When a company finally gets its operational ducks in a row, the performance can be impressive. Couple that with a rising tide of improving underlying conditions, and the performance can be exceptional. That's the basic thesis on Home Depot (NYSE:HD) these days, as operational improvements started years ago are really bearing fruit and the company is starting to see the positive impact of improving housing markets.
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Another Solid Quarter
Revenue rose more than 7% this quarter, leading to another beat relative to sell-side expectations (2% in this case). Comps were up 4.3% overall, with U.S. comps up nearly 5%. With comp growth in line with expectation, the revenue beat was largely a product of the calendar shift relative to last year. Within the overall revenue growth figure, the average ticket was up about 5%, while transactions were up half that amount.
Home Depot also once again posted solid margin improvements. Gross margin improved about 20 basis points from the year-ago level, which was mostly consistent with investor expectations. Operating income was strong, though, climbing 22% as operating margin expanded by 130bp and exceeded expectations.
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Working Well, Front To Back
That Home Depot is seeing good comp growth is not entirely surprising. If you looked at the performance of companies that supply Home Depot – a list that includes Masco (NYSE:MAS), Electrolux (Nasdaq:ELUXY), Stanley Black & Decker (NYSE:SWK), Sherwin-Williams (NYSE:SHW), Akzo Nobel (Nasdaq:AKZOY), and USG (NYSE:USG) – it looks like revenue in the first quarter was up around 2% to 3.5% for the most part.
But this isn't just about Home Depot riding a recovery in the demand for building supplies, tools, housing fixtures, and the like. It seems as though Home Depot is gaining share, both in the core home improvement category and in appliance sales (even with good recent results at Best Buy (NYSE:BBY) in appliances).
It also looks like Home Depot is coupling improvements in the front end of the store with the back end of the store. What I mean is that Home Depot has spent more than a little effort in recent years on improving its supply chain economics and internal cost efficiencies. That's allowing the company to improve margins without having to fight self-destructive pricing battles, and it also looks like it's doing no harm to the company's in-stock position or merchandise assortment.
The Bottom Line
I've been a step or two behind Home Depot for some time now, as I've underestimated both Wall Street's desire to own housing recovery stocks and Home Depot management's ability to drive ever-better margin improvements. Margin leverage is an underappreciated driver of stocks, and in some cases is one of the most significant factors in determining which stocks outperform over time. Even though Home Depot already sports very good operating margins and returns on capital for a big-box retailer, recent performance is making me reconsider what's possible and sustainable on a long-term basis.
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To that end, I still believe that Home Depot will grow its revenue at a long-term rate of around 4%. On the cash flow side, though, I'm willing to go up to the 6% to 7% range given those margin improvements. That's still not enough to produce an attractive fair value (around $67 per share), and other metrics like EV/EBITDA, PEG, and EV/revenue do have Home Depot shares looking pricey today. All the same, I wouldn't get off a fast horse in mid-gallop – if I had already seen the nearly 60% jump in Home Depot shares since last year I might consider some protective stops for at least part of my position, but I wouldn't be in a rush to sell unless/until the comp growth and margin improvement starts to peter out.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.