Home Depot: A Buy at Current Levels?

Home Depot (HD) has come down a lot. Maybe I should buy it.

Many value investors have interest or have bought Home Depot (HD) in recent quarters, as it has sold off on concerns over the real estate bust. Indeed, it seems like the quintessent value stock - high quality, strong cash flow, and temporary economic problems. A growthier alternative would be Lowe's (LOW). So why haven't I bought it?

When I look at a stock, I try to forecast its profitability several years into the future - building a big spreadsheet model that takes into account economic cycles and the individual company's dynamics. I look at several years of financial history, usually going back around seven or more years. I analyze the balance sheet and cash flow statement, and the footnotes and management commentaries. Then I look forward; but I do not necessarily try to build a precise forecast - nobody really knows what will happen on July 25, 2010. Instead, I look at the company under different economic environments - expansion, recession, high margins, low margins, growth, etc. I then value the company based on a "probability-weighted" average (I don't assign actual probabilities, I just look at was is "reasonable"). Then I look at upside and downside.

While building a forecast model is not unusual among analysts, taking the long view is. Most investors who build models are really only interested in a couple of quarters, maybe a year or two. Indeed, not many will take the two-year forecasts very seriously. And Wall Street is obsessed with precise forecasts of earnings. A company misses expectations by a penny or two, and investors get very upset. In value investing, precision doesn't really work very well.

However, by looking further into the future than most investors, and, not coincidentally, by looking further into the past than most investors, I get to notice things that others fail to notice. Sometimes these things lead me to conclude that a stock is absurdly cheap because the current conditions leading to the cheapness are clearly temporary. Sometimes, however, these things I notice lead me to conclude a stock is not cheap because the period before the sell-off is no more representative of the company than the current period is.

I have indeed looked at both Home Depot and Lowe's - twice this year, and once last year. Back in April my numbers were telling me that both were cheap and selling at a discount to intrinsic value. However, I couldn't get one nagging problem out of my head: the companies experienced a surge in both margins and revenues in the last three years that coincided with the surge in real estate markets. Since a real estate bubble is not likely to repeated, how much of that margin boost was solely attributed to the real estate bubble? In other words, was HD and LOW experiencing "windfall" profits that are now drying up, not to be repeated again? This question is extremely important to placing a value on the company - it would provide me with the appropriate assumption as to the sustainable profit.

While it might be understandable that the boom would make a difference in sales, why would it make a difference in margins? Because, to put it succinctly, for retail companies, higher sales per store mean higher margins; lower sales per store mean lower margins. The retail business is a little more complicated than that, but not much.

The first time I ran the numbers I decided that I didn't have enough data to answer that question, and when I made optimistic assumptions the valuation was only barely in my buy range. So I held off.

More recently, however, the stocks have continued to sell off. So I drilled down on that issue some more. While I don't have "the answer" now, I do have more data. There are a couple of more quarters of the bust under their belt, and I could look back to their operating conditions prior to the real estate boom. Prior to the boom, HD tended to operate at around 9-11% EBITDA margins. During the boom, those margins moved to 13%+.

Now some of that improvement could have resulted from operating improvements - HD has worked hard on improving their profitability. But, the most conservative estimate of margins would be 10%, while the most optimistic would be 13%. Thus, the "sustainable" range is probably somewhere in between. Plugging in 12% put HD's valuation level out of my buy range at the time. And, I think 12% is still pretty optimistic.

What about now? The stock has sold off some more since I did the 12% analysis, but is still only barely below my buy point (assuming 12% EBITDA margins). While I think 12% margins are probably achievable for HD in optimal economic environments, I'm not yet convinced that it is "normal". Thus, I would like to see a little more margin of safety before I take the plunge.

Could I be wrong? Certainly. Maybe 13% is the new "normal" for Home Depot. It's possible - plenty of companies experience permanent increases in margins. If so, then the stock will make a good investment over the next few years. Then again, maybe 10% is "normal." We won't know that answer for sure for a couple more years.

From an investor's standpoint, are you willing to make that bet? For me, I try to make investments that I think are either sure bets, or give me enough upside to offset the risk and uncertainty in the forecasts.

At $28, HD is closer than it was at $35, but not close enough for my comfort level.

Disclosure: No position