Is Home Depot a Buy at Current Prices?

| About: Home Depot, (HD)
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I can already tell that I am going to like Home Depot's (NYSE:HD) New CEO, Francis Blake.

Within months of taking the reins of the largest home improvement company in America, Blake has made a couple of key decisions that prove he understands the basics of running a business.

The first - and arguably most important - decision he made was to sell HD Supply Disposition, the Home Depot unit that worked directly with general contractors.

Yes, it's true that the unit brought in $11.8 billion per year in revenue, which means that sales will automatically be lower by 13% next year.

And yes, it's true that he had to lower his sale price from $10 billion to $8.5 billion, which means that shareholders get less money in their pockets for the sale.

But when you look at the financials of Home Depot without the HD Supply Unit, it becomes clear why Mr. Blake did shareholders a favor by getting rid of it.

Let me explain:

In 2006, Home Depot earned $5.7 Billion on $90.8 Billion in sales, which equates to a profit margin of 6.278% ($5.7 Billion/$90.8 Billion). That means that for every $1 in sales Home Depot did last year, they earned 6.278 cents.

Without the supply unit last year, however, Home Depot would have still earned over 5 billion dollars - $5.245 billion to be exact. But it would have only booked $79 billion in sales, a decline of roughly 13%.

At first that sounds like bad news - nobody likes to do less business than they did the prior year. But the reality is that Home Depot's profit margin would have climbed to 6.639%, an increase of roughly 3/8 of one percent or 370 basis points.

Now that may not sound like a big deal to you and me. But would you refuse me if I offered you 3/8 of one percentage point of $79 billion in sales each year?

Of course not! You'd be giving away $296.25 million bucks each year!

If Mr. Blake focuses on each cost center of Home Depot as hard as he says he will, he may even get his net profit margin back up to 2005 levels of 7.2%, an increase of one full percentage point since he took over.

That alone would mean an additional $790 million in cash that goes directly to shareholders each year (1% of $79 Billion). And it would mean that the company is more profitable than arch-competitor Lowe's (NYSE:LOW), with profit margins of 5.9% in 2006.

Why is it important for a business to fight for every single percentage point?

Because it means the business is running at optimal efficiency and is able to reinvest the maximum amount of money possible into future growth.

In Home Depot's case, that means it would have had an extra $296.25 million to reinvest into its business last year alone (by increasing profitability by 3/8 of one percentage point).

Since Home Depot has a Return-On-Capital of 15%, it will make an additional $44.4 million each year (15% of $296.25 million).

That's why the stock market tends to reward companies that have high profit margins with higher price-earnings (P/E) multiples relative to their peers.

(This is a big clue to the whole return-on-capital discussion we've been having. I'm just talking about the "return" side of the equation, the net income.)

The second move Mr. Blake made that I like is that he bought back almost 15% of Home Depot stock, which will have an immediate and direct impact on earnings per share.

Last year, Home Depot had 2.062 billion shares outstanding. Based on the post-sale earnings of $5.246 billion, the company would have earned $2.54 per share.

But ever since the buyback, that number has been reduced to 1.804 billion, meaning that the company would have earned $2.90 per share, an increase of roughly 14%. Not too bad.

The big question, however, is whether Home Depot is a buy at current prices.

Although I like what management is doing now, I still need to see more to make that decision.

But one thing's for sure - I wouldn't be a seller here if I owned it.