rate of approximately 25.5 percent
  • Share repurchases of approximately $5.0 billion
  • Diluted earnings per share growth of approximately 3.1 percent to $10.03
  • Capital spending of approximately $2.7 billion
  • Depreciation and amortization expense of approximately $2.3 billion
  • Cash flow from the business of approximately $14.1 billion
In response to the Q4 results, shares have sold off a bit. I think it's because of the relatively slower growth (3.3% on the top line and 3.1% on the bottom) that management is calling for in 2019. Considering the fact that HD shares are trading at a premium (~18x 2019 EPS guidance), I can understand the market's pause. However, I wouldn't be surprised if management isn't just being cautious due to the numerous economic headwinds that the world faces today that have sparked fears of slowing growth. This soft guidance appears to be a trend across many sectors/industries at the moment. It will be very interesting to see if these weak guides become a reality or if these management teams are sandbagging a bit, setting themselves up to outperform expectations.
Either way, I have to say that HD is not cheap at the moment. Paying 18x forward for a physical retail name is a lot (to me, at least). In a fairly recent piece that I wrote about Home Depot, I said that my price target was $165. I'd still love to buy HD shares at $165 (I actually had the chance late in December when the market was melting down, but didn't prioritize Home Depot; that is too bad, but then again, I picked up some great deals back then elsewhere, so I'm not going to get too upset). At $165, HD would be trading for ~16.5x forward earnings. To me, that's probably closer to fair value.
However, I have a history of success when it comes to purchasing shares of companies after big dividend increases. This is why I bought shares of Home Depot at $184.52 on Thursday. The way I see it, no sane management team would increase their dividend by 30% if they weren't really confident in the direction that their business is heading. I'm happy to pay a bit of a premium for access to this strength (as well as the much higher dividend yield).
Since HD is still trading above my fair value target, I wasn't willing to go all-in. The shares I bought on Thursday represent about a 1/3 position for my portfolio. Because of this, I would absolutely love to see further weakness in Home Depot, which would give me the opportunity to fill out my position at lower prices. My next price target is going to be in that $165-170 range (my previous fair value range). Like I said before, I'd feel very comfortable paying ~16.5x for HD shares. After that, I'd probably be looking to buy in the $150 area, which would represent ~15x forward earnings.
I don't necessarily expect HD shares to sell off that low anytime soon. For much of the past decade, it has traded in a range in excess of 20x earnings. However, it's important to note that during recessionary periods, this business model does struggle a bit and shares were trading in the 12-13x range in the aftermath of the 08/09 Great Recession (this is also when the company was forced to freeze its dividend).
So, while some people out there might be being thinking, "Yeah right, HD at 15x?! You must be out of your mind, Nick," it's important to remember that history oftentimes repeats itself with regard to value ranges and it wasn't all that long that HD traded for a much lower premium than it does today.
We're 10 years into an economic expansion. All cycles end at some point in time. I don't know when the next recession will hit, but I'm about 99% certain that HD will suffer when it does.
I may have to wait until then to buy the rest of my HD shares. But now that I've given myself entry level exposure, I'm happy to sit back, collect this ~3% dividend, and wait for better prices. I'd rather go this route than waiting for an unknowable amount of time to pick up shares during recessionary weakness. I like the fact that HD augments my income stream now, in the present. If I was just investing with capital gains in mind, I would have definitely waited. But, as you know, my passive income stream is a higher priority of mind, and HD seems like a great part to add to my dividend growth machine.
This is a similar approach that I took with Illinois Tool Works (ITW) after it announced a ~30% dividend increase last year. In that scenario, I was able to average down lower, having initially bought ITW shares at $140 in August of 2018 and then again at $123 in October. I discussed this in my ITW articles at the time, but its big dividend increase inspired me to pay up a bit for that first lot of shares purchased as well. I suppose you could say that it was a mistake doing so (ITW still trades below $140). However, in a similar light here, I'm always happy to pick up equity shares yielding 3%+ with double-digit dividend growth prospects. ITW offered that after its unexpectedly large dividend increase and HD followed suit this week. I suspect that with time, both of these high-quality names will move higher. So, why wait to add a bit of exposure when they're meeting my income-oriented expectations?
Only time will tell if this dividend increase news causes the stock to spike upwards or if the recent weakness will take back over and HD will head back down towards the $160 level that it bounced off of late last year. Regardless, I'm glad to be back, using an acceptable dividend yield/growth threshold to justify my purchase. High-quality companies like HD rarely go on deep sales, so if you're a value investor like me, it's difficult to pick up shares. However, from time to time, I break my rules, and I think a 32% dividend increase is enough reason to do so.
I think it's clear that certain retail names are separating themselves from the pack and Home Depot is one of them. Back in 2016/2017, I basically sold out of the retail space because I was concerned with the pressures that Amazon.com (NASDAQ:AMZN) (and other e-commerce names) were putting on the segment. Obviously Home Depot has done well since then, proving the naysayers (myself included) wrong. Walmart (NYSE:WMT) is another example of a company that appears to have turned the corner (though WMT doesn't offer nearly the same sort of dividend growth prospects that HD does, which is why I bought HD and not WMT).
Both HD and WMT have integrated the online and physical components of retail together nicely and are experiencing strong growth because of it. However, this isn't the case across the board. Other big box names are really struggling. When I sold out of HD, I also got out of the drug store space, selling Walgreens Boots Alliance (NASDAQ:WBA) and CVS (NYSE:CVS). I sold Target (NYSE:TGT) and Kroger (NYSE:KR) as well. I was able to lock in profit on all of these trades with the exception of CVS, which I took an 11% loss on. But if you look at the stock charts of many of these names since 2017, you see that they've continued to trend lower. Furthermore, I held on to Amazon, which has continued to skyrocket.
So in general, I made out relatively well exiting the retail space. However, I'm not ashamed to admit when I am wrong. I totally underestimated Home Depot back then and therefore undervalued the stock. The market has spoken clearly since I sold my shares in 2017, and at this point in time, all I can say is congratulations to all of those who stayed long and grew their wealth. Now, I'm right there with you, enjoying this ride. I don't have any plans to sell this name moving forward. You know what they say, "fool me once, shame on you, and fool me twice, shame on me." Well, I won't be fooled twice by this retail name. I hope to hold it for years and collect these rising dividends along the way!
If you enjoyed this piece, please stay tuned for the upcoming Seeking Alpha marketplace service that I'm currently working on, The Dividend Growth Investor Club. I'm hoping that this will be a place where income-oriented individuals can come together and discuss their ideas as we all pursue financial freedom. I'll be posting a variety of exclusive content, including single stock research, sector DGI watch lists chock-full of relevant fundamental data and sample portfolios with different target dividend yield and growth thresholds for Club members. I'm working hard and getting closer and closer to launch. I think we're a week or two away, so get ready to buckle up and take this ride with me.

Disclosure: 

I am/we are long HD, AMZN, ITW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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