Don't Be Afraid of Home Depot

In this episode of MarketFoolery, host Chris Hill and analyst Jim Mueller take a look at some of the market's biggest news. Amazon (AMZN -1.65%) finally announced the location(s) of its HQ2 campus(es). Why did it pick two cities? Why are they both on the East Coast? And why on Earth did it start with a pool of 20 cities earlier this year?

Home Depot (HD -0.31%) shares fell despite the company reporting great news in just about every possible category. Why has 2018 been so unkind to the home improvement retailer? And, the duo dip into the Fool mailbag to answer a listener question. What happens to the S&P 500 when it changes out companies, and how long does the process take? Tune in to find out more.

A full transcript follows the video.

This video was recorded on Nov. 13, 2018.

Chris Hill: It's Tuesday, November 13th. Welcome to Market Foolery! I'm Chris Hill. With me in studio to explain everything that's going on today is Jim Mueller.

Jim Mueller: Yeah. Hey, Chris!

Hill: We're going to get to Home Depot's earnings, we're going to dip into the Fool mailbag. We will start with the big news of the day. I don't think it's just big news in our neck of the woods, I think this is the big business news of the day, and that is Amazon officially announcing that it has selected New York City and Northern Virginia -- specifically Crystal City in Northern Virginia -- for its two new offices. I personally will not refer to them as headquarters. If they had just picked one city and put 50,000 employees there, I'd say, "Fine, that's your second headquarters." But two this is two new large offices. They also announced an operations base that they're opening in Nashville with about 5,000 employees.

Mueller: Good for Nashville. Seattle still remains the headquarters of Amazon, despite this Long Island City in Queens and Crystal City, just up the Metro a few stops from here. Why two? The earlier discussion was it'd be down in the Austin or Dallas area, for the second one. Crystal City was pretty much chosen. That would let Amazon have some exposure out in more conservative country and balance their political leanings. But now, they've got Seattle, the left coast, and they've got the D.C. area, Northern Virginia, which is very liberal-leaning, and New York City -- again, liberal-leaning. So maybe they're tripling down on that.

Hill: Now this process is over. I think it would be worth our taking a minute or two to look back and ask, among other things, how do we think this went? By the way, I noticed on Twitter right before we started taping the phrase "National Landing" was trending on Twitter. And I thought, "What is that?" Amazon is apparently branding its location in Northern Virginia as National Landing.

Mueller: They're not even here yet, [laughs] and they're renaming parts of it.

Hill: Right. Respectfully, they're not here. Also, no one who lives in this area is going to refer to it as National Landing. It's Crystal City. And that's fine, there's nothing wrong with that. But now that we've gone through this whole process, what impressions are you left with? One impression I had when the whole thing started just about a year ago, when they announced, "Here are the 20 cities on our list," my first reaction then remains to this day, which was: that's way too many cities. When they came out and said, "We've come up with our finalists. It's 20 cities," I looked at that list and thought, "I can cross at least five off immediately, and I'd be happy to bet a large chunk of money that it won't be these cities."

Mueller: Right. I mean, besides the entertainment value of the whole thing. Williams Shatner had a great voiceover for Chicago in their video. Kansas City's mayor wrote 1,000 product reviews for Amazon as part of their pitch. Setting all that aside, which is awesome on its own, but still. The shortlist: a million population, good public transports, airport that goes to Seattle, that's all good. Quite a few cities match those. But why bother, and why make it so public? Yeah, it gave those cities a way to toot their own horns. They might benefit from either a smaller office space or location from Amazon. But other businesses might also say, "Hey, they missed out on Amazon, but we kind of like what they do." So, there's that. But I think they had the top five done a year, a year and a half ago, and were saying, "We're going to focus on these areas."

Hill: It's interesting to see how, now that the process is over, some pretty big name-columnists -- Kara Swisher, Scott Galloway, Derek Thompson -- coming out and taking Amazon to task, fairly or unfairly, saying, "Look, they knew all along. This was a charade." Some people are using the phrase "con job," that sort of thing. Who knows? They may have known all along, but that ascribes a mal-intent that I'm reluctant to put on Amazon. And part of that has to do with this last-minute switch. It is seemingly last-minute because, for a very long time, the whole conversation was, "We're looking for one city and we're going to put 50,000 employees there." It's really only in the last two weeks that it's come out, "It's going to be two cities."

