Home Depot: Don’t Rely On SRS Acquisition Yet (NYSE:HD)

Investment Thesis

The last time I wrote about Home Depot (NYSE:HD), in November 2023, I talked about how the company’s investments in technology should allow it to be more efficient. However, I did raise my concern about the company’s strategy to shift its focus towards the Professional segment. I had a Hold recommendation on the stock. Since my article was published, the stock has gained 11.9%, underperforming the S&P 500, which gained 17.8% during the same period.

In this article, I discuss the company’s Q1 report and analyze how the company’s strategy which involves shifting its focus towards the Pro segment has progressed so far. I also offer my insights on the company’s planned acquisition of SRS Distribution and its long-term impact on the company.

First Quarter Highlights

Home Depot had a mixed quarter, as an unexpected delay in Spring and the challenging macro environment weighed on the company’s results. While diluted EPS of $3.63 was down 5% y/y, it beat analyst estimates by $0.03. Revenues, on the other hand, came in at $36.4 billion and were not only down 2.3% y/y but also missed analyst estimates by $224.6 million. Comparable sales declined 2.8% during the quarter, coming in worse than analyst expectations of a decline of 2.2% y/y. Customer transactions and the average ticket of customers both declined by 1% and 1.3% y/y respectively.

Despite the tough start to the year, management reaffirmed their guidance for FY24 with both sales growth and diluted EPS growth expected to be 1%, buoyed by the fact that it’s a 53-week year. The 53rd week is expected to contribute $2.3 billion in sales and approximately $0.30 to diluted EPS. The company also expects gross margins of approximately 33.9% and operating margins of 14.1%. As a result of the company’s decision to acquire SRS Distribution, it has paused its share repurchase program. However, the company declared a quarterly dividend of $2.25 per share.

Even the Pros are Feeling the Heat of Higher-Rate Environment, but the End is Near for the Pain

One of the main drivers of HD’s decline in comparable sales growth was the delayed start to Spring. On the face of it, while this might sound like a bad excuse, given the segment that HD operates in, it is not something that the company can do anything about, especially since the weather has a major impact on the industry’s ability to sell outdoor categories. Given that the firm re-affirmed its FY24 guidance of a 1% decline in comparable-store sales, it does suggest that the company expects to make up for the decline in Q1 as the weather improves. Management, during the earnings call, offered some support to this notion as it said that in areas where the weather was good, sales were strong.

Having said that, the Pro segment, which is where the company is focusing on lately and where the company believes the growth opportunity lies, keeps facing headwinds borne out of the high-interest rate environment. Both the Pro and DIY segments’ performances were negative for the quarter, and while the backlog of the Pro segment remains stable, given the fact that homeowners continue to focus on smaller projects, the segment continues to face the heat. For instance, comparable sales of large-ticket items (priced above $1,000) saw a decline of 6.5% y/y.

It’s not all doom and gloom, however, for HD and its attempts to capture the Pro segment. The company’s investments in fulfillment, sales force, specific digital assets, and order management capabilities, designed for the Residential Pro segment, for instance, are paying off. Markets where this “new ecosystem,” was launched have outperformed the other large Pro markets in aggregate, which suggests that the moves made towards capturing the Pro segment are slowly starting to pay off.

Moreover, the company also announced that it would be launching job site pickup or returns, which should allow the customer to initiate a return from the job site as opposed to having to return items to the store themselves. This feature is likely to be a huge boost for the Pro segment, which should help the company acquire new customers as well as retain existing customers.

Furthermore, while the macro environment remains challenging for now due to the higher-interest rate environment, all signs point to the Federal Reserve about to start its rate-cutting program in the coming months, especially after the latest inflation data came in cooler-than-expected. While the impact of rate cuts might not be felt immediately, this would nonetheless be a huge boost for HD as it would finally start getting customers off the sidelines. The rate cuts would also make loans for large projects more digestible for customers, which would subsequently help the company boost the Pro Segment. Even in a high-rate environment, according to the latest US retail sales data, the building material segment did see a 0.5% increase sequentially, similar to the growth rate seen in March. So, now that we are not too far away from the rate-cutting program, there are reasons to be optimistic for HD investors, especially concerning the company’s Pro segment.

Acquisition of SRS in Line with HD’s Strategy but Don’t Expect Any Impact Anytime Soon

One of the major announcements made by the company during the quarter was its intention to acquire a residential specialty trade distributor, SRS Distribution, for $18.25 billion. The acquisition, if completed, would be the largest in HD’s history.

The decision to acquire SRS is in line with the company’s strategy. As I mentioned the last time I wrote about HD, the company has switched its focus from the DIY segment to the Pro segment. SRS is a key player in three specialty trade verticals: roofing, pool contracting, and landscape. Acquiring SRS will offer HD immediate access to Pro customers within this vertical, and will also allow the company to leverage SRS’s expertise to further boost the Pro segment.

