02 December 2007

HD: Financial Analysis through October 2007 (Update)

We previously posted an analysis of Home Depot's (HD) preliminary report on the October 2007 quarter.  The company's initial report was limited: the Balance Sheet was condensed, and the Cash Flow Statement was omitted.   Home Depot subsequently submitted a more complete quarterly report in a 10-Q filed with the SEC.

Our evaluation, adjusted to account for new information, is reported below.   For completeness, information from our initial post that is still relevant has been repeated. Gauge score calculations, however, have been omitted because we don't have sufficient historical financial data at this time that is representative of Home Depot's new corporate structure.

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 sold 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.

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

Net interest and other non-operating 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 below by each gauge.

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 up from 24 percent last year at this time; the company has become much more leveraged as it borrows money to repurchase shares.
  • Debt/CFO = 1.9 years, 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 = 2.6 percent, down somewhat 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.
The following measures have weakened:
  • Revenue growth = -1.4 percent year-over-year, down from +2.9 percent
  • Net Income growth = -22 percent year-over-year, down from +2 percent
  • CFO growth = -1.1 percent year-over-year, down from +4.7 percent.


The following measures have improved:
The following measures have weakened:
  • Operating Expenses/Revenue = 90.5 percent, up from 88.3 percent in a year
  • ROIC = 16.4 percent, reasonably healthy, and down just a tad from 16.6 percent in a year.

Value. Home Depot's stock price fell from $40.16 on 31 December 2006 to $31.51 on 31 October 2007. By then end of November, it was down to $28.56. The following metrics were calculated (per our usual practice) using October's closing price.

These value measures all suggest the shares have become less expensive on a relative basis:
  • Enterprise Value/Cash Flow = 10.4, 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 = 26 percent discount, compared to a five-year median of a 8 percent discount
  • Price/Revenue ratio = 0.72, lower than its five-year median of 1.07.
The average P/E for the Retail (Home Improvement) Industry is currently 12.6.  The average Price/Revenue for the Industry is currently 0.75.

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 an illusion.  Investors fear that a recovery in the housing industry 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.

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