Home Depot Hits Tough Spot After CEO's Regrettable 'Lack of Storms' Comment

We have now moved into the later part of Q3 earnings season. The last lap of earnings season, while lightly populated as far as sheer numbers of names still needing to report, is heavily populated by well-known retailers. 

The first large retailer out of the gate among the "big box" crew, on Tuesday morning, was Home Depot (HD) .

Though I haven't been long these shares in quite a while, I have a warm spot in my heart for Home Depot. Years ago, when unemployed after being laid off back when all of the cool kids on Wall Street were being laid off, I worked the lumber aisle in my local Home Depot for a spell. I'm not one for sitting on the couch and collecting unemployment benefits while looking for work. I'd rather work while looking for work. I would have become depressed if I allowed myself to wallow.

Much to my surprise, in the wake of the Great Financial Crisis, everyone I worked with at Home Depot was someone who had also lost a good-paying job. We were all professionals at something other than selling lumber and loading trucks with 80 pound bags of cement. Just as much to my surprise, I loved that job.

They treated their hourly wage employees with respect and they even gave us shares in the stock just to stick around. My time there ended when the Army called and needed to send me somewhere for about a month and a half and then, when I got back, one of my old colleagues called needing a chief economist at least on an interim basis and on the hop. Poof! I was back on Wall Street, to stay, as it turned out.

I still believe that I am probably the only individual ever to critique Home Depot earnings and the ensuing conference call on Bloomberg Radio, as (unbeknownst to Bloomberg Radio), I was working the lumber aisle in one of the stores. They probably thought I was still working at 11 Wall Street. I needed the exposure. They didn't ask and I wasn't telling them what I was temporarily doing at that time to get by. Just another strange but true life story in the saga of your best pal.

Numbers

They aren't really pretty. For the firm's fiscal third quarter, which ended November 2, Home Depot posted an adjusted EPS of $3.74 (GAAP EPS: $3.62) on revenue of $41.352 billion. While that top-line print did beat Wall Street, while reflecting year-over-year growth of 2.8%, the adjusted bottom-line number missed by 9 cents a share. The GAAP EPS print missed by about 12 cents per share.

Total sales included about $900 million from eight weeks of GMS Inc sales after the acquisition of that company. Comp sales were only up 0.2% globally and just 0.1% nationally. I think I have a mini-problem with this line in the press release and maybe some others are as well. CEO Ted Decker commented, "Our results missed our expectations primarily due to the lack of storms in the third quarter, which resulted in greater than expected pressure in certain categories."

While we all know that a juicier market for home sales is a necessary requirement for Home Depot and its chief competitor Lowe's (LOW)  to do well, do not blame the lack of an awful hurricane season for your problems. You can think it, but don't say it out loud or write it. Does HD employ a PR person that could maybe help this guy? Blame housing. Don't blame your potential customers for not having their lives upended. Business management 101, dude.

Operations

As mentioned above, net sales were up 2.8% over the same period last year. The cost of sales also increased 2.8% to $27.537 billion, leaving a gross profit of $13.825 billion (+2.9%). That put the gross margin at 33.4%, in line with last year. Total GAAP operating expenses grew 5.7% to $8.462 billion, leaving a GAAP operating income of $5.353 billion (-1.2%) as GAAP operating margin dropped to 12.9% from 13.5%.

After accounting for interest, other income and expenses and taxes, GAAP net income dropped 1.4% to $3.601 billion. This works out to $3.62 per fully diluted share, down from the year-ago comp of $3.67. The firm did release adjusted earnings, primarily for the purpose of amortization related to acquired intangible assets. After adjustments, Home Depot posted an adjusted operating income that dropped 0.8%, an adjusted operating margin that decreased from 13.8% to 13.3% and an adjusted EPS of $3.74, down from $3.74 for the year-ago period.

Guidance

For the full fiscal year, Home Depot guided total sales toward annual growth of 3%, up from prior guidance of 2.8%. However, operating margin is seen at just 12.6%, well below the Wall Street consensus of 13.3%. Additionally, adjusted full year EPS is now projected to suffer an approximate 5% decline. The firm had previously guided towards a 2% decline. Wall Street is not loving this guidance at all.

Fundamentals

For the first nine months of the fiscal year, Home Depot posted operating cash flow of $12.978 billion (-14.3%). Out of that number has come capex spending of $2.621 billion (+9.9%). This has left free cash flow of $10.35 (-18.8%). Out of this number, the firm paid out $6.863 billion in cash dividends to shareholders. The firm has not repurchased stock for its corporate treasury this fiscal year.

Looking over the balance sheet, HD ended the period with a cash position of $1.684 billion and inventories of $26.203 billion. That puts current assets at $36.115 billion. I did notice that inventories were almost 10% higher than they were last year at the same time. My guess is that this would be a result of a calm storm season. Current liabilities add up to $34.367 billion. That places the firm's current ratio at 1.05, which is seen as a (barely) passing grade.

That said, the firm is staring at $3.2 billion in short-term debt and $6.471 billion in current installments of longer-term debt. Hmm, so you're telling me that the firm has to pay off or refinance $9.671 billion in debt this year while sitting on a cash pile of just $1.684 billion and a ton of inventories that may be rapidly dropping in value. That ain't pretty, gang. In fact, it's downright ugly.

Total assets amount to $106.274 billion including $32.683 billion in goodwill and other intangibles. At 31% of total assets, that's not a problem just yet. Total liabilities less equity comes to $94.158 billion including $46.343 billion in longer-term debt exclusive of the portion labeled for current installments. Home Depot has a debt problem in my opinion.

My Thoughts

Though I may have warm feelings for Home Depot, I have to call balls and strikes as I see them. The business is in a tough spot. Sales are still growing, but organic growth is slight. Margins are shrinking. Cash flows are still robust but are also in a state of contraction. The CEO appears to have some issues communicating to shareholders.

The CFO should probably be working to repair what seems to be a rather sloppy balance sheet. 

Richard McPhail has held the post since 2019, so don't hold your breath. The firm obviously needs to put most of its free cash flow into debt reduction. Paying shareholders the lion's share of free cash is noble, but at some point, if at the expense of sustained balance sheet health, it becomes destructive. Home Depot may not be there yet, but the firm is knocking at that door. ​

​Home Depot stock had developed what looked like a cup-with-handle bullish setup, into October. That ship looks to have sailed though:

​The failure of that handle to rise out of its tailspin has turned the recent action in HD shares into a head-and-shoulders pattern of bearish reversal with a $373 pivot. For me, that puts the downside target in the $320 range.

Relative strength is now back in technically oversold territory, while the daily MACD looks like something out of a cheap monster movie. The stock has lost its 21-day EMA, 50-day SMA and 200-day SMA. This has forced swing traders out of the stick and portfolio managers to reduce exposure. April's low stands at $326.31. The stock does not have to test that level. But I would not at all be surprised if it did.

At the time of publication, Guilfoyle had no positions in any securities mentioned.