Home Depot (HD) reports... and the knee-jerk was to the downside.
First, a disclaimer. I am long this name coming into Tuesday morning. Yes, I did say that I was getting out of Home Depot several months ago. I did exactly that, then. Yes, I was brought back across that wall as the shares sold off this year. My current net basis is $282 and change, so this morning's selloff has wiped out my profit. What to do now? Let's explore, shall we?
On Tuesday morning Home Depot released the firm's fiscal first quarter financial results. For the three month period ended April 30th, Home Depot posted a GAAP EPS of $3.82 on revenue of $37.257B. While the EPS print compares to $4.09 for the year ago period, this result did beat Wall Street by a few cents. The sales number fell more than $1B short of consensus, while reflecting a 4.2% contraction from Q1 2022.
What probably has investors most spooked this morning were the comp (same store) sales, which were -4.5% overall and -4.6% in the US. As net sales contracted 4.2%, the cost of those sales contracted 4.1% to $24.7B. The left a gross profit of $12.557B (-4.5%). Operating expenses decreased by just 2.9% to $7.006B, pressuring operating income that suffered a 6.4% drop to $5.551B. After accounting for interest and taxes, net earnings printed at $3.873B (-8.5%).
Guidance
I think beyond performance, at least a significant portion of this morning's selling pressure developed in response to the firm's full year outlook. Both sales and comp sales are expected to drop between 2% and 5% for the full fiscal year. The firm sees an operating margin of 14% to 14.3%. The above Q1 performance was good for an operating margin of 14.9%, so the firm expects the environment for profitability to toughen further. Home Depot also sees an earnings per share decline of 7% to 13% for the year.
Fundamentals
For the period reported, Home Depot generated operating cash flow of $5.614B, up significantly from $3.789B a year thanks to a huge swing in changes in working capital. Out of this came CapEx of $905M, leaving $4.709B in free cash flow (FCF). Despite the beefy print for FCF, this is where it gets dicey. The firm spent $2.887B in the repurchase of common stock and $2.118B in cash dividends paid to shareholders. This means that the firm returned 106% of free cash flow to shareholders.
It's great to return capital to shareholders, for they are the owners of the company., However, it is almost always prudent to limit those returns to a maximum of 100% of FCF, probably less. Why? Because it's a trap. The day a firm needs to be flexible with its free cash, and is forced to walk away from its own repurchase program or cut its dividend will be seen as a lousy day by shareholders, especially those who don't really get cash flows, balance sheets, and how those returns are created.
Turning to the balance sheet, HD ended the quarter with a cash position of $1.26B (down huge from just three months ago) and inventories of $25.371B (up from three months ago), leaving current assets at $32.423B (in-line with three months ago). Obviously the less cash/bloated inventories story has been sub-optimal for many businesses in this environment.
Current liabilities add up to $25.446B, including $1.338B in shorter-term debt. The firm's current ratio stands at 1.27, which is no problem at the present. We don't normally hold retailers to the same standards as other types of businesses when considering quick ratios as retailers are by definition inventory-centric. This needs to be watched. HD's current inventory valuation is a rough $10B above what was normal for the firm until 2022.
Total assets amount to $76.386B, including just $7.447B and no other intangible assets. At less than 10% of total assets, this is no problem at all. Total liabilities less equity comes to $76.024B, including long-term debt of $40.915B. I am not going to pretend that I am cool with long term debt that runs at more than 32 times the firm's cash position, because I am not, regardless of the terms.
In fact, I find it quite irresponsible to divert 100%+ of free cash flow toward the return of capital to shareholders while cash levels run almost dangerously low and stand absolutely dwarfed by debt-load. Management has to be smarter than this.
My Thoughts
There's a lot to not like here. The stock closed on Monday night at 18 times forward looking earnings, so at least it's not overtly overvalued. Margins are under pressure. Sales are under pressure. Comparable sales are under pressure. The firm does not see utter collapse, but does expect this pressured environment to, at a minimum, extend through the balance of this fiscal year. That's three more quarters (at least) of backwards momentum if nothing changes.
In addition, while the firm's current situation is fine, the overall balance sheet has problems that the firm could address through proper allocation of free cash flow. It might be best to get started on this while that free cash flow is beefy. That has not happened just yet. It is going to hurt, but in my opinion, the firm needs to rebuild the entry for net cash on its balance sheet and the only way to do this without injuring the business is to divert funds that were going to be returned to shareholders.
That will be a problem for the share price, which is probably why management has been slow to get there. I love the business. I am always at my local Home Depot. I just don't trust current management and no longer have any desire to be long this name.
Readers will see that HD has been mired in a downward sloping channel since December (with the exception of that early February pop). The shares gave up their 200 day SMA (simple moving average) three months ago (on earnings) and have failed to retake and hold that line on multiple occasions since. The shares have also surrendered their 50 day SMA as well as their 21 day EMA.
That means that the swing traders are out, and portfolio managers who had been ready to add exposure if HD had popped above that 50 day line this morning, will instead withdraw more than they already had. The stock, in my opinion, will be a hot potato for a little while. If one is feeling the itch this morning to buy the dip, remember to wait for the community of analysts to all weigh in. I am not sure that I would expect a bevy of downgrades, but I definitely would be looking for some downwardly revised target prices.
I will be working my way toward the exit door this morning. Which will create some cash. That's probably a good thing.
