24 December 2006

HD: Analysis through Oct 2006

In a remarkably short period of time, Home Depot has morphed from a premier growth stock to a potential value stock. The shares can't seem sustain a price rise no matter how many billions the company spends on buybacks, nor how many times they hike the dividend.

Unfortunately, the reasons for optimism are few indeed. One possibility raised in the media (and quickly denied) was that a hedge fund or two might offer to buy the company. A cynic might believe this rumor was floated by short-term traders looking to boost the stock price for quick profit. We'll see.

Cash Management. This gauge reads 5 points of the 25 possible. The current ratio was a mere 1.17 after the quarter ending in October. Accounts receivable to revenue were 15 days, whereas receivables were reliably less than 10 days from 1994 to 2004. The company is holding 83 days worth of inventory, as measured by cost of goods sold. Inventory levels have been edging up modestly. Against the same measure, Wal-Mart has about 50 days of inventory. At least debt is under control: we consider the LTD/Equity value of 24 percent to be ideal. To be fair, there's no evidence to suggest that improvements to any of the cash management parameters would translate into stock price gains. In fact, we see the opposite situation. The cash management score has a negative correlation with stock price performance.

Growth. The growth gauge also stands at 5 out of 25 possible points. While revenue increases of 14 percent does not a growth stock make, it is, at least, better than more anemic results over the last few years. Revenue/assets equals 1.71, continuing a long trend of less efficient use of resources. While the company brings in more than $6 billion of operating cash flow every 4 quarters, the amount has been more or less static for more than four years. Net Income growth had been a better story, but the weak 9 percent year-over-year growth seen in the latest results is troubling.

Profitability. Only 7 of 25 points here. The accrual ratio is +6 percent (negative values are ideal). This can be attributed to the failure to increase cash flow from operations. We have no particular complaint with 18 percent return on invested capital other than that we were seeing values in the low 20 percents not that long ago. You can probably guess that there is nothing in the free cash flow to equity value of 11 percent to get us excited. The same is true for the operating expenses to revenue figure, which is stuck at 89 percent.

Value. All of the preceding was insignificant, compared to the Value gauge. Of the four gauges, it is the only one that correlates well (correl. coeff. = 0.6) with Home Depot's stock price. The current score of 12 of 25 points reflects how inexpensive the stock has become, but it's not a raging buy sign. The PEG ratio is 1.33 (using the 31 Oct stock price of $37.33, per our custom). The trailing P/E was 12.5. Price/revenue was 0.85. And, the P/E was only 78 percent of the S&P 500 P/E.

Overall. The overall gauge, after the October 2006 quarter, reads 34 out of 100 possible points. When the score bumped up to 45 after the July 2006 quarter, we were hoping October's results would show a confirmation that HD had turned the corner. We were disappointed.

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