Home Depot: A High Quality Dividend Machine

Photo by Marques Thomas on Unsplash

The Company

Home Depot, Inc. (HD) is a multinational home improvement retailer that primarily operates in the United States, Canada, and Mexico. The business serves as a one-stop shop for customers seeking products, services, and expertise for their home improvement projects. They serve both DIY enthusiasts and professional contractors. In addition to operating large warehouse style retail stores, Home Depot drives sales through its online platform, installation services, tool and equipment rental, pro services and various home services.

The business was incorporated on June 29, 1978 with the first retail location in Atlanta, Georgia. 3 years later, on September 22, 1981, the company went public with the influx of capital further fueling its growth and expansion. During its 40+ year history on the market, Home Depot has delivered a return nearly twice as high as the S&P 500.

Streak of Beating the S&P 500

I was only able to scrounge data since May of 1985. During the 466 full calendar months between 1985 and today, Home Depot has averaged a 1.93% monthly return, relative to a 1.00% return for the S&P 500. Measuring the stock on a rolling 5-year return, at the end of each month, we have 410 data points that can be compared to the S&P500. Home Depot has outperformed the index during 302 of these rolling 5-year periods (73.66% rate of success). This outperformance is better visualized in the chart below.

And this chart that shows the margin of over/underperformance.

The data tells us that Home Depot was a great company to own in the 80’s and early-to-mid 90’s. And again briefly around the dot-com bubble and following the financial crisis. More recently the margin of outperformance has been shrinking. The elevated excess returns, relative to the S&P 500, Home Depot was able to deliver in the 80’s and 90’s dwarf its streak from the last two decades. It’s worthy to note that between 2012 and 2019, Home Depot outpaced the S&P 500 by at least 100%, not a shabby margin of outperformance by any means.

Since July of 2011, Home Depot maintained a consecutive streak of 147 rolling 5-year periods of outperformance relative to the S&P 500. This streak was broken in October of 2023, by a mere 0.75%. In November of 2023, Home Depot’s rolling 5-year return once again rose above the return of the S&P 500, since then it has built a cushion of +30.4% (as of month-end February 2024).

High Quality Business

The main reason why Home Depot was able to grow at nearly twice the rate of the S&P 500 was because it is a high quality business, it has a competitive advantage and it dominates its industry.

They are one of the largest home improvement retailers globally, with a significant market share in the United States. It’s main competitor is Lowe’s, another major player in the industry.

Home Depot has consistently demonstrated strong financial performance, with steady revenue growth and healthy margins.

They have a very extensive market reach with a broad customer base ranging from DIY enthusiasts to professional contractors.

They have a robust supply chain and distribution network, allowing them to carry a wide range of products and fill orders promptly.

Home Depot succeeded in integrating its brick-and-mortar stores with its online platform, adapting to a changing retail environment.

They have brand recognition, a knowledgeable staff and a high commitment to customer service. I can attest to this personally as a former associate, granted its been nearly two decades since my brief stint working in the lumber and building materials department at the Melrose Park location.

Home Depot also operates in a resilient industry as home maintenance is unavoidable regardless of economic conditions. That being said the business is not entirely immune to economic downturns. It also has to continue adapting to evolving market dynamics and maintain its competitive edge to see continued success.

Financial Metrics

Let’s evaluate how attractive Home Depot looks through the lens of business quality. I believe a great place to start evaluating the quality of a business is what I like to call the quality quadrant. This quadrant comprises four key financial metrics that serve as reliable indicators for gauging the operational strength of a business. These metrics are the return on capital employed, total revenue, gross margin and the free cash flow conversion ratio.

The return on capital employed tells me how profitable a company is and how well it has utilized its capital. Effectively turning capital into profits is the primary driver of generating shareholder value.

Over the last decade, Home Depot has seen its Return on Capital Employed (ROCE) remain relatively healthy, oscillating around 40%. Between 2014 and 2018 the ROCE climbed steadily year-after-year. But since 2019 we’ve see a few bumps and declines. However, a ROCE around 40% is still very healthy and far better than what most companies can muster.

Revenue represents the financial inflow generated by a business through its operations. Positioned at the forefront of the income statement as the top-line figure, revenue provides a key indicator for assessing the pace of a business’s growth when analyzed across historical values.

Over the last decade, Home Depot has nearly doubled its total revenue. Between 2014 and 2022, the company experienced consistent year-over-year growth. Total revenue in 2023 came in about 3% below the prior year but forecasts are pointing for positive growth to resume starting next year.

Gross margin is the portion of revenue that is left over after direct costs are subtracted. It is one of the most important indicators of a company’s financial performance. This metric shows the cash available for various crucial purposes, including sustaining operations, servicing debt, distributing to shareholders, and fueling future growth.

Over the last decade, Home Depot has maintained a steady gross margin right around 33%. There is however a very modest downward trend looking at the entire past decade. This may prove to be concerning if it continues to persist going forward.

The free cash flow conversion ratio is a measure of a company’s capability in transforming profits into free cash flow. In straightforward terms, free cash flow reigns supreme, and companies adept at generating robust levels of free cash flow enjoy greater financial flexibility.

Over the last decade, Home Depot has done a swell job converting profits into free cash flow. The two post pandemic years did see a small decline but Home Depot turned it around in the prior year. I would love to see Home Depot consistently keep their conversion ratio above 40% going forward.

Dividend History

Home Depot has paid a dividend since 1989, but after 18 years of consistent dividend growth they broke their streak. Between 2007 and 2009 the annual dividend remained fixed at $0.90 per year. In 2010 Home Depot resumed annual dividend increases and is currently on a 15 year streak (inclusive of 2024). Since 2011, the annual dividend has grown by a double digit rate until the current year. Last month Home Depot raised its quarterly dividend from $2.09 to $2.25 or about 7.65%.

Throughout the last decade, Home Depot has maintained a healthy payout ratio, hovering between 40% and 60%. Throughout the decade the payout ratio has trended higher but should remain fairly healthy especially as the company slows its rate of dividend increases.

Valuation

Valuation, though more art than science, requires us to establish a baseline for fair value. To help me with this task, I leverage three techniques to evaluate the attractiveness of a particular stock: dividend yield theory, the price-to-earnings multiple valuation and the price-to-free-cash-flow per share multiple valuation.

In the image below you can see the results of each valuation method, along with historical valuation charts and the average valuation combining all three methods.

Using the Price to Free-cash-flow per share we get the most favorable valuation, suggesting Home Depot is about 15% undervalued. While dividend yield theory and the P/E multiple are both relatively close to fair value. Averaging all 3 valuation methods we can see that Home Depot is about 5-6% undervalued.

Since no valuation method is ever precise, my interpretation of the valuations is that Home Depot is a reasonable buy today, but not as attractive as it has been on several occasions during the last 7 years.

Final Thoughts

I currently hold a long position in Home Depot, with intentions of holding on to my shares for as long as I find it to be a high quality company. I strongly recommend conducting your own in-depth due diligence beyond the brief analysis I shared with you today. This way, you can assess whether you share my belief in Home Depot as a high quality business and whether the current valuation aligns with your own investment criteria.