Fitch Ratings has assigned The Home Depot, Inc.'s proposed senior unsecured notes issuances, which it expects could be up to $3 billion, a 'A' Issuer Default Rating (IDR).
Proceeds will be used for general corporate purposes, including replacing cash on hand after the funding of the $8 billionHD Supply Holdings, Inc. acquisition, which closed Dec. 24, 2020.
Home Depot's 'A'/Outlook Stable Long-Term IDR reflects its scale and cash flow generation, coupled with its solid track record of comparable store sales (comps) growth and margin expansion. The ratings also reflect management's publicly stated long-term leverage target of 2.0x on an adjusted debt/EBITDAR basis, capitalizing leases at 8.0x.
KEY RATING DRIVERS
HD Supply Acquisition: On Dec. 24, 2020, Home Depot closed its acquisition of HD Supply, a company that Home Depot owned prior to a 2007 sale. Following a recent business sale, HD Supply's business focuses on maintenance, repair, and operations (MRO) products within the home improvement and construction segment. Key customer verticals include multifamily dwellings and the hospitality industry. Home Depot has recently invested in this space, including a 2015 acquisition of Interline Brands. The MRO business allows Home Depot to capitalize on its existing strengths as a leader in the home improvement space, generate additional revenue opportunities, and diversify its business modestly away from the highly cyclical housing market.
The purchase price was approximately $8 billion in enterprise value, or $9 billion in market capitalization less $1 billion in net cash following HD Supply'sOctober 2020 sale of its construction and industrial business to Clayton Dubilier & Rice for $2.9 billion in cash; HD Supply had approximately $1.9 billion in debt and $71 million in cash as of Aug. 2, 2020. Fitch calculates HD Supply's pro forma 2020 revenue and EBITDA at $2.8 billion and approximately $500 million, respectively; therefore Home Depot paid a 16x multiple. This assumes around 10% declines in revenue and EBITDA from 2019 pro forma levels, in line with 1H20 results, given HD Supply's exposure to the challenged hospitality industry.
Fitch expects Home Depot's current capital raise will be used, in part, to replace cash balances spent to complete the acquisition. Home Depot's cash level of $14.7 billion as of Nov. 1, 2020 was elevated relative to the approximately $2 billion level at YE 2019 and 2020 given strong YTD business performance, the issuance of $2.25 billion of debt in 2020 net of other projected debt repayment, and the company's suspension of share buybacks in response to the coronavirus pandemic.
Strong 2020 Performance: Home Depot's 2020 performance has been strong, despite macroeconomic challenges, with revenue up 18% through the nine months ended October 2020, as consumers have increased spending on their homes amid the coronavirus pandemic. Fitch believes performance has been supported by government stimulus through the height of the shelter-in-place phase and consumer savings from spending declines on services like travel and entertainment. Consumer behavior, including more time spent at home, has led to increased remodeling activity.
Given its current momentum, Fitch forecasts Home Depot could generate around $125 billion in 2020 revenue, up approximately 14% from 2019. EBITDA could be up around 10% to $20 billion, as increased operating expenses related to the pandemic, including higher wages and more stringent safety protocols, somewhat mitigating topline strength. Assuming the pandemic recedes in 2021, Home Depot could see revenue declines against challenging comparisons as consumer behavior reverts somewhat to pre-pandemic spending priorities. Fitch estimates Home Depot's 2021 revenue, prior to the impact of the HD Supply acquisition, could decline around 5% to the $120 billion range. EBITDA, prior to the impact of HD Supply, could remain near the $20 billion expected in 2020 on operating expense declines.
Fitch expects that Home Depot has strengthened its already leading industry position in 2020 given its ability to serve customers through its robust omnichannel model. For example, on its 2Q20 earnings call, the company indicated that 2Q20 digital sales doubled compared with 2019 to over 14% of total sales. During the quarter 60% of digital revenue was either delivered from or collected by the customer at a store. Fitch believes Home Depot's omnichannel offering is a key competitive differentiator which should allow it to gain share through the remainder of the pandemic and longer term.
