Home Depot – Assessing the moat

The Home Depot, Inc. is a home improvement retailer that sells building materials and home improvement products. The Company sells a wide assortment of building materials, home improvement and lawn and garden products, and provides a number of services. Home Depot operates throughout the United States, Canada, China, and Mexico. Home Depot currently encompasses ~24% of the Home Improvement market in the US and has effectively grown sales in the last decade without expanding its store footprint. The financial impact of this strategy is strong economies of scale, reinvestment into the customer through lower prices and a highly free cashflow generative business model due to limited capital expenditure requirements. There are two key moats’ that provide HD a sustainable advantage over its competitors.

1) Economies of scale

HD has a formidable size advantage over competitors, allowing cost savings via logistical efficiencies, inventory sourcing savings and a fixed cost base spread over a higher revenue base. This is due to that fact that HD generates 50% more sales than Lowe’s. HD is focused on sales volume and velocity as opposed to margins which competitor Lowe’s has historically prioritized. Their focus was selling less at a higher price while HD sought to sell more at a lower price which translated to stronger customer loyalty and repeat transactions. Lower prices led to more sales which led to greater absolute profits and lower fixed costs per item sold, allowing HD to reinvest back into the customer in the form of even lower prices and a repetitious cycle focused on customer satisfaction. See the below quote from “Built from Scratch” which details Arthur Blank and Bernard Marcus’ journey as co founders:

“The Home Depot is far ahead of Lowe’s in every major measurement of success. We produce on average about 40 percent more volume out of our big boxes than they do at a 40 percent greater rate of profitability.”

The superior execution is evident in HD’s comp store sales vs. key competitor Lowes:

As well as superior asset efficiency:

2) Intangible asset (Company culture)

Home Depot’s attractive prices are reinforced by a strong customer centric culture that forms a powerful intangible asset moat.

“When you only copy somebody and don’t really understand why they’re doing what they’re doing, you’re never going to be as good as the original. That’s Lowe’s problem vis-a-vis The Home Depot. They copy almost everything we do, from store design to marketing. But the reason they still only achieve about 60 percent of our volume is that they don’t understand the essence of what we do: take care of the customers.”

This attention on the customer is reflected by the fact that aisle numbers don’t exist in any of their stores. This design is so that associates can’t simply direct customers based on an aisle number. Instead, the employee has to take them to where they need to go, establish a relationship and offer advice. This is especially valuable in the home improvement category because the vast majority of non pro customers do not know what they are doing. A helpful associate that is passionate about home improvement will have every opportunity to provide expert advice on a topic that the shopper likely knows very little. The opportunity for this level of service differs greatly from other retail stores where invariably the consumer already has a reasonable idea of what they want, may not want to be disturbed and does not require a practical explanation of how to fix their specific problem. Home improvement is unique in the respect that the retailer does not merely sell products, it is an opportunity to provide professional (or semiprofessional) advice that goes beyond the bounds of most retailer-shopper relationships. These experiences become sticky for the customer, ensuring recurring shoppers in the future. This relationship also provides a layer of defense against online as a customer entering a home depot store is looking for more than just the best prices, benefitting from free tips on how to best complete their desired project. The following quote sums it up well…

“Our people were already instructing weekend warriors in an informal way. Putting on How-To-Clinics became a way of formalising the teaching and making it available to all of our customers and further cultivating their interest in do-it-yourself home improvement. We saw people who were all thumbs before they came into The Home Depot go on to do room additions or build their own homes. That’s a big part of how we created demand that never existed before.”

The second distinct intangible competitive advantage that HD possesses is how the firm treats employees – co founders Arthur Blank and Bernard Marcus often attributed the single greatest reason for their success as the effort to take care of associates. These employees are pivotal to providing an enjoyable shopping experience and as a result, HD puts a larger percentage of overall sales revenue back into expenses via employee payroll than its competitors. Management view employee wages as an investment rather than an expense and it shows as they continue to reinvest in the customer by increasing sales people, even as each store gets busier. The below chart demonstrates that sales per square foot has been the key driver of growth whereas sales per associate has been less meaningful. This demonstrates that as the business has grown, they have not simply expanded store footprint which would have each yielded a lower return on each subsequent capital investment. Instead, HD has grown its associates in line with sales (particularly when adjusted for average ticket size growth.) The ratio of associates to customers remains broadly unchanged, demonstrating the ongoing commitment to excellent customer service.

The associate-customer relationship benefits both parties as nearly all associates are passionate about at least one particular DIY category and enjoy the challenge of solving customer problems. The most important hiring criteria for HD’s sales staff is product and project knowledge. This creates a rewarding workplace for HD employees, driving greater enthusiasm from sales staff and an overall better customer experience once again. Another quote from the HD book reinforces this point well…

“Our Atlanta Training Center teaches new and existing store managers and district managers how and why our culture, philosophy and leadership approach works… The sign at the front entrance of our main offices in Atlanta says “Store Support Center” Not “World Headquarters.” It is not a corporate ivory tower. It is truly the store support center. We want everybody in this building to know that we are here to support the stores.” 

Co Founder’s Bernie and Arthur would reportedly spend 25-30% of their time in stores, seeking to train managers in the Home Depot culture and teaching merchandising.  It is this decentralized org structure that enabled senior management to support their associates in-store and in turn, remain close to the customer. Based on the above discussion, it appears that HD has a relatively defendable moat but the question remains…

What returns are available for HD at the current valuation ?

HD has grown sales over its existing store footprint only adding 39 stores over the course of the decade to reach a total of 2,291 vs. Lowes which added 232 for a total of 1,977. As the graph below highlights, comp store sales have hovered around 5% for the decade, enabling strong underlying sales growth despite the lack of store rollout. HD has ~24% market share but has a strong track record of growing above the market rate of ~3% and I expect this to continue given its superior customer offering and circular reinvestment of profits.

HD’s margins have expanded from 3% of sales during the GFC to 10% in FY19 although further margin expansion is unlikely due to a desire to reinvest profitability on customer retention. This kind of long term thinking underpins the sustainability of Home Depot’s competitive advantage and enables the business to continue to take share. HD’s limited capital requirements lead to significant free cashflow generation. With the bulk of cashflow repaid to investors in the form of dividends or share repurchases. Capex has remained in the range of 1.5%-2.5% of sales and I do not expect this to change in the future.

Home depot has returned between 11%-14% of sales to shareholders every year since 2014 and is currently yielding a 3.8% return of capital (share buybacks + dividends.) Although it is a well moated business with a terrific track record, the opportunity for future growth is limited given that the business does not seek to reinvest for growth. Therefore, shareholder capital appreciation is likely limited to 5% earnings growth (driven by 5% sales growth and limited appetite for margin expansion as the business reinvests in lower prices.) The attractiveness of HD’s capital returned to investors is somewhat offset presently by the very strong share price run it has had on the back of a stimulus driven home improvement boom – as an indicator HD just posted 25% like for like sales in Q2. HD currently trades at near an all-time high multiple on peak earnings.

As a result, HD is at present more of a ‘hold’ than a ‘Buy’ but if the multiple compresses, presents a compelling opportunity due to its strong competitive advantage. Through a DCF, I value the current business at ~$341bn with limited upside from the current price.

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