09 June 2007

HD: Financial Analysis through April 2007

We have updated our analysis of Home Depot's (HD) financial results for the quarter ending on 29 April 2007 to address the data reported to the SEC on Form 10-Q. Our evaluation, adjusted to account for new information, is reported in this post.

Home Depot is the largest retailer of home improvement merchandise, including large amounts of lumber. Customers include do-it-yourself homeowners and professional contractors.

Management problems and worries about the slowing of the housing market have morphed an erstwhile growth company into a potential target of 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 the former CEO.

This update is the first one that includes the additional Cash Management metrics identified here. Prior data has been revised to reflect the new metrics.

When we analyzed Home Depot after the results from January became available, the Overall score was a modest 30 points. Of the four individual gauges that fed into this composite result, Profitability was the strongest at 11 points. Growth was weakest at 4 points each.

Now, with the available data from the April 2007 quarter, our gauges display the following scores:

Cash Management. This gauge dropped 1 point from 7 points in January. The Current Ratio is now 1.4, which is weaker than we like. However, it has moved up from 1.2, and is now above its five-year median value. Long-Term Debt/Equity is a leveraged 45 percent. The debt ratio was 47 percent in January and 24 percent 12 months ago. We suspect the debt increase from last year had something to do with $4.5 billion spent on acquisitions, including $3.5 billion for Hughes Supply and the undisclosed amount for twelve Home Way stores in China. Inventory/Cost of Goods Sold rose to 82 days from 72 days three months ago and 81 days in April 2006. The recent rise in inventory (all product ready for sale) may be due in part to slower sales growth, but it is probably mostly due to the normal spring build up prior to the summer season. Accounts Receivable averaged 14 days of Revenue, compared to the 12-day level seen one year earlier.
Debt/CFO is 1.8 years, meaning that about 21.5 months of Cash Flow from Operations would be required to pay off the company's short and long-term debt. This ratio was 1.0 years one year ago and 0.3 years two years ago, so we see that the company is becoming more leveraged. On the other hand, Working Capital/Capitalization is up to 6.6 percent from 4.4 percent a year earlier. The Cash Conversion Cycle Time is 40.2 days, which is a bit less efficient that the 37.4 day period of year ago. Efficiency, as measured by this parameter has been on a long-term decline.

Growth. This gauge increased 2 points from 4 points three months ago. Revenue growth slowed to 8 percent year over year, from 13 percent a year ago. Net Income declined 12 percent; earnings were up 18 percent a year ago. The additional $350 million spent on interest expenses in the recent year contributed to the net income decline. CFO declined 6 percent year over year. Revenue/Assets is 1.62. The long-term trend down in this parameter indicates that the company has become less efficient at generating sales. A stock buyback, reducing assets, wasn't enough to break the negative trend.

Profitability. This gauge dropped 3 points from the prior quarter's 11 points. ROIC slipped to a moderate 15 percent from 19 percent a year ago. FCF/Equity was steady at 11 percent. Operating Expenses/Revenue edged up in the last year from 88 percent to 90 percent. The change was primarily due to a decline in Gross Margin. The Accrual Ratio, which we like to be both negative and declining, moved in the right direction from +6 percent to +4 percent. This tells us that more of the company's Net Income is due to cash flow, and, therefore, less is due to changes in non-operational balance sheet accruals.

Value. Home Depot's stock price fell over the course of the quarter from $40.74 to $37.87. The Value gauge, based on the latter price, increased to a weak 8 points from 6 in the last quarter. It was 10 points twelve months ago. The P/E at the end of the quarter was 14, about the same as recent quarters. The average P/E for the Retail (Home Improvement) industry is just a bit more expensive at 14.7. To remove the effect of overall market changes on the P/E, we note that the company's current P/E is 15 percent less than the average P/E, using core-operating earnings, of stocks in the S&P 500. This discount to the market multiple has expanded over the last five years. Since Net Income fell, the PEG ratio is N/A. The Price/Revenue ratio, which is less affected by the one-time factors that cause wide swings in earnings, declined to 0.8. The decrease suggests the shares have become less expensive. The average Price/Sales for the Retail (Home Improvement) industry is 0.95.

Now at disappointing 30 out of 100 possible points, the Overall gauge has been weak for all but one quarter in the last three years. [In the summer of 2006, when the stock price fell below $35, the Value gauge temporarily stirred.]

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