During the worst housing market since World War II, Home Depot (HD) found religion of sorts, and under the leadership of Chairman and CEO Frank Blake, the company embarked on a multi-faceted plan that has significantly improved the company's operations. Home Depot had ridden decades of double digit sales and earnings growth to expand its store footprint, and leverage into additional businesses that deviated from the company's iconic orange box stores. General Electric (GE) alum and former CEO Robert Nardelli was replaced in January of 2007, and Blake took aggressive actions to divest non-core assets and to streamline the supply chain. The company focused on allocating excess capital to shareholders in productive ways, instead of engaging in an empire-building campaign, which wouldn't leverage Home Depot's durable competitive advantages in North America. These steps have led to substantial increases in free cash flow, while improved margins set the stage for attractive earnings growth, as the housing market continues to improve. Despite these many positive trends and a strong belief in the company's leadership, I believe Home Depot is fairly valued at current prices, and I would need to see a significant sell-off before obtaining the required margin of safety to invest.
The internet has clearly had a transformative impact on most retail operations. Companies such as Blockbuster, Staples (SPLS) and Best Buy (BBY) have seen their businesses severely impacted by the ease of internet transactions. Some of the major disadvantages of internet retail are potentially higher shipping costs on heavier items, and the inability to obtain same-day delivery in most markets. Few retailers, if any, are more insulated from the destructive competitive dynamics of the internet than Home Depot. Much of the supplies that the company sells are quite heavy, and many times trips to the store are to the building supplies store to acquire much-needed materials to finish a project where time is of the utmost importance. Currently, the company is advancing its buy online, ship to store concept, which has the opportunity to enhance its customer experience.
Home Depot and Lowe's (LOW) hold a duopoly in the home improvement market in the United States. Other stores have tried to compete effectively, but if a construction team is trying to finish a project and is in need of supplies, they would be silly not to go to the location where their needs can be completely fulfilled. The housing and home repair markets are certainly cyclical, but are not in danger of becoming obsolete any time in the near future. It would be nearly impossible for a new entrant to take serious market share away from the existing incumbents. Therefore we view this segment of retail as being one of the safest places to earn returns in excess of the cost of capital.
When the housing market crashed, Home Depot already had a mature store base with very little opportunity for store growth. Frank Blake correctly identified this and instead focused on improving technology tools to improve supply chain visibility, which was an area where Home Depot had previously lagged behind Lowe's. Blake drove costs lower, but due to the horrendous macro conditions it was difficult to see the full impact of these investments in the company's financial statements. The company divested its professional supply business and ancillary retail operations in 2007 and 2009, respectively. In 2012, the company determined that it would halt its big box operations in China, opting for more localized concepts. Management is focusing much of its current investment efforts into driving further improvements in its cost structure and supply chain, where it can get more assured investment returns on invested capital.
The fact that Home Depot remained quite profitable despite the worst housing crisis since World War 2 speaks volumes about the quality of the company's business. Return on equity hit trough levels in 2009 at 12.75%, and returns on invested capital that year were 6.16%. Because of Blake's reduced spending on expansion, the company actually increased its free cash flow in 2009 and 2010, despite steep revenue declines mainly caused by divestments and a rough consumer environment. Importantly, Blake returned much of this free cash flow to shareholders via dividends and stock buybacks. The company has reduced the share count from about 2.062 billion diluted shares outstanding at the end of 2006 to 1.491 billion, as of February 3rd 2013. Just about all of this 28% reduction in diluted shares outstanding took place at prices far below Home Depot's recent price of roughly $67.50, and below my estimates of intrinsic value. Even with the huge buyback program, Home Depot has increased its dividend payout consistently over the last 5 years, and the goal of the company is to pay about 50% of earnings as dividends. With the remaining retained earnings, the company invests in the business and buys back its own stock.