Mueller: And they and they justify that by saying, "We don't want to put too big a burden into the area." 50,000 new jobs is a lot of housing, a lot of transportation, a lot of heavy traffic. Already, the Crystal City traffic is really pretty bad. But, yeah, it might have been known a lot further ahead of time. One of our colleagues I was talking this morning with said, they bought a house in the Crystal City area, and she had seen the construction drapes over the buildings. And not just your brown canvas. These were polka dot. [laughs] Those have been up there for the last year or so. Maybe they'd already chosen. Something big was coming to Crystal City, but nobody was saying who. And now it's Amazon.

Hill: I think if you're an Amazon shareholder... whatever reputational ding Amazon takes from this, and I don't know if it's long-lasting, I think as a shareholder, you have to feel pretty good about these choices. I'll just speak for myself. There were a bunch of cities on that list that I looked at and thought, "That makes sense to me." One city that was on the list of 20 right off the bat that I thought, "There's no way it's going to be this," there was Los Angeles. That's not a knock on Los Angeles. I just thought, "If their headquarters is in Seattle, I don't see what the advantages are to putting another huge office on the West Coast." As you mentioned, Dallas was a city I looked at, and I thought, "That would make sense." Atlanta would make a lot of sense, too.

Mueller: Chicago. Many of them would make sense. Miami, I'm not quite so sure about. Newark, New Jersey; but that's close to New York. New York had two or three in the running.

Hill: I crossed Miami off the list right off the bat because I thought, Jeff Bezos is someone who has built for him a 10,000-year clock. I don't think someone who's building a 10,000-year clock is buying beachfront property, is putting a huge office in Miami.

Mueller: No. What he bought was a $23 million home in the D.C. area. [laughs] 

Hill: Yeah. Let's move on to some earnings. Home Depot's shares are down a little bit today. You and I are both scratching our heads wondering why. This third quarter report for Home Depot -- it was a strong quarter, and they raised revenue guidance for the full fiscal year.

Mueller: They raised revenue. They raised earnings guidance for the full fiscal year. They raised comps guidance for the full year! Real quick numbers, they got a 5.1% increase in revenue to about $26 billion, just barely ahead of the Street's estimates. Comps was 4.8% with 5.4% in the U.S., which is nice and solid. Net income was up 32% to $2.51 per share. That beats the Street's guess of $2.26 quite handily. Then, they raised sales, comps guidance, and diluted EPS growth for the rest of the year, one more quarter. And the shares are down 3% or so.

Hill: Yeah. And, as great as this stock has done over the last ten years, 2018 has not been a great year for shares of Home Depot.

Mueller: No. They're down 2% or something up through last night, before the earnings release. Maybe it has something to do with the housing market. We've had stories over and over. September saw something like a 5% drop in new home starts. They revised downward August numbers. I do know that a good number of analysts -- the first four, for sure, and a fifth one later on, out of the dozen or so on the call -- talked about housing on the call. Management was saying, "Look, guys, we're selling stuff. People are moving up in price points, to newer products." Even in the bad areas like LA, where it's really expensive to live, their sales are growing. 

Whether it's higher housing prices driving people to improve their homes, I don't know. Their model says, they're very upfront, "Our directionally correct but inaccurate model is telling us that sales are going to continue to grow, so we raised guidance."

Hill: Depending on how granular investors want to get with a retailer, yes, we talk about revenue and earnings and those sort of things, but even when you go a couple levels deeper with Home Depot's latest quarter, and you look at things like sales per square foot, overall transactions, the average ticket price, all of those were up!

Mueller: Yeah, the ticket was up like 3.5%!

Hill: So, I'm wondering if at least some of the, if not skepticism, then some of the questions about Home Depot from these analysts, were focused not just on the individual consumers -- people like you and me -- but on the contractor side of the business. That's a healthy chunk of Home Depot's business. I don't off the top my head know what percentage that is, but I know it is a not-insignificant chunk of their business. 

Mueller: I think it actually might be the larger part of their business. But they were saying contractors are growing. Their online business is growing. Online comps, 28% growth for the quarter. They're seeing higher conversion rates by double digits compared to last quarter. Modestly bigger tickets.