Solid Long-Term Track Record: Prior to 2020, Home Depot has grown EBITDA and posted mid-single-digit comps every year since 2010, with 5.0% average annual comps and EBITDA margin growth of nearly 500bp from 11.4% 2009 to 16.7% in 2019. Operating momentum has been supported by positive home improvement industry fundamentals, especially regarding repair and maintenance projects. Home improvement retailers have further benefited from benign industry square footage growth (including very modest unit expansion from Home Depot and chief competitor Lowes Companies) and competitive resilience to the discount and online channels.
Success in the home improvement industry requires significant investments in inventory breadth and customer service, and discounters generally focus on categories with narrow assortment needs and limited customer service. Online competition, meanwhile, has been limited due to short purchase windows and the bulky/heavy nature of home improvement inventory (note that nearly half of Home Depot's existing online sales involve in-store merchandise pickup).
Investing in One Home Depot: In December 2017, at its biennial investor meeting, Home Depot management announced its intention to double its strategic investments over the next three years by deploying internally generated cash flow toward core capability improvements across the business. These investments, which Home Depot expects to total approximately $11 billion over 2018-2020, are being directed toward infrastructure technology, supply chain efficiency and in-store improvements. At the time, the company viewed the current macro environment and housing backdrop as an opportunity to proactively invest in cutting-edge capabilities to streamline its supply chain (both upstream and downstream), enhance its online/omnichannel capabilities and more broadly build upon its leading position in the home improvement retail space.
The company's growth initiatives are designed to leverage Home Depot's existing scale to broaden its customer base and share of wallet. For example, the 2015 acquisition of Interline Brands gave Home Depot access to the underpenetrated residential facility maintenance and repair market and the acquisition of HD Supply would support expansion here. Meanwhile, Home Depot is using its online infrastructure to expand online product assortment and offer customers increased product knowledge, while promoting its in-store pickup capability.
In its December 2019 investor meeting, management indicated that progress on its plans has been modestly slower than expectations, though expressed confidence in the company's ability to fortify its competitive advantages through accelerated investments. Management believes it may have underestimated the complexity of executing on its goals, leading to a longer pathway than originally anticipated. Fitch recognizes that some progress in the near term could be interrupted by management focus on navigating its business through the coronavirus and economic slowdown, although longer term opportunities for Home Depot to solidify its strong positioning remain intact.
Disciplined Capital Allocation: Home Depot's scale and stable growth have allowed it to comfortably manage to its adjusted debt/EBITDAR target of 2.0x for several years. Fitch expects management to continue to balance its leverage targets against its goal to return cash to shareholders over the longer term, with incremental debt issuance expected to support share purchases and upcoming debt maturities.
Home Depot's 'A'/Outlook Stable rating reflects its scale, with over $125 billion in projected 2020 revenue, leading position in the U.S. home improvement retail space, and cash flow generation, coupled with its solid track record of topline growth and margin expansion. The ratings also reflect management's publicly stated financial policy of targeted adjusted debt/EBITDAR of 2.0x over the long term.
Walmart (AA/Stable) is over 4x the size of Home Depot from a revenue standpoint with comparable leverage expected to trend toward 2.0x following debt repayment post the leveraged acquisition of a majority stake in Flipkart. Target Corporation (A-/Stable) also manages leverage around 2.0x, though is smaller than Home Depot, generating $78 billion in sales in 2019. Target has seen market share improvement in recent years as it invests in omnichannel capabilities, while sharpening its price message relative to discount peers.
Each of these peers competes against each other as well as the online channel. However, the home-improvement industry's bulky product array, heavy service component and need to source inventory rapidly for current jobs make the category somewhat protected against online incursion relative to many other consumer products categories. As such, prior to significant digital growth in 2020, Home Depot's online penetration was around 10%, well below the 20% to 30% seen across much of the consumer space. Home Depot effectively leverages its website to drive in-store sales as approximately 50% of online U.S. orders are picked up in their stores.
Amazon's 'A+'/Positive Outlook rating reflects its strong positions in global e-commerce and cloud computing services, close customer connections, strong FCF generation and reasonable leverage profile with adjusted debt/EBITDAR (capitalizing rent at 8.0x) at 1.7x in 2019. The rating considers the company's impressive track record of strategic vision and execution and its flexible operating platform, which provides growth opportunities across numerous verticals. The Positive Outlook reflects the company's strengthening operating and financial profile, and increased confidence in adjusted debt/EBITDAR remaining below 2.0x over time.