I can't overstate how important it is that management downgraded its international aspirations where it had very little durable competitive advantages, if any, in favor of a strategy that focuses on maximizing investor returns through improved profitability and intelligent capital allocation. Many market participants are hugely critical of Edward Lampert at Sears Holding (SHLD), but solid capital allocation is by far and away one of the most important determinants of shareholder returns in retail stocks. Sears has a tough competitive dynamic but if the company would have expanded like other retailers such as Best Buy did, bankruptcy would have been a much more likely scenario. Some of the best performing retail stocks have been companies such as Autozone (AZO) and Autonation (AN), which were also large Lampert investments. Both management teams have done an excellent job at allocating cash to the highest returning opportunity, whether that be expansion, leveraging technology, or buying back their own common stock. Frank Blake seems to be cut from a similar cloth, and with a very strong hand to play at Home Depot, the future looks quite exciting.
On February 26th, Home Depot reported excellent 4th quarter earnings, highlighting improvements in the housing market, an increase in demand caused by Hurricane Sandy, and an extra week of sales. Sales in the quarter were up 13.9% YoY to $18.2 billion, and comparable store sales were up 7%, with U.S. stores leading the way up 7.1%. Home Depot earned $1.0 billion or $.68 per diluted share in the quarter, which was up from $774MM and $.50 per diluted share YoY, respectively. The company estimates that the extra week added approximately $1.2 billion in sales and .07 per share in earnings per diluted share, in the quarter and year, respectively.
For fiscal year 2012, Home Depot grew sales by 6.2% from 2011 to $74.8 billion. Total company comparable store sales for the year increased 4.6%, and comp sales for U.S. stores were up by 4.9% in 2012. Home Depot earned $3.00 per diluted share, which was up 21.5% from $2.47 in 2011. The numbers would have been about $.10 per diluted share better, had it not been for a $145MM, net of tax, charge associated with the closing of some stores in China. Home Depot achieved an operating margin of 10.4% and a 17% return on invested capital for 2012. These met or exceeded the company's 2009 goals, proving that management is doing what they said they would do, which is often not the case, unfortunately.
On the strength of an excellent 2012 and an improving climate heading into 2013, Home Depot raised its quarterly dividend by 34% to $.39 cents per share. Management expressed its interest in paying out about 50% of earnings as a dividend, which I view as a huge positive in terms of capital allocation. In addition, the company's board of directors authorized a $17.0 billion share buyback, which replaced its previous program. Since 2002, the company has bought back approximately 1 billion shares for $37.5 billion. Management is laser-focused on increasing shareholder value through the maximization of sound capital allocation, and excellent operating performance. The company's goal is to attain a return on invested capital of 24% by the end of fiscal 2015.
For 2013, Home Depot expects sales growth of 2%, headlined by comparable store sales growth of roughly 3%. The company only intends to open about 9 new stores and hopes to be able to drive both gross and operating margin improvements, culminating in roughly 65 basis points of operating margin expansion. The company intends to buy back about $4.5 billion worth of stock, and including buybacks expects diluted earnings-per-share-growth of 12% to $3.37. Home Depot expects to generate roughly $7.2 billion in cash flow from operations and has capital spending plans of $1.5 billion, which would peg free cash flow at about $5.7 billion. Home Depot averaged investing well over $3.5 billion per year on property between 2003-2008, so the improved free cash flow dynamics are really a combination of reduced spending and improved profitability. New home inventory levels are exceptionally low and many home-owners have deferred remodeling plans due to the weak economic landscape. These dynamics will likely lead to a solid runway of earnings growth. If the company hits its return on invested capital target, the company could potentially earn between $6-7 billion by 2015. The large stock buyback should increase per share value even further, as long as the company is diligent about only buying back stock when it trades below the intrinsic value.
With all of this positivity it might seem strange to be neutral on the stock, but it really comes down to demanding an adequate margin of safety. At $67.50, Home Depot trades for about 20 times 2013 earnings. Book value severely understates Home Depot's real estate value, which is marked at cost on the balance sheet. With a current market capitalization around $95 billion, Home Depot trades at about 13.5 times my peak earnings estimate of $7 billion. My estimates could be overly conservative if the housing rebound is stronger than I expect, but I'd want to buy the company at $.50-60 cents on the dollar to really be interested, and at current levels I just can't justify such a valuation. If I were long Home Depot, I would look to take some profits off of the table after reaping the benefits of this excellent management team. I'd only look to re-establish a position if the stock traded down to the low $50's.
Additional disclosure: I am long Sears Holdings bonds.