16 November 2007

HD: Financial Analysis through October 2007

We have analyzed Home Depot's (HD) preliminary report for the October 2007 quarter, and this post reports our tentative results. The financial statements in the company's report were limited in that the Balance Sheet was abbreviated and the Cash Flow Statement was omitted. We will update our evaluation after the company submits a complete quarterly report to the SEC in a 10-Q filing.

It has been a momentous year for the largest retailer of "do-it-yourself" merchandise, which includes building materials, home improvement supplies, and lawn and garden products. Robert Nardelli was forced out as Chairman and CEO because of dissatisfaction with the company's operating performance, stagnant stock price, and bountiful executive compensation. His elephantine severance package became a cause célèbre. After Frank Blake took over, the company decided to sell the Home Depot Supply division, which served professional contractors. The purchase by a consortium of private equity firms closed on 31 August 2007 for $8.5 billion. The final price was $1.8 billion less than the figure originally negotiated, after problems surfaced in the housing and credit markets. The company used the proceeds and other funds to complete a $10.7 billion Dutch Auction tender offer for its own shares. The offer is part of a larger $22.5 billion "recapitalization" plan, although there has been speculation that the further share repurchases will be delayed considerably.

A fund controlled by Sears Holdings chairman and successful investor Edward Lampert acquired 16.7 million Home Depot shares, valued at $541.3 million, during the third quarter.

We analyzed Home Depot after the April 2007 quarter, but we passed on the July quarter because there was speculation the Home Depot Supply sale might fall through. We have more data now, but we will defer gauge score calculations for another quarter to allow the dust to settle.

Before we examine the metrics associated with each gauge, let's review the latest quarterly Income Statement. Please note that the presentation format below, which we use for all analyses, may differ in material respects from company-used formats. A common difference is the classification of income and expenses as Operating and Non-Operating. The standardization is simply for convenience and to facilitate cross-company comparisons.

October 2007
October 2006
18961 19648
Op expenses

CGS (12622) (13044)

Depreciation (431) (401)

SG&A (4144) (3981)

Other 0 0
Operating Income
1764 2222
Other income

Investments 0 0

Interest, etc. (125) (92)
Pretax income
1639 2130
Income tax
Net Income
1071 1333

$0.59/sh $0.65/sh
operations (1)

20 157
1. Primarily HD Supply
Revenue in the October 2007 quarter was 3.5 percent less than in the year-earlier quarter. The Cost of Goods Sold (CGS) was 66.6 percent of Revenue, up slightly from 66.4 percent last year. Depreciation expenses were 2.3 percent of Revenue, up from 2.0 percent. Sales, General, and Administrative (SG&A) expenses were 21.9 percent of Revenue, much greater than the 20.3 percent one year ago.

The lose-lose combination of lower Revenue and higher costs, as a percentage of Revenue, led to 20.6-percent decrease in Operating Income.

Net interest expenses were $33 million more than last year. The Income Tax Rate was 34.7 percent, down from 37.4 percent. Net Income from continuing operations declined by 19.7 percent.

Key metrics are reviewed gauge-by-gauge in the lists below. The values should be considered tentative and we are deferring gauge score calculations because of missing data and because some historical data hasn't been adjusted to reflect the new corporate structure.

Cash Management.

The following measures have improved:
The following measures have weakened:
  • Current Ratio =1.1; much weaker than we prefer, but not too much below the five-year median value of 1.3.
  • LTD/Equity = 65 percent; the company has, intentionally, become much more leveraged as it borrows money to repurchase shares.
  • Debt/CFO = 1.7 years (based on an estimate of CFO), up from 1.2 years in October 2006. Debt may be on the rise, but it appears to be affordable.
  • Inventory/CGS = 89.2 days, compared to 87.3 days 12 months ago. The five-year median is much less at 76 days, which suggests that sales have been slower than expected.
  • Working Capital/Market Capitalization = 2.5 percent, down not too much from 3.2 percent in October 2006.


The following measures have improved:
  • Revenue/Assets = 176 percent, way up from 154 percent in a year; stock repurchases decrease assets, which create the illusion of improved sales efficiency.
  • CFO growth = 11 percent year-over-year (estimated), up from +4.7 percent.
The following measures have weakened:


The following measures have improved:
  • FCF/Equity = 22 percent (estimated), up from 12 percent
  • Accrual Ratio = 1.2 percent (estimated), down from 4.7 percent.
The following measures have weakened:

Value. Home Depot's stock price fell from $40.16 on 31 December 2006 to $31.51 on 31 October 2007, and it has continued to drop in November. The following metrics were calculated using October's closing price.

These value measures all suggest the shares have become less expensive:
  • Enterprise Value/Cash Flow = 9.3 (estimated), down from 12.6 in October 2006
  • P/E = 12.8, down from 13.4. The five-year median P/E is 15.6 (when the company was growing)
  • P/E to S&P 500 average P/E = 20 percent discount, compared to a five-year median of a 9 percent discount
  • Price/Revenue ratio = 0.72, xx percent (higher, lower) than its five-year median of 1.07.
The average P/E for the Retail (Home Improvement) Industry is currently 12.7. The average Price/Revenue for the Industry is currently 0.76.

The slowdown in home sales has trimmed Home Depot's Revenue and slashed its Earnings. The stock market has punished Home Depot (HD) shares mercilessly, especially since the completion of tender offer, which provided some support to the shares during the summer. The shares now appear to be on sale, but that may be illusionary. Investors probably fear (quite reasonably) that a recovery in the housing business is a long way in the future. Home Depot appears able to, um, weather the storm, although we would have to reconsider this assessment if they borrow another $10 billion to buyback more stock.

1 comment:

  1. Error in link from the right: Current Gauge Readings -> WMT: 6-4-3-12>29 it's link to this article about HD and not to WMT.