A retreat in the housing market is coming. It's anyone's guess as to when that downturn will happen, but there's no question of a slump eventually hitting the industry again. That's just a fact about cyclical sectors like housing, which are tied to the inevitable swings in broader economic growth.
In its annual report, Home Depot's (HD 0.86%) management warns investors that the retailer's financial performance "depends significantly on the stability of the housing and home improvement markets." These sectors have been expanding steadily since about 2010, but how bad could things get for the business once that pace cools off?
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Roll back the tape
Investors have a good idea of how a sharp downturn might hurt Home Depot, as its sector was among the hardest hit during the financial crisis. With home sales, employment, and residential construction plummeting, spending on home improvement collapsed from a $900 billion annual pace in early 2006 to just $370 billion by late 2010.
In response, Home Depot's sales shrank from a high of $79 billion in 2007 to $71 billion two years later. Other financial metrics fell even harder. The retailer's operating margin, return on capital, and earnings each declined by 40% or more from 2006 to 2010. Home Depot suspended raising its dividend for three years during the worst of the crisis, and the stock fell by as much as 50% during the Great Recession. Yet the company stayed solidly in the black during this period. Yes, net earnings dove to 3.2% of sales in 2008 from 5.4% the prior year, but that's as bad as things got for shareholders.
A stronger recovery
Net earnings for the most recent 12-month period hit a record 8.6% of sales, which gives investors just a hint of the incredible recovery that Home Depot has enjoyed since the business bottomed out in 2008. Revenue recently crossed a $100 billion annual pace, and the market leader achieved that result mainly through surging customer traffic at existing locations rather than with help from a quickly expanding store base.
Operating margin just hit a record, too, at 14.5% of sales, while Home Depot's 34% return on invested capital makes it among the most efficient businesses on the market. Peer Lowe's (LOW 1.49%) hasn't been able to keep pace with any of these key metrics. The industry's second-place retailer logged 4% comparable-store sales last year, compared to Home Depot's 6%. Its operating margin is still stuck in single digits, and return on invested capital is 19%.
LOW Operating Margin (TTM) data by YCharts.
These performance gaps suggest that Home Depot's rally is being driven by more than just a steadily improving industry.
The next downturn
Its store footprint has held relatively firm since 2010, and so it's hard to see how an overextended sales base would hurt the company in the next downturn. Its market-thumping profitability, meanwhile, provides an even bigger cushion to protect earnings when the industry cools off again.
As for risks that could pinch shareholders, the company has taken on plenty of extra debt over the last few years. And its 55% payout ratio, compared to Lowe's 35%, doesn't leave much room for continued growth if another multiyear downturn hits the sector.
CEO Craig Menear and his team are keeping a close eye on rising mortgage rates, which could slow industry growth in the coming quarters. They see plenty of reasons for optimism about continued expansion, though, including home price appreciation and a historically low rate of housing formation. Home improvement spending is at $766 billion, which still leaves room for gains before it challenges the $900 billion high set just over a decade ago.
Investors may or may not witness another downturn before that record is broken. But even a sharp slump on par with the crisis that hit the industry in 2008 wouldn't seriously challenge Home Depot's long-term operating health.
