Home Depot Inc (HD): A Premier Long-term Dividend Growth Stock

Home Depot Inc (NYSE:HD) has paid uninterrupted dividends since the late 1980s and is a dividend growth machine.

Since making its first quarterly dividend payment of 0.044 cents per share in 1987, Home Depot’s dividend has increased to 69 cents. The quarterly dividend has also more than doubled since 2012.

Home Depot possesses many of the qualities I love to see in a business. It earns a high return on invested capital, generates excellent free cash flow, maintains healthy payout ratios, operates in a slow-changing industry, and has created substantial value for shareholders over time.

This is the type of business I like to own in our Top 20 Dividend Stocks portfolio. While Home Depot’s current dividend yield (2%) is too low for some income investors, dividend growth potential is excellent and management expects earnings to continue compounding at a double-digit rate over at least the next several years.

Let’s take a closer look at this premier long-term dividend growth stock.

First though, let’s see how a collection of the top investors in the hedge fund world have been trading it of late. Home Depot was in the portfolios of 74 of the investment firms tracked by Insider Monkey as of March 31, up from 62 on December 31. Those 74 investors held 2.80% of the home improvement retailer’s shares, valued at $4.63 billion. Billionaires Andreas Halvorsen, Ray Dalio, and Stanley Druckenmiller were among the new shareholders of the stock during the first quarter.

Business Overview

Home Depot began operating in 1978, approximately 32 years after Lowe’s Companies, Inc. (NYSE:LOW) was founded. Despite its later start date, Home Depot is now the world’s biggest home improvement retailer with about $88 billion in annual sales.

The company has more than 2,200 retail stores (Lowe’s has over 1,800 locations) and maintains the number one market share position in the U.S., Mexico, and Canada.

Home Depot’s stores carry around 35,000 items covering a wide variety of building materials, lawn & garden products, and home improvement products. Its online catalog maintains over 1 million products. Online sales represent a little over 5% of Home Depot’s total revenue and have about tripled over the last few years.

The majority of the company’s customers are do-it-yourself consumers, who account for roughly 60% of Home Depot’s total sales.

Professional contractors, which only account for 3% of Home Depot’s total customer base, generate 40% of the company’s total sales because they spend much more on projects each year.

Business Analysis

Home Depot’s dominance in the home improvement market primarily stems from its economies of scale, strong brand recognition, valuable real estate locations, supply chain expertise, customer service, and leading breadth of products and services.

As the largest player in the market, Home Depot is the low-cost provider and can afford to offer one of the broadest lineups of products and services while investing in in-store displays and service staff to help customers get everything they need for their next project.

Home Depot’s employee base is another advantage. According to the company’s investor day presentation, the average tenure of store managers is over 14 years with Home Depot, and 94% of department supervisors started as sales associates. This helps the company provide more consistent project support to customers shopping in the store.

Home Depot also enhances its customer experience by partnering with suppliers to bring innovative and exclusive items to the market that help customers save time and money. Many suppliers depend heavily on Home Depot and have little bargaining power.

Smaller rivals cannot match Home Depot’s offerings, breath of merchandise, brand recognition, customer experience, and price points.

The company’s extensive IT systems and supply chain form other competitive advantages. Moving and selling millions of products is almost mind-boggling, but Home Depot has developed the extensive know-how needed to be a successful retailer.

This is particularly important when it comes to e-commerce. The company is focusing on creating a better customer experience, increasing the connection between its stores and website.

Home Depot has been opening massive direct fulfillment centers to meet the needs of online shoppers, and the company was even named Internet Retailer of the Year in 2015.

These investments improve Home Depot’s ability to scale and better meet the needs of online shoppers. Smaller rivals with less cash to invest and a smaller store network cannot keep up with Home Depot. If I had to guess, this will cause the market to further consolidate over the next decade.

Finally, with so many different products and a constant need to maintain properties, the home improvement market has simply proven to be resilient and slow-changing over the years.

A handful of major players control the majority of this mature market, making it very difficult for new entrants to disrupt the space.

Looking ahead, the company expects to add about $13 billion in total sales between 2016 and 2018 to reach its new three-year target of $101 billion in revenue. Management also targets operating margin expansion from 13% to 14.5% and an improvement in return on invested capital from 27% to 35%.

If successful, Home Depot’s sales will grow close to 5% per year over the next three years while earnings compound at a mid-teens clip. Incremental growth will be driven by Home Depot’s digital business and push to serve more professional contractors.

Home Depot estimates that its addressable market in the U.S. is $550 billion with the home improvement market accounting for $300 billion and services representing $200 billion. Maintenance, repair, and operations account for the remaining $50 billion.

In other words, Home Depot currently has about 15% market share in the U.S. and sees room for continued expansion, particularly in services (less than 3% market share), online sales (just over 5% of company-wide sales), and business with professional contractors.

Home Depot will likely remain a force for a long time.

Key Risks

Over short periods of time, Home Depot’s business is sensitive to U.S. GDP and the housing market.