Furthermore, the Specialty Contractor segment is expected to show tremendous growth in the coming years. According to a report by the Business Research Company, the specialty trade contractors’ market is expected to grow to $7.9 trillion by 2028 globally at a CAGR of 6.7%. And while this market includes residential, non-residential, and utility system construction segments, the growth rate is impressive. The company, during the earnings call, suggested that it serves a market whose total addressable opportunity is estimated to be $1 trillion. Of this, HD’s management estimates the Pro segment to have a TAM of $250 billion. The SRS acquisition, therefore, is HD’s attempt to fast-track its attempts to capture the market. Taking all things together, the acquisition, in my opinion, makes sense.

However, I wouldn’t expect any impact from the acquisition in the short-to-medium term. During the earnings call, management announced that the acquisition is expected to be completed only by the end of FY24, and as such, there would be no boost to the earnings and revenue from the acquisition. Furthermore, this acquisition is a bet based on TAM, a metric that does not exude confidence given that it’s merely a projection. As such, the extent of the gains, which the company can generate through the acquisition remains uncertain. Investors, in my opinion, should not put much weight on the acquisition and its impact until we receive more evidence. Moreover, the acquisition does come at the expense of share repurchases, which, once again, is not exactly a positive for investors, especially in the backdrop of a challenging macro environment.

Valuation

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Source: LSEG Workspace (formerly Refinitiv), HD’s Q1 Earnings Report, Seeking Alpha and Author’s Calculations

The company, as I mentioned earlier, re-affirmed its FY24 guidance and now sees FY24 diluted EPS growing by 1% y/y. Despite the tough start to the year due to delayed Spring, management did announce, during the earnings call, that in areas where the weather was good, they did see strong sales. As such, I have assumed the 1% EPS growth for my calculations, which translates to FY24 EPS of $15.26.

The company currently trades at a forward P/E of 22x. Historically, the company has been trading at a multiple of 20x, according to LSEG Workspace (formerly Refinitiv). Given the challenging macroenvironment that the company currently operates in, I have assumed the historical multiple of 20x for my calculations.

The company, according to Seeking Alpha, currently trades at a forward PEG ratio of 6.6. At a forward P/E of 20x, this would translate to an FY25 earnings growth of 3%, which is a reasonable estimate given that the macroenvironment would be more favorable for HD once the Fed starts to cut rates and the housing market rebounds. I have assumed this earnings growth for my calculations, which translates to FY25 diluted EPS of $15.72.

At a forward P/E of 20x and a projected EPS of $15.72, we would get a price target of $314, which suggests that the company is overvalued at current levels.

My price target has not changed since the last time I wrote about the company because my previous FY24 projections came in line with the management’s guidance and my projected earnings growth has also remained at similar levels (3% vs 3.7%).

Despite the overvaluation, I would not recommend taking a short position in the stock, given that it is only about 8% above my price target. Furthermore, the macro environment remains extremely dynamic, and if the Fed starts to cut rates as expected in the coming months, then it would benefit HD. As such, I maintain my Hold rating. Existing investors, however, could book some profits at current levels in my opinion.

Risk Factors

The main risk factor is that in addition to pausing the share repurchase program, the SRS acquisition will also increase the company’s leverage. Both of these don’t bode well for income-loving investors and would be an even bigger risk if the acquisition doesn’t play out as expected.

Then there’s the risk that the macroenvironment could remain challenging for longer, especially if the rate cuts don’t take place as expected. For now, the Fed is expected to begin the rate-cutting program in September. However, any surprises in inflation could delay the program, which could subsequently cause consumers to further defer the big-ticket projects, thereby causing a drag to the company’s top and bottom lines.

Concluding Thoughts

It was not a good start to the year for HD. The company continues to face the heat from a challenging macro environment, as evidenced by the worse-than-expected comparable store sales. To make matters worse, the weather played spoilsport as well, as a delayed start to the Spring caused more damage to the company’s sales. And while management is confident that it will make up for it in the coming quarters as the weather gets better, the underlying macro environment is expected to remain challenging in the short term.

The company’s decision to acquire SRS appears to be a smart move, especially since it would offer the company new avenues within the Pro segment, an area where the company sees a lot of growth potential. However, this acquisition is not expected to have any impact until next fiscal year and does come with a lot of question marks, given that the acquisition’s success is based on TAM, a metric that doesn’t exude much confidence. Moreover, the acquisition will also increase leverage and put an end to the share-repurchase program.

Having said all of this, the fact that the rate-cutting program is about to commence later this year does offer relief for the company. Customers who have deferred big-ticket projects could make a comeback once the rate cuts are initiated, which should offer relief for HD. From a valuation standpoint, the company continues to remain overvalued in my opinion. And while I don’t advocate a short position in the stock, profit-taking for existing investors might not be such a bad idea.