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Executive Summary:

We believe that Home Depot (NYSE:HD) is a medium quality company with a Business Quality Score of 5 based on a scale of 1 to 10 (10 is best). Also, shares of Home Depot appear to be overvalued based on a discounted cash flow analysis. Home Depot stock would need to fall 33.4% to reach fair value based on the closing price of $66.44/share for Home Depot shares on 02-20-2013.

Critical Information:

We consider Home Depot to be a business in transition. In 2000, Home Depot's board of directors hired Bob Nardelli as CEO. Bob Nardelli was a hard charging GE-trained command-and-control type manager. Nardelli's management style was a great fit for his previous position as the head of GE's electric power turbine business. Strict Six-Sigma business processes are great for the precision manufacturing industry but are ill suited for the home improvement retail industry.

Some of the changes Nardelli made helped Home Depot modernize their inventory management and logistics systems. However, many other changes damaged Home Depot's core business. Most of these damaging changes were related to cost cutting. One of the most damaging was that Nardelli cut staff, particularly highly experienced salespeople. From the start, Home Depot has had a policy of hiring experienced trades people to fill sales/customer service roles. These salespeople helped customers solve their home repair/improvement problems with great skill. Home Depot's culture valued such experienced salespeople and this was one of the secrets of Home Depot's success. Unfortunately, Nardelli replaced highly experienced salespeople with inexperienced part-time salespeople to cut costs without regard for the long term health of Home Depot's business.

Also, Nardelli decided to expand into the low-margin wholesale contractor supply business (Hd Supply). Nardelli thought that the retail business had mostly saturated its market and that the contractor supply business would help grow revenues. Reportedly, Nardelli also liked the nature of the wholesale business because it was a better fit with his Six-Sigma, highly analytical, management style. The retail side of Home Depot's business was more free-wheeling and entrepreneurial in nature. In home improvement retailing, customer service is one of the keys to a thriving business and Nardelli did not understand this because he could not easily measure this aspect of the business.

In early 2007, Home Depot's board of directors fired Nardelli. We believe that Home Depot has returned to its roots and is now focusing more energy on customer service. Furthermore, Home Depot sold its contractor supply business in August 2007 to focus on its core retailing business.

We believe that Home Depot is managing a successful turn-around of its business. Especially in regards to its customer service issues. Also, the last recession/downturn in housing had a significant negative impact on Home Depot's business. In the last few years, housing seems to be making a moderate comeback and economic growth seems to be steady. Therefore, we believe that future business conditions should provide Home Depot with a favorable environment for earnings growth.

Business Quality Analysis:

Home Depot has a Business Quality Score of 5 out of 10 based on an analysis of historical data. We assign a Business Quality Score to each company undergoing analysis. The score is based on a scale of 1 to 10 with a value of 10 indicating the best possible Business Quality Score. Our Business Quality Score is a proprietary metric which takes into account the 10 year historical performance of the company. Performance is measured considering the absolute performance (and trends) in revenues, earnings, profit margins, and returns on assets/equity.

Low Business Quality Scores (3 or lower) indicate companies that are in a cyclical or commodity business. These businesses have erratic revenues and earnings with associated low profit margins and poor returns on capital. Low quality companies operate in highly competitive/cyclical businesses where consistent profits are nearly impossible to achieve.

Medium Business Quality Scores (4 to 6) indicate an average quality business that operates in a business environment that is not overly cyclical in nature. Also, the products or services these businesses provide are not yet commoditized but do operate in a highly competitive business environment. Moreover, these businesses do not have durable competitive advantages that will allow these businesses to earn consistently high returns on capital. Companies with a medium Business Quality Score can sometimes be good investments if bought at deeply discounted prices and sold at fair value. This is in contrast to investments in businesses with high Business Quality Scores where paying fair value for shares can yield good returns if held for the long term.

High Business Quality Scores (7 or higher) indicate companies that are in high quality businesses with some type of durable competitive advantages that keep competitors at bay. These businesses typically have steadily rising revenues and earnings with associated high profit margins and high returns on capital.

Revenue:

Home Depot's revenues have had mediocre performance over the last 10 years growing at an annualized growth rate of 1.9%. In contrast to the last decade, Home Depot's performance was great in the 2003 through 2007 period growing at a 9.3% annualized growth rate. Revenues took a big hit in the 2008 through 2010 period declining at a 4.2% annualized rate. However, we believe that Home Depot is a turn-around story that will continue to grow revenues as they have since 2011. In our opinion, Home Depot will grow revenues at a 5% annualized growth rate over the next decade.

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Earnings Per Share:

Home Depot's earnings grew at an annualized growth rate of 4.7% over the last decade. However, the earnings were not consistent with huge earnings shortfalls in 2008 and 2009. In fact, earnings dropped 18.6% in 2008 and dropped 39.6% in 2009. Wide variation in earnings is not indicative of a high quality business with strong competitive advantages. Home Depot's performance in this regard is one reason we gave Home Depot a medium level Business Quality Score of 5. However, we believe that Home Depot has solved many of its problems and that Home Depot will have annualized earnings growth of about 7% in future years.