Home prices began rising in 2012 and have since increased nearly 30%, according to the Case-Shiller Home Price Index. Home prices are still a bit below peak prices, but the wind has been behind Home Depot’s back for several years.

Higher home values cause homeowners to view their homes as an investment rather than an expense and have helped housing turnover return to its normalized rate, resulting in higher purchases of goods and services from home improvement retailers.

To this point, Home Depot says that big-ticket transactions over $900 in value have grown every quarter since the second quarter of 2011. Home Depot has also more than recovered the $13 billion of sales lost during the last recession.

While an unexpected slowdown in the economy and/or housing market would potentially hurt Home Depot’s near-term earnings, these events have little bearing on the company’s long-term earnings potential.

The bigger risks facing Home Depot are changing demographics, evolving customer shopping preferences, and potential market saturation.

For the first time ever, more Americans 18 to 34 years old live in their parents’ house (32.1%) than with a partner in their own home (31.6%).

It’s difficult to say what impact the Millennial generation’s different housing choices will have on the home improvement retail market, particularly if Millenials continue brining the home ownership rate lower.

Another demographic risk could be that the aging population shifts a lot of work from do-it-yourself customers to professional contractors. However, Home Depot already generates about 40% of its sales from contractors and is positioning itself for this trend by readjusting its organization to have a group dedicated on solving the needs of contractors.

Perhaps the biggest uncertainty facing all brick-and-mortar retailers is the rise of e-commerce and how customers shop. Home Depot has said that close to 60% of customers now start their buying journeys online before they even enter a Home Depot store.

Consumers can now buy virtually any product they desire using just the phone in their pockets – there is no longer as great of a need to visit huge stores to find what you need.

In other words, store size is not quite the advantage that it was 10 years ago, potentially creating opportunity for lower-cost internet retailers to begin stealing market share.

Home Depot has long been taking steps to fight off potential e-commerce competition. The company’s digital business has nearly tripled in the last few years and now accounts for over 5% of total company-wide sales.

Home Depot is fortunate to participate in many product categories that are less susceptible to online competition, in my view. Many products sold by home improvement retailers are for unique projects that require a hands-on evaluation and some consultation.

For example, a do-it-yourself remodel project requires the consumer to review paint colors, flooring designs, cabinet options, and more. Figuring out all of the materials needed is also difficult.

Home Depot’s online store is a major help and interconnects with its brick-and-mortar operations. According to Home Depot’s 2015 annual report, over 40% of the company’s online orders are picked up inside of a Home Depot store.

With more than 2,200 store locations across North America, Home Depot is better able to provide customers with omni-channel convenience compared to its smaller rivals.

Home Depot’s scale also gives it a leg up in e-commerce. The company has three massive direct fulfillment centers across the country that allow it to reach most of its U.S. customers in two business days or less when shipping directly to a home or job site.

Once again, smaller rivals cannot afford to make these investments, strengthening Home Depot’s hold on the number one market share spot.

Aside from demographics and changing customer preferences, market saturation is probably the biggest risk challenging Home Depot’s long-term earnings growth trajectory.

It’s hard to say how many big box home improvement retailers the country needs. Home Depot’s efforts to expand its addressable market into services and MRO markets (e.g. its $1.7 billion acquisition of MRO player Interline Brands last year) could be an indication that growth opportunities in traditional home improvement are nearing capacity – especially given its status as the largest player in the market.

Overall, Home Depot doesn’t appear to face many critical risks. Its strong brand, massive store base, economies of scale, leading e-commerce operations, and valuable real estate will keep it relevant and generating cash for a long time.

Dividend Analysis

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. Home Depot’s long-term dividend and fundamental data charts can all be seen by clicking here.

Dividend Safety Score

Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. A score of 50 is average, 75 or higher is very good, and 25 or lower is considered weak.

Home Depot Inc (NYSE:HD)’s Dividend Safety Score of 74 is excellent and indicates that the company pays one of the safest dividends in the market.

The company’s strong safety rating begins with its conservative payout policy. Home Depot targets a dividend payout ratio of 50% of earnings with a goal of increasing its dividend every year.

The company’s payout ratio over the last 12 months is 55%, essentially in line with management’s target. Over a longer period of time, we can see that Home Depot’s payout ratio has increased from the mid-teens in 2005 to sit closer to 40% in recent years.

A payout ratio of 50% provides a good margin of safety for most businesses. Even if earnings unexpectedly fell by 30%, the company’s payout ratio would still be below 70%.

Source: Simply Safe Dividends

Another factor impacting dividend safety is how well a company performed during the last recession, which served as the ultimate stress test for many businesses.

As seen below, Home Depot’s sales fell at a mid- to upper-single digit rate in fiscal years 2009 and 2010. The housing market obviously performed much worse than that, so Home Depot held up better than one might have expected.

Despite its moderate sales declines, earnings and free cash flow per share each declined by more than 25%. Home Depot incurs substantial fixed costs due to the nature of its store base, resulting in operating leverage.

