Home Depot: Look for Improvements

The Home Depot Inc. (HD) serves several groups: Do-It-Yourself customers, Do-It-For-Me customers, and professional contractors. The company’s Do-It-Yourself customers are usually homeowners who purchase products at Home Depot which they intend to install themselves at their homes. These clients receive special treatment from Home Depot in that the company hosts “how-to” clinics. The Do-It-For-Me customers are usually home owners who purchase materials at Home Depot, then hire a third party to install the project. Professional contractors include professional remodelers, general contractors, repairmen and tradesmen. Home Depot provides extra benefits to these clients such as additional delivery and will call services, dedicated staff, extensive merchandise selections, and expanded credit programs.

Five years ago (2001) Home Depot traded at roughly $40 to $50 per share. Now the stock trades for roughly $36 per share, while CEO Bob Nardelli is $245 million richer. Long time investors in Home Depot are disappointed, angry, and feeling neglected.

What these investors haven’t acknowledged, though, is the fact that a stock price doesn’t always represent a company’s true value. At previous levels, specifically during 2001, Home Depot was quite clearly an overvalued security. At current levels, though, HD represents a compelling bargain. Ah, the power of Mr. Market.

In 2001, Home Depot traded at an average of 36x earnings according to ValueLine; now the multiple stands at 13x 2005’s earnings. There is one fact that investors must consider: As the CEO of Home Depot, Bob Nardelli is assigned to run the company, not the stock. Despite what people may say, it is almost impossible for the CEO of a company to control or manipulate the multiple Mr. Market ascribes to a given security. However, Nardelli has proven quite capable of managing what the CEO of a company can control -- sales, cash flows, shares outstanding, margins, and so on.

For example, sales have increased to $85.5 billion during 2005 from $53.5 billion in 2001. Gross margins have increased from 31.6% in 2001 to 33.5% during 2005. The company’s store base has increased from 1333 in 2001 to 2042 at the end of 2005. And shares outstanding have fallen to 2.138 billion from 2.346 billion at the end of 2001.

In addition, Wall Street has become angry with the fact that the company has stopped formally reporting same stores sales ('SSS') numbers. Becoming angry over this fact seems to show a lack of understanding of the company’s long term business plan. This plan is the strategy of “cannibalizing” certain areas, meaning the company will place a new store close to an already existing store. While this strategy inevitably hurts the company’s existing store, the company gains market penetration, and increases total company sales. According to the company’s recent 10Q, “our new stores cannibalized approximately 18% of our existing stores as of the second quarter of fiscal 2006, which had a negative impact to retail comparable store sales of 2.1%.” It boggles my mind as to why analysts would become angry if a given company decides to stop reporting figures that are essentially irrelevant in the grand scheme of that company’s long term business plan.

During 2005, besides reaching all time highs in average ticket ($57.98), gross profit margins (33.5%), and operating margins (11.5%), the company made several improvements in their overall product base. The company expanded their patio lineup with their proprietary brand, Hampton Bay. They enhanced their grill lineup using both proprietary (Charmglow) and exclusive (Ducane) brands. In addition, they increased their power tool lineup adding exclusives from Makita and Milwaukee for their do-it-yourself customers. Not only did the company improve their product lineup, but they also modernized store technology. The company continued to install self-check-out registers, and rolled out their back-end scanning system received by all stores in the United States and Canada, among other advances.

I valued the stock using scenario analysis and discounted cash flow analysis. I define scenario analysis as looking at the potential dividends, multiple expansion, and future earnings of a given situation to arrive at a value. For example, with Home Depot I considered the multiple expanding to 14-16x earnings. I believe this is still a conservative multiple as Lowe's Companies Inc. (LOW), which is also cheap in my opinion, is currently trading at 15x earnings. I believe earnings are going to grow to $3.10-$3.50 per share during the year ending in 2008 (operating year 2007). In addition, investors are going to receive about $1 per share in dividends during this time, assuming there is no special dividend. Add this together and I come up with a value of $44 to $57 per share. While this seems high considering the company’s market cap, wide analyst following, and current share price, I believe $44 represents an overly conservative figure, providing a margin of safety.

Here’s why: The analyst consensus for operating year 2007 earnings per share is $3.28 per share, a rather significant amount above my conservative $3.10 per share used to find the bottom range. In addition, that $44 per share assumes a 14 earnings multiple, a figure that’s roughly in-line with the sector of Home Improvement Retail. As icing on the cake, I think this sector is cheap as whole; therefore the average multiple is likely to expand in coming years.

On the discounted cash flow side, I found a value of $41 to $47 per share. I used a variety of operating margin and sales growth assumptions, placing the most weight on 8-9% increase in sales per year and a slight decline in operating margins.

Investors seeking to leverage their returns and size in the stock might want to consider using options. For example, investors could put on a synthetic long by selling January 2009 $35 puts for $3.60 and purchasing the January 2009 $35 calls for $7.30. As such, the investor would own 100 shares of HD until 2009 for $3.70 per share, assuming the stock stays above $35 per share. However, investors unfamiliar with options should certainly learn the strategies before putting on option positions.

Valuation first, emotion second. This isn’t the way investors are approaching Home Depot at the present time, but this should change, in my opinion.

Disclosure: I have a long position in HD.

HD 1yr Daily Chart

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Comments

[WC Whiner]

What risk does the ongoing housing slowdown pose to your thesis?

One note, for more-efficient exposure long or short, I like single-stock futures better than synthetic stock. For identical exposure, the synthetic long costs $360 cash and takes $1600 margin, the SSF costs $0 cash and takes $750 margin.

[Ha]

Hey WC,
Kevin here. The macroeconomic issue of housing certainly plays an issue. The company has already said 06 #s should come in on the low side of issued guidance. That said, it's clearly a sector-wide issue as Lowe's, arguably the better company, has made similar announcements.

That said, I think the issue is probably priced in at this level and EPS/sales growth should still be positive.

Just my thoughts,
Kevin Kelly
ValueBlogger.com