Fitch expects 2020 revenue growth could be around 15% to the $126 billion range, given 18% topline expansion through the third quarter. Results have been supported by strong spending on home improvement projects given increased time spent at home and savings from spending declines on services. Fitch forecasts Home Depot's standalone revenue could be down around 5% in 2021 to the $120 billion range on a challenging comparison, resuming low single-digit growth in 2022. The HD Supply acquisition could add around $2.8 billion to Home Depot's revenue on an annualized basis.
EBITDA in 2020 could expand around 10% to the $20 billion range, with EBITDA margins declining toward 16% from 16.7% in 2019. Margin declines are due to heightened operating expenses related due to coronavirus pandemic, including associate bonuses and higher cleaning expenses. Fitch expects much of this additional expense burden to reverse in 2021, yielding standalone EBITDA trending close to 2020 levels despite the projected topline contraction. HD Supply could add around $500 million to Home Depot's EBITDA beginning 2021.
FCF (after dividends), which was $5.1 billion in 2019, could be in the $5 billion-$6 billion range in 2020 on EBITDA growth and remain in this range beginning 2021. Historically, Home Depot deploys FCF and proceeds from debt issuance for share buybacks, in line with its public adjusted leverage target of 2.0x. Longer term, Fitch would expect Home Depot to continue to manage its FCF and balance sheet such that adjusted leverage sustained close to 2.0x.
In early 2020, the company issued $5 billion in unsecured notes to fortify liquidity at the onset of the coronavirus pandemic in the U.S. The company subsequently repaid $2.75 billion of 2020/2021 maturities and approximately $1 billion of commercial paper outstanding. Consequently, assuming around $3 billion for the proposed notes issuance, YE 2020 debt could be up around $4.25 billion to approximately $35 billion. Year-end cash, meanwhile, could be around $3 billion given $3 billion in January 2021 debt proceeds and $8 billion used for the HD Supply acquisition.
Factors that could, individually or collectively, lead to positive rating action/upgrade:
Continued positive operating trends together with a sustained reduction in adjusted debt/EBITDAR (capitalizing leases at 8.0x) to below 1.5x could lead to a positive rating action. This is not expected given management's 2.0x adjusted debt/EBITDAR target.
Factors that could, individually or collectively, lead to negative rating action/downgrade:
Weaker operating trends or a move by management to more shareholder-friendly policies that cause adjusted debt/EBITDAR to increase to the low 2x range on a sustained basis could lead to a negative rating action.
BEST/WORST CASE RATING SCENARIO
International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.
LIQUIDITY AND DEBT STRUCTURE
Solid Liquidity Position: As of Nov. 1, 2020, Fitch estimates Home Depot's total liquidity at approximately $21 billion, supported by cash on hand of $14.7 billion and availability on its various revolving credit facilities totaling $6.5 billion, net of letters of credit. In March 2020, the company increased its CP program to $6.0 billion from $3.0 billion and further increased liquidity by adding a second 364-day credit facility totaling $3.5 billion. The company's $6.0 billion CP program is fully backstopped by a $2.0 billion credit facility maturing December 2022, a $1.0 billion 364-day facility maturing December 2020, and the new $3.5 billion facility maturing March 2021. Additionally, in March 2020, the company raised $5.0 billion in unsecured notes to further fortify liquidity; proceeds were used to repay $1.75 billion of 2020 notes maturities and approximately $1 billion of CP. In January 2021, the company prepaid $1 billion of notes due April 2021.
Home Depot is maintaining a slow pace of new-store expansion, having opened just four net stores in the year ended Feb. 2, 2020. Low levels of capex (around 2% of sales) resulted in strong FCF after dividends at an average of $5.6 billion for the last three years. FCF is projected to remain in the $5 billion to $6 billion range beginning 2020.
The company has significant financial flexibility through adjustments to share repurchases, which have averaged almost $8 billion annually for the last four years.
SUMMARY OF FINANCIAL ADJUSTMENTS
Fitch adjusts for non-cash stock-based compensation. For example, stock-based compensation totaled $251 million for FYE Feb. 2, 2020. Additionally, Fitch treats interest on lease liabilities and amortization of lease assets as operating costs in accordance with Fitch's lease criteria at the time of committee.
DATE OF RELEVANT COMMITTEE
17 November 2020
REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING
The principal sources of information used in the analysis are described in the Applicable Criteria.
Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg
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