24 February 2007

HD: Analysis through Jan 2007

Home Depot (HD) is the largest retailer of hardware and other merchandise, including large amounts of lumber, for home construction and improvements. It sells to do-it-yourself homeowners and professional contractors.

Former CEO Robert Nardelli was forced out because of an uproar over his hefty compensation, the company's weak performance relative to principal competitor Lowe's, and Home Depot's long-stagnant stock price. The furor intensified after his dismissal when word got out about how he left with a gargantuan golden parachute. To be fair, Mr. Nardelli also took actions -- share buybacks and dividend hikes -- generally considered to be investor-friendly. Nevertheless, conditions at Home Depot, and worries about how the company will handle the slowing of the housing market, morphed a premier growth company into a potential acquisition by a value-seeking hedge fund. More likely is the divestiture of the low-margin Home Depot Supply division, which serves contractors, and which was championed by Mr. Nardelli.

When we analyzed Home Depot after the quarter that ended in October 2006, the Overall score was a modest 34 points. Of the four individual gauges that fed into this overall result, Value was the strongest at 12 points. Cash Management and Growth were tied for weakest at 5 points.

We have since updated the analysis to incorporate Home Depot's financial results for the latest quarter, which was the fourth of fiscal 2006. (Since the press release announcing these results did not include all of the items that make up a Balance Sheet or Statement of Cash Flows, the analysis will need to be revised when the full set of financial statements is submitted to the SEC.) With data available through 28 January 2007, our gauges now display the following scores:

Cash Management. This gauge has flat-lined at 5 points for the last 10 quarters. The Current Ratio moved up from 1.2 to 1.4. We would prefer to see it a little higher. Long-Term Debt/Equity surged to 47 percent, up from 24 percent the previous quarter. The debt ratio was only 10 percent one year ago. (The company claims the debt rise "Increased the efficiency of its capital structure by increasing its financial leverage." We want to know if the funds received were used to buyback stock or to make productive investments.) Inventory/Cost of Goods Sold is now 76 days. The inventory level was 83 days at the end of the pre-holiday prior quarter, when inventory levels are always high. The inventory level was 77 days at the end of January 2006, and the current inventory level is very much consistent with typical January level for this company. The consistency suggests sales met internal expectations. Accounts Receivable/Revenues are 13 days. This is a little better than recent levels, but actually a bit higher than typical values at the end of January. A sustained increase would indicate the company is having more trouble getting paid by its customers.

Growth. This gauge increased one point from October. Revenue growth is now 11 percent year over year, down from 12 percent a year ago and 13 percent the year before that. (The fourth quarter was especially weak for Revenue, up only 4 percent from the previous fourth quarter.) Net Income growth didn't happen: Net Income declined by 1 percent, after having increased by 17 percent a year ago. Increased interest expenses and a 1 percent rise in the income tax rate hurt Net Income most. On the other hand, CFO growth appears to be -- without a CF statement, we can't be sure) an impressive 25 percent, whereas CFO contracted 6 percent a year ago. (Maybe an extraordinary charge to year-earlier CFO made current year comparisons easier.) Revenue/Assets is 174 percent; it is lower than after other January quarters. It indicates that the company is becoming less efficient at generating sales.

Profitability. This gauge increased 3 points from October. (The increase is counter-intuitive given the decline in Net Income, but it reflects the apparent increase in CFO. We wouldn't be surprised to see the gauge drop when full financial data becomes available in the upcoming 10-K submittal.) ROIC slipped to a still-healthy 17 percent. It was 19 percent a year ago. FCF/Equity jumped up to 18 percent from 10 percent. Operating Expenses/Revenue steadied at 89 percent. However, this masks a 1.2 percent decline in Gross Margin. The Accrual Ratio, which we like to be both negative and declining, fell from 7 to 2 percent. (If confirmed,) This tells us that more of the company's Net Income is due to CFO, in contrast to changes in balance sheet accruals.

Value. This gauge, based on the stock price of $40.74 on 31 January, dropped to a weak 6 points, compared to 12 and 9 points 3 and 12 months ago, respectively. The P/E at the end of the quarter was 14.2, about where it has been for the last year or so. The average P/E for the industry is 16. To remove the effect of overall market changes on the P/E, we note that the company's current P/E is at a 13.5 discount to the average P/E, using core operating earnings) for stocks in the S&P 500. A 9 percent discount to the market has been more common in recent years. (When HD was a growth company, its P/E had a 100 percent premium to the market.) Since Net Income declined, the PEG ratio is not applicable. The Price/Revenue ratio has declined to 90 percent from 106 percent. The decrease suggests the shares have become less expensive. The average Price/Sales for the industry is 103 percent, which would tend to confirm this view.

Now at a disappointing 27 out of 100 possible points, the Overall gauge is towards the lower end of its range over the last 10 quarters. The score hit 62 points after the July 2004 quarter, when the stock price was below $34. The stock price rebounded above $40 in a mere three months, but never got any higher.

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