One of the things they think that might be helping that is that delivery schedules are getting better and better. They've been working on something called responsive delivery. Depending on the zip code, they can get you down to the day of the delivery. That really helps contractors, especially when they're planning multiple things going on at a property.

Hill: Our email address is [email protected]. Our Twitter handle is @MarketFoolery. If you want to drop us a question on either one of those platforms, please do so. Question from Ian Granger in Bristol. The one in England, not the one in Connecticut, for all you ESPN fans. Ian writes, "What happens to an S&P 500 ETF like VUSA when a company leaves and a new one joins?" He refers to the recent reports that Tesla is being eyed as a potential addition to the S&P 500 index. Ian's asking, does this update right away? Or is it the next quarter?

Mueller: The too long, didn't listen answer to that is, it happens right away. Ian, you can turn off the radio now. [laughs] Actually, the S&P changes a lot. I found some commentary from senior members of the S&P, like Dr. David Blitzer, who in 2014 was the managing director and the chairman of the Index Committee. He was in charge of the whole thing. They consider a lot of things when they're adding a company to the index. It's not strictly the 500 largest companies in the U.S. It's not that. 

Hill: Kind of like how Home Depot management said, "It's directionally correct, but it's inaccurate."

Mueller: [laughs] Right. The requirements to be in the S&P: a certain size. $4-5 billion is usually the lower end of it. It has to have enough liquidity. It has to have a minimum float of about 50% of the shares available for trading. I have a short story about that in just a second. Profitability, balance sheet, part of an emerging industry that's becoming an important part of the market, and so on.

What happens is, the day before the new company comes in and replaces somebody who's going out -- either because they went bankrupt, they got purchased, they're going private, or they just dropped to be too small, those are several reasons why a company might go out -- index funds and ETFs that are tracking the S&P tend to buy a lot of the new company. In fact, the vast majority, I looked at a couple of examples. For instance, Rollins, the guys behind the Orkin Man for bug control, a company I happen to own shares of, they joined on October 1st. The trading day before that was September 28th. 25.6 million shares traded hands. The normal range was a million or less.

Hill: [laughs] Okay, so that's more.

Mueller: Yeah. Fortinet, the same thing. They joined on October 11th. On the 10th, they traded 33.4 million shares when their range was 1-2.5 million on a normal day. So, it happens right away. They don't wait until the end of the quarter. 

Getting back to the story about the minimum float, it's an actively managed index. It has a committee of members from Standard and Poor's figuring out who's going to be on, why they should be added, and what companies should drop. For instance, of Blitzer related an interesting story in 2014, after Lehman filed for bankruptcy. AIG was being bailed out by the U.S. Treasury. And the U.S. Treasury bought like 90% of the shares. That left only 10% for the float. They have this 50% rule. They said, "What's going to happen if we drop AIG from the index right in the middle of this horrible mess that the market is seeing? That's going to send a horrible signal." So, they suspended that rule for AIG. A few years later, after the Treasury had sold the shares back to the public, it had recovered, so the 50% rule came back into effect for them.

Hill: You mentioned that one of the requirements for addition to the S&P 500 is profitability. I think that, as much as anything, is what people are watching with respect to Tesla. It's not just profitability. It's the most recent five quarters.

Mueller: Yeah, there's that, and also a going concern. They're not too worried that Tesla is going to go out of business or bankrupt anytime soon. But as far as I know, it's just rumors. I'm not sure where that stands.

Hill: Before we wrap up, I just want to say thank you to Stan Lee, not just for his service to our country, but also for being one of the great creators of the last 50 years. For anyone who's watched a Marvel movie, or for anyone who's a Disney shareholder and has seen what Marvel has done for the business of the Disney Company --

Mueller: No more cameos.

Hill: I read something this morning. First of all, 95 years old, that's amazing. Apparently, Stan Lee filmed cameos for the three Marvel movies that are coming out in 2019. 

Mueller: Oh, that's awesome. 

Hill: So, he will continue to be on the big screen long after he has departed this earth. Jim Mueller, thanks for being here!

Mueller: Thank you, Chris!

Hill: As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's going to do it for this edition of Market Foolery. The show is mixed by Dan Boyd. I'm Chris Hill. Thanks for listening! We'll see you tomorrow.