Idea Of The Week: Home Depot’s Strong Foundation

Recovery in the housing market has helped shares of Home Depot Inc. (HD.N) increase 47% in the past year to close at an all time high of $118.00 per share on Aug. 5. Strong operational efficiency and capital allocation discipline also have allowed Home Depot to build a solid foundation of high quality earnings. Let’s take a walk down the aisle to see what’s in stock for earnings expectations this quarter and to look at the stability of the world’s largest home improvement retailer’s earnings.

Home Depot is expected to report earnings on Aug. 18 and analysts currently estimate a 3.6% year over year (YoY) increase on revenue of $24.68 billion and earnings of $1.71 per share, up by12.5%. The home improvement retailer is also expected to increase U.S. same store sales by 4.47% and total same stores sales by 3.49%.

Exhibit 1: Select U.S. Housing Economic Indicators vs. HD.N Close

Source: Thomson Reuters Eikon/StarMin. Click here for updates on the economic data in this chart. 

Construction zone

Several economic housing data points indicate that Home Depot has the right tools for good earnings.. The June quarterly average for the seasonally adjusted U.S. Pending Home Sales Index (USNAR=ECI) is up 10.5% and the June quarterly average seasonally adjusted U.S. Private Residential Construction Spending Index (aUSRCONS/A) is up 10.4%.

Exhibit 2: StarMine Alpha Model Indicator Highlights for Home Depot

Source: Thomson Reuters Eikon/StarMine

No red tape

Home Depot has eight bullish indicators, five of which are within the top decile, and no bearish indicators. Additionally, three out of four of StarMine’s four credit risk models rank the company within the top 10% of North American companies. Home Depot scores a 97 out of a possible 100 on StarMine’s Structural Credit Risk (SCR) model, which forecasts the probability of default within 12 months, and provides an implied credit rating of AA+. This is good sign following the July 22 announcement that Home Depot will acquire Interline, a direct marketer and distributor of broad-line maintenance, repair and operations products, for $1.625 billion in a deal expected to be completed by the quarter ending in November 2015.

Built on quality

The quality of earnings has been shown repeatedly to be an important indicator; those companies whose earnings come from sustainable sources are likely to generate better financial results over the longer term. Home Depot has a StarMine Earnings Quality (EQ) score of 94 on a scale of 1 to 100, with 100 representing the highest quality earnings. That puts the home improvement maker firmly in the top decile of companies in North America, which is a bullish signal. A look into some of the model’s components helps to show why Home Depot scores so highly.

Exhibit 3: Home Depot Return on Net Operating Assets vs. Specialty Retail Industry Mean

Source: Thomson Reuters Eikon/StarMine

The right projects

Over the past 19 quarters, Home Depot has consistently improved generating trailing four quarter (T4Q) return on net operating assets (RNOA), bringing it to 44.6%, which is 21.1 percentage points higher than the Specialty Retail industry mean. This means the management of this home improvement retailer is selecting the right projects.

Exhibit 4: Home Depot T4Q Operating Profit Margin vs. Industry Mean

Source: Thomson Reuters Eikon/StarMine

Efficient operations

Home Depot has successfully continued to build trailing four quarter operating profit margin (OPM) over the past 19 quarters to 12.8% while remaining above the Specialty Retail industry median, currently 7.0%. Last quarters’ T4Q operating income of $10.8 billion increased 15.4% from the prior year.

Exhibit 5: Home Depot T4Q Net Operating Asset Turnover vs. Industry Mean

Source: Thomson Reuters Eikon/StarMine

Picking up a hammer

Net operating asset turnover (NOAT) measures how efficiently a company uses its operating assets to generate revenue, and our model measures both the absolute level and the rate of change in asset turnover. Home Depot’s T4Q revenue of $84.4 billion increased 6.3% from the prior year, while T4Q average net operating assets (ANOA) only decreased 3.2% to $24.2 billion, allowing their T4Q NOAT to increase 9.8% to 3.49 and match the industry median. Discipline in capital allocation combined with operational efficiency demonstrated by the 15.4% increase in T4Q OPM resulted in an increase of 7.2 percentage points in T4Q RNOA, bringing it to 44.6%.

Given management’s track record for efficiency and capital discipline, analysts will be on the lookout for macroeconomic forces that could deviate from current expectations. So far, however, the company’s course looks like a blueprint for success.

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