Management held Home Depot’s dividend flat during the financial crisis. While the company is sensitive to the economy and housing market, its mix of repair products and services help it endure difficult market environments.

Return on invested capital is one of the most important financial ratios for dividend investing because it can be a good indicator of business quality. Companies with strong competitive advantages will usually earn high and stable returns, allowing them to compound earnings faster and pay safer dividends.

Home Depot significantly improved its return on invested capital since the housing crash, increasing it from 8% in fiscal year 2009 to 26% last fiscal year. Home Depot is clearly a very efficient and profitable operator.

Free cash flow is another key metric that influences a company’s ability to pay a dividend. Free cash flow allows a company to invest and return capital to shareholders without needing the assistance of capital markets.

Home Depot has been nothing short of a free cash flow machine. As seen below, Home Depot’s free cash flow has increased from a peak of $2.06 per share at the housing bubble’s peak in fiscal year 2007 to a whopping $6.17 per share last fiscal year.

Home Depot’s stores generate excellent free cash flow because many of their expenses are fixed. As same-store sales increase, expenses do not rise as quickly. In fact, management estimates that the company’s expenses will grow at about 50% of Home Depot’s sales growth rate over the next few years.

As Home Depot continues to make its stores and supply chain more efficient and new store growth slows, free cash flow should continue rising to support a safe and growing dividend.

Financial leverage is another big factor impacting dividend safety. A company will always make its interest and debt payments before paying a dividend.

Home Depot has close to $21 billion in debt compared to $3.3 billion in cash on its balance sheet. However, the company’s excellent profit generation and valuable real estate reduce any debt-related fears.

Home Depot’s net debt / EBIT (earnings before interest and taxes) ratio is 1.4, which means its total book debt could be retired with cash on hand and just 1.4 years of EBIT. This seems pretty conservative to me given the slow-moving nature of the home improvement retail industry.

The company’s real estate portfolio is also very valuable and supports the debt load. At the company’s most recent investor day, management estimated the value of Home Depot’s real estate at $35 billion, easily backing the debt carried by the company.

Home Depot also maintains a strong long-term debt rating of single-A.

Overall, Home Depot’s current dividend payment is extremely safe and supported by the company’s reasonable payout ratio, excellent free cash flow generation, high returns on capital, business stability, and manageable balance sheet.

Dividend Growth Score

Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

Home Depot’s Dividend Growth Score is 88, which suggests that the company has some of the strongest dividend growth potential in the market.

Home Depot has paid uninterrupted dividends since 1987 and increased its dividend every year since 2009.

Management last boosted the company’s dividend by 16% in February 2016, marking its seventh consecutive increase to its annual dividend.

Large home improvement retailers have proven to be very reliable dividend growers. For example, Lowe’s has raised its dividend for more than 50 straight years and is a member of the dividend aristocrats list.

As seen below, Home Depot has increased its dividend at an annual growth rate of 19% over its last 10 fiscal years, and annual dividend growth has exceeded 20% over more recent time periods.

Going forward, management targets a dividend payout ratio of 50%, which is about where the company’s payout ratio sits today.

In other words, unless management is willing to increase Home Depot’s targeted payout ratio, dividend growth will likely follow earnings growth over the coming years.

Under Home Depot’s new three-year plan through 2018, management’s targets imply annual earnings growth in the mid-teens. If I had to guess, Home Depot will continue growing its dividend by at least 10% per year over the next few years.

Valuation

According to our database of dividend-paying stocks, shares of Home Depot trade at 23.2 times trailing earnings, which is a premium to the dividend stocks in the Consumer Discretionary sector, which have a median price-to-earnings ratio of 19.2.

Home Depot’s dividend yield of 2% is about in line with its five-year average dividend yield. While earnings growth could be in the mid-teens over the next few years under management’s strategic plan, I believe long-term earnings are more likely to grow at a high-single digit rate. Home Depot is already a giant company in a fairly mature company, and

Under my earnings growth assumption, Home Depot appears to offer annual total return potential of 9-11% per year (2% dividend yield plus 7-9% annual earnings growth).

Given my earlier concerns about the mature state of the home improvement retail market, I would prefer to wait for a better entry point on the stock – its current multiple seems a bit high relative to my expectations for long-term growth.

Conclusion

From a fundamental perspective, there’s not much to dislike about Home Depot. The company maintains the largest market share in the home improvement retail industry, benefits from economies of scale, is a supply chain expert, and is positioning itself to remain relevant for years to come by investing aggressively in e-commerce.

Home Depot Inc (NYSE:HD) is a prime example of a blue chip dividend stock. Consistent free cash flow generation, time-tested operations, a strong brand, healthy payout ratios, and consistent earnings growth all contribute to the company’s solid dividend story.

Home Depot is on my watch list for a better entry point and is a high quality company for long-term dividend growth investors to keep an eye on.

Disclosure: None