Dividend Report Card: Home Depot

In this series, we analyze financial metrics to begin answering the following questions about a company's dividend:

1. Over time, has this company steadily increased its payouts?
2. How sustainable is the dividend?
3. Does the company have room to further increase the dividend?

The Dividend Report Card wasn't designed as a buy or sell signal but rather as a tool to gauge the health of a company's dividend. For a full explanation of each category, click here for a tutorial.

Today's pupil is Home Depot (NYSE: HD) , which posts a 3.1% yield. The last time we looked at it in February, it scored a "B." Let's see if it's improved its score this time around.

Dividend history

Source: Home Depot investor relations.

Home Depot held its quarterly dividend steady from 2006 to 2009 as it assessed the carnage of the housing bubble's deflation. It had done the same between 1999 and 2001 during that recession, but resumed dividend growth on both occasions.

Past returns don't guarantee future results, however, so dividend history is only 10% of the final grade. That said, for this category, Home Depot scores a 5 out of 5.

Sustainability

Source: Capital IQ, a division of Standard & Poor's, as of Aug. 23.

If we take Home Depot's operating leases into account, its interest coverage is probably closer to seven or eight times, but that's still quite good and wouldn't have changed the score. It appears to have plenty of earnings and free cash flow cover to maintain the current dividend.

It's worth noting that these figures have improved since we last looked at Home Depot. This is mostly due to higher profitability and improved working capital management.

Growth

Potential dividend growth remains the biggest question for Home Depot. The company has pulled back on reinvestment in recent years, reducing capital expenditures as a percentage of sales from 4.5% in 2006 to just 1.7% in the past 12 months, and store count has been relatively flat since 2008.

Essentially, Home Depot has taken its foot off the gas and still cruising along having "floored it" years earlier (no pun intended), but eventually it'll need to tap the gas again to maintain momentum. Higher reinvestment needs could result in less free cash left over for dividends and buybacks.

At this point, assuming 6%-8% dividend growth over the next few years is probably a fair estimate. Of course, if the housing or construction market gets worse, the dividend growth rate could be slightly lower.

Competitors
An "ungraded" section of the Dividend Report Card is to see how a stock's current yield stacks up against that of direct competitors. If it's too high relative to competitors' yields, the board could be tempted to slow the growth rate, or vice versa, to bring it more in line with the industry average.

For the first time in at least a decade, Home Depot's dividend yield approximates Lowe's yield, leaving dividend-minded investors with a tough choice between the two major home improvement retailers. (To make the choice tougher, Lowe's scores an "A" on the Dividend Report Card.)

Pencils down!
With all the numbers in, here's how Home Depot's dividend scored:

Home Depot's final score has improved a full letter grade since we last looked at it, which is certainly an encouraging sign. Overall, Home Depot's dividend looks healthy, but investors should pay attention to the company's growth strategy.

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