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A company's earnings per share is a measure of profitability for a company. The earnings per share is calculated by dividing the net income attributable to the common stock by the average number of common shares outstanding. One drawback in using earnings as a profitability measure is that it does not consider the amount of assets needed to generate the earnings. Earning the same profit using fewer assets is more profitable but this is not captured in the earnings per share calculation.

High quality companies will have steadily rising earnings that do not vary greatly through a full business cycle (expansion-recession-expansion). Investing in high quality companies is fairly easy assuming an investor has realistic profit expectations and has the patience to wait for a reasonable stock price relative to the company's value.

Lower quality (cyclical) companies will have earnings that vary greatly over a business cycle. Often these cyclical companies will experience a drastic reduction in earnings during economic recessions. Investment profits can be had with investments in cyclical companies but the timing of the buying and selling of the investment must be in sync with the ebb and flow of the stock market. Typically, the stock market will start to recover about 6 months before the economy comes out of recession. However, this point in time is not obvious in the moment and is only known later with the benefit of hindsight. Furthermore, timing when to sell a cyclical stock is even more difficult. Timing the stock market is a matter of luck so it is best to stick with the higher quality stocks where market timing is not as critical to investing success.

Net Profit Margin:

Home Depot has had net profit margins in the range of 3.2% to 7.2% over the last 10 years with an average net profit margin of 5.6%. Home Depot's net profit margin was 4.0% or better in 9 out of 10 years. We expect the net profit margin to hover around its long term average of 5% in the coming years.

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The net profit margin is net income divided by net revenues. For non-retailing companies, a consistent net profit margin of 7% or higher is an indicator of a good company with some type of durable competitive advantage. In the retailing sector a net profit margin in the range of 2.5% to 5% is the norm even for the best companies. Ideally, the net profit margin should be steady or rising over the past 10 years.

Return On Assets:

Home Depot has had a return on assets in the range of 5.4% to 14.0% over the last decade. Home Depot's performance in this regard is pretty good considering that the return on assets was above 7.0% in 8 out of 10 years. We expect the return on assets to hover around Home Depot's long term average return on assets of 10% in the coming decade.

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Return on assets is a measure of how much profit is generated from a company's assets independent of how much debt is used to finance the acquisition of those assets. The return on assets is sometimes a better measure of profitability than return on equity because the return on equity can be significantly increased by adding more debt to a company's balance sheet. Adding more debt to a company can inflate profits but comes at the price of a greater risk of bankruptcy.

Measuring profitability using the return on assets does not have this problem because to calculate the return on assets the net income plus the interest expense net of income tax savings is divided by the average total assets of the company. Thus, by dividing the net income (adjusted for the affects of debt financing) by the total assets (debt + equity) of the company it cancels out the positive effects of debt.

The return on assets is great for comparing the profitability of companies with different levels of debt in their capital structures. Generally speaking, a consistent return on assets of about 7% or more is a good indication of a good business with some type of durable competitive advantage. One exception to this rule of thumb is the banking sector where a return on assets of just 2% is considered exceptional.

Return On Equity:

Home Depot has had a return on equity in the range of 13.0% to 22.9% during the last 10 years. Home Depot's performance in this area is good considering that the return on equity was above the critical 15% level in 8 out of 10 years. We believe that Home Depot's return on equity will continue at its long term average of about 19% for the foreseeable future.

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Return on equity measures a company's performance in financing and using assets to generate earnings. In contrast to the return on assets, the return on equity considers the affect of financing in generating profits. To calculate the return on equity the net income (minus dividends paid on preferred stock) is divided by the average common shareholder's equity. As a rule of thumb, a consistent return on equity of 15% or more (assuming a reasonable level of debt financing) is an indicator of a good company with some type of durable competitive advantage.

Valuation:

A discounted cash flow analysis revealed a fair value for Home Depot shares of $44.28/share. We use the percent of revenue method in our discounted cash flow analysis. The model assumes an average weighted cost of capital (WACC) of 9.9%. Our WACC is calculated using a proprietary formula unique to our firm. An average annualized revenue growth rate of 5.0% is projected over the next 10 years. An average annualized revenue growth rate of 3.0% is assumed for every year thereafter.

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Conclusion:

Home Depot appears to be a medium quality company with an overvalued stock price. Based on a fair value of $44.28/share and the Home Depot closing stock price of $66.44/share (on 02-20-2013) the stock must fall 33.4% to reach fair value.

Disclaimer: Ulfberht Capital is not an investment advisor. This article is not a recommendation to buy or sell securities. Always consult your investment advisor before making any investment decision.

Source: Home Depot: Overvalued By A Significant Margin