Home Depot warns that its earnings in fiscal Q3 and Q4 will fall short of estimates due to lower lumber and building material prices. Under normal circumstances, long-term investors might regard such news as a short-term hiccup. However, with the company's earnings growth now barely staying ahead of its growth in capital employed, the potential for lower overall returns in the future is growing.
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Earnings disappointments are a rarity for Home Depot, which has built up an enviable reputation for itself over the years as a consistent perforrmer through thick and thin. Given that reputation, the knee-jerk reaction of a rational investor might be to look past the near-term disappointment as little more than a bump in the road. OK, earnings will come in a little light for the next few quarters. Big deal, right? The company is still on track to put up 16% to 17% year-over-year EPS growth this year and is targeting 23% to 25% growth in fiscal 2001. That doesn't sound too shabby at all for a 22-year-old retailer with $42.8 billion in trailing revenues.
However, the market didn't take that view today as Home Depot's shares were hammered for a nearly 30% loss. That's a far cry from the "this too shall pass" reaction one may have expected. Sure, investors are a bit jumpy these days after being put through the earnings warning wringer numerous times in the past few weeks. Still, Home Depot's outsized cratering today seems to indicate more of a "step-back-and-think" opportunity than a flat-out "buy-on-the-dip" opportunity for those investors following along at, ahem, home.
"While our earnings outlook for fiscal 2000 is short of our long-term earnings growth target, the company's rates of profitability and return on capital are continuing at very strong levels," President and CEO Arthur Blank soothed in this morning's press release. Profits have never been much of a problem for Home Depot. Much like Wal-Mart (NYSE: WMT), the company has used an everyday low price strategy to lure increasing numbers of customers into its stores and drive its top line. De-emphasizing margins, the firm has used high asset turns and an exceptional customer experience to pave the way for higher operating earnings. It's in the return on capital area, though, where some cracks in the model are starting to show up.
Granted, Home Depot remains a star performer as far as its overall business returns. For the trailing 12-month period ending in fiscal Q2, return on invested capital was about 18%, little changed from a year ago. But while that ratio continues to hold up well, the growth rates of its underlying components have been looking less rosy in recent months, as the following table suggests:
Q298-Q299 Q299-Q200
NOPAT +46% +30%
Invested Capital +23% +28%
The primary takeaway from this analysis is that while the company's profits -- as measured by trailing 12-months net operating profits after tax (NOPAT) -- have continued to grow, the rate of growth has slowed over the past year. Meanwhile, the rate of growth in the company's invested capital base has accelerated. Last year, NOPAT growth was still twice the rate of invested capital growth. Today, however, the two metrics are growing at almost the same rate.
The upshot is that Home Depot's return on marginal capital, which looked so great just a year ago, has turned sour. Today's dramatic share price reaction to what would otherwise be a short-term earnings slip-up is quite likely the market's way of coming to grips with this fact.
With management reiterating on a conference call today its intention to increase the storebase at a 20% annual clip, Home Depot is facing the unattractive possibility of basically growing its earnings at essentially the same rate as its invested capital base in the coming years. If that is indeed the case, then the result is essentially a wash as far as value creation is concerned. In sum, this is a situation for longtime investors in the company to keep an eye on, as it suggests that Home Depot's returns -- in terms of both its business and stock market returns -- may be lower in the future than they have been in the past.
Your Turn:
What do you think? Are Home Depot's best days behind it, or are they yet to come? Post you opinion on the company's discussion board.
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