Foundational weakness sets Home Depot shares up for another fall

Key Points

• Home Depot had a better-than-expected report, but outperformance is tepid, and guidance was lowered. 
• The capital returns are safe and should help to support the market over the next few quarters.
• Home Depot stock is range-bound with little room to maneuver except sideways. 

If a rising tide lifts all ships, then a falling 1 can sink them, and a falling tide is what Home Depot NYSE: HD and other retailers are facing. The Q3 results were better than expected, but continue the narrative played out this year. That is 1 of underlying momentum and better-than-expected results offset by persistent weakening and diminishing guidance.

In the case of Home Depot, as with United Parcel Service NYSE: UPS, this foundational weakness will keep high-quality shares under pressure for the foreseeable future. The takeaway is that Home Depot is fundamentally sound and can continue delivering value to shareholders over the long term, so buying the dips is an excellent strategy.

Home Depot has tepid quarter, guides lower

Home Depot had a fine quarter so far as business goes; it produced reasonably stable revenue and sufficient earnings and guided for the same. The bad news is that revenue is down compared to last year, and the margin of outperformance relative to consensus is tepid at best. CEO Ted Decker commented on a noticeable shift from large-ticket discretionary items to smaller projects, a trend seen elsewhere in retail and likely to persist well into next year. 

The $37.7 billion in net revenue is down 3% compared to last year and beat consensus by a slim 28 basis points. That fact could be enough to get the market moving higher, but there is also deleveraging to account for and economic signals suggest a weak holiday quarter and Q1/Q2 period. Internally, comps are down 3.1%, led by a 3.5% decline in the core US market. Comps are down on a 2.4% reduction in ticket count and a -0.3% decline in average check. 

The margin news is mixed and unfavorable to the stock price action. The company’s cost of sales contracted but less than revenue, causing a leveraged decline in gross margin amplified by rising costs. The good news is that earnings beat by a nickel; the bad is that net income of $3.8 billion is down about 1000 basis points compared to the top-line decline of 300 basis points, and the guidance isn’t bullish. 

The company narrowed the range for revenue and margin, but the result is deleveraging and a midpoint for earnings below the prior estimate and analyst's consensus. Home Depot now expects revenue to fall 3% to 4% compared to the prior 2% to 5%, with an operating margin of 14.1% to 14.2%. This should result in an EPS decline of 9% to 11% compared to the previous 7% to 9% and the expected 9.25%.

Home Depot capital returns are safe

Home Depot’s tepid results do little to alter the capital return program. The company's cash flow and balance sheet are strong enough to withstand the slowdown in business while paying dividends and repurchasing shares. Repurchases topped $6.4 billion YTD to double the dividend distribution, with shares near $290. 

The balance sheet shows some impact from reduced cash flow but is still strong, with current liabilities flat, long-term debt and total liabilities all down compared to last year. Cash is down roughly $0.60 billion, but the company is well-capitalized, with over $2 billion on the books. If it can be called that, the only issue with the balance sheet is inventory, which is down significantly compared to last year and a contributor to this year’s cash flow. Inventory control is good but can only fall so far before business suffers. 

Oversold or further to fall; analysts will make the call on this range-bound stock

The analysts' sentiment ahead of the Q3 report was optimistic and suggested the stock was oversold, but that may change now that the guidance is in. As it is, the low-price target of $292 is above the current price action, highlighting a floor for the market. The caveat is that the low price target and consensus may move lower and weigh on price action over the next few days, weeks and months to keep the stock range bound. Regardless, the consensus target of $341 is below the top of the trading range and provides a ceiling for price action.