Home Depot (HD) reported better than expected 4Q21 results driven continued upside in sales.  However, investors chose to focus on conservative guidance and modest pressure on gross margins, accelerating the recent pullback in the shares.  HD management has been very cautious about forward-looking commentary since the pandemic began despite consistently seeing sales growth well above its own and Wall Street expectations.  Northlake thinks 2022 revenue guidance will prove conservative as secular drivers of home improvement spending will continue to have a greater impact than tough, pandemic-fueled comparisons.  After a 30% pullback in 2022 from all-time highs, we believe the shares are even more attractive on severely compressed valuation metrics.

Stock Reaction:  HD shares had pulled back sharply going into the report, falling from $415 at yearend to $347 ahead of the 4Q21 earnings report.  Traders were focused on the end of the home improvement cycle as mortgages rates rose, government stimulus ended, and consumer pocketbooks were pressured by inflation for routine consumables like groceries and gasoline.  With sentiment already sour, HD’s guidance for 2022 revenue to “slightly positive” on “flat” operating margins reinforced the“cycle is over” bear case.  The shares fell as low as $299 pressured by the earnings and Ukraine-related market selloff before recovering to $316 in the historic market rally to end last week.

Earnings Analysis:  HD’s 4Q results were quite strong, driven by same-store sales growth of 8%.  Throughout 2021, management and investors have been expecting a sales slowdown after work-from-home and stay-at-home drove a surge in do-it-yourself home improvement spending.  Despite another quarter of elevated growth (pre-pandemic trend was 3-4% year-over-year growth), traders noted that a portion of the strength came from inflation in commodities like lumber (2X during 4Q21) and a shift toward Pro, or contractor, spending with DIY softening modestly.  The commodity inflation also triggered a small slip in gross margins relative to expectations.  As we have outlined in previous quarterly HD updates, gross margin disappointments often lead to investor consternation and downside stock price volatility.

Management reinstated formal guidance for the first time since the pandemic with its 2022 forecast.  We believe the willingness to provide guidance shows management’s confidence in the outlook despite the cautious outlook.  HD management has always struck us as conservative and seems happy to guide carefully and subsequently produce upside surprises.  Given the difficulty of forecasting the future environment, we suspect management just wanted to play it safe, and results will ultimately easily exceed guidance.  We also note that management indicated that its guidance does not build in further inflation.

Northlake believes the pandemic has created a secular increase in demand for improvement that should overcome the very tough comparisons to 2020 and 2021 sales growth (1Q21 sales grew 31% making 1Q22 the toughest comp.  Secular growth drivers include (1) millennial demand, (2) work-from-home, and (3) a big step-up in home prices/values.  Millennials have been slow to buy homes compared to prior generations but data is clear showing recent improvement.  A return to offices seems likely as the pandemic hopefully is winding down, but we expect work-from-home has made permanent gains that drive home improvement spending. We also believe almost two years of spending more time at home and noticing potential home upgrades has created a large backlog of projects that is further supported by rising home values.  These secular growth drivers should allow HD to beat its conservative outlook and “comp the comp” as Wall Street likes to say.  Furthermore, the company’s increased focus on e-commerce and Pro capabilities that we have discussed in prior updates remain positive secular influences.

Normally, we do not directly attribute our analysis to Wall Street analysts, but Credit Suisse added a few interesting points about HD’s 2022 guidance including playing it safe given the newly promoted CEO begins his term on March 1^st, ongoing supply chain impacts leaving store shelves with less inventory, and a surge in contractor demand as concerns about letting workers in homes dissipates.

Target Price: In last quarter’s update, we noted HD had exceeded our $375 target and we revised our target to $425 based on HD shares sustaining a premium multiple to the S&P 500 of 25X.  Despite the poor sentiment toward the shares and concerns about near-term growth that have driven the stock down this year, we still feel a premium multiple is warranted based on the secular drivers we outlined and management’s superb record of operational excellence leading to above forecast growth.  HD reported $15.53 in FY21 and we think 2022 and 2023 will be at least $16 and $17, respectively.  The shares now trade at under 20X conservative year ahead estimates, still just a modest premium to the market multiple.  We expect HD’s 2022 growth to comfortably exceed management guidance and 2023 estimates to rise.  The market multiple has contracted, so even if we drop our HD target P-E from 25X to 22X, we think an initial recovery in the shares to $375 based on current 2023 estimates is a reasonable expectation later this year.  We continue to think $425 and higher is in the cards as the secular growth story for home improvement and HD’s industry leadership reemerges.

HD is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov