13 April 2008

HD: Financial Analysis through January 2008 (Update)

We previously posted a financial analysis of Home Depot's (HD) preliminary report on the quarter and fiscal year that ended 3 February 2008 (i.e., fiscal 2007). Our evaluation was limited because the company didn't provide a full Balance Sheet, nor Cash Flow Statement.

In early April, Home Depot filed a complete Form 10-K annual report with the SEC. The 10-K, of course, fully sated our data needs. Our financial analysis, adjusted to account for new information, is reported below. Because Home Depot's corporate structure changed radically in 2007, readers are cautioned that our gauge scores could be misleading because they are based partially on comparisons of current financial data with historic results. We suggest waiting another couple of quarters, at least, to see how well the company performs with new management and without its former Home Depot Supply unit, which was sold last August. Caution is also advisable simply because of the uncertain state of the housing market.

The additional information in the 10-K did not change the Income Statement. Readers interested seeing how the Income Statement for the fourth quarter matched up with our expectations are referred to our earlier financial analysis.

Taking the data in the 10-K into consideration, our gauges now display the following scores:

Key metrics are reviewed below for each gauge.

Cash Management. This gauge improved from an estimated 5 points in October 2007.

The following measures contributed the most to the score:
With respect to the DSO figure (also known as Receivables/Revenue), a footnote to the company's financial statements indicates that receivables associated with Home Depot's credit card are not consolidated into the company's results. The receivables are owned by a third party that manages the credit card program.

The following measures contributed the least to the score:
  • Current Ratio =1.2; much weaker than we prefer, but not too much below the five-year median value of 1.3.
  • LTD/Equity= 64.3 percent, up dramatically from 46.5 percent last year; the company became more leveraged when it repurchased many of its shares.
  • Debt/CFO = 2.3 years, up significantly from 1.5 years in January 2007.
  • Inventory/CGS = 87.3 days, compared to 84.2 days 12 months ago. The five-year median is a much lower 77.4 days, which suggests that sales were slower than expected. (A footnote indicates that Home Depot values Inventory at the lower of cost or market each quarter.)
  • Working Capital/Market Capitalization = 3.0 percent, down from 5.4 percent in January 2007.
Debt isn't appreciably higher in dollar terms, but it is supported by fewer assets and less cash flow.

Growth. This gauge didn't change from October 2007. The score was decent, although perhaps misleadingly so, because the following highly weighted ratio provided a very good result. The other Growth metrics were awful:
  • Revenue/Assets = 174.5 percent, way up from 151.2 percent in a year; stock repurchases decrease assets, which create the illusion of improved sales efficiency.
The following measures contributed nothing to the score:
  • Revenue growth = -2.1 percent year-over-year, compared to -3.1 percent previously
  • Net Income growth = -20.1 percent year-over-year, compared to -9.8 percent
  • CFO growth = -25.2 percent year-over-year, down from +15.7 percent.

Profitability. This gauge fell from an estimated 15 points in October 2007.

The following measures contributed the most to the score:
  • Accrual Ratio = -14.2 percent, compared to +10 percent. Negative values, especially if becoming more so, can be an indicator of high quality earnings. However, in this case, the ratio fell because of the switch from using cash to invest in the business to using investments as a source of cash.
  • ROIC = 15.0 percent, down slightly from 15.2 percent in a year
  • FCF/Equity = 12.2 percent, down from 16.5 percent in the year ending January 2007.
The following measure contributed little to the score:

Value. The price of Home Depot shares edged down from $31.51 on 31 October 2007 to $30.64 on 31 January 2008. The following Value metrics are calculated using January's closing price.
  • Enterprise Value/Cash Flow = 11.3, down from 12.1 in January 2007 and a five-year median of 12.8.
  • P/E = 12.2, down from 15.5 one year earlier. The five-year median P/E is 15.7 (when the company was growing instead of contracting)
  • P/E to S&P 500 average P/E = 27 percent discount, compared to a five-year median 9 percent discount
  • Price/Revenue ratio = 0.72, down from 1.0 last year and its five-year median of 1.07.
Current statistics for the Specialty Retailers can be found at Reuters.

None of the gauge scores are that bad, but, as explained above, unusual circumstances may have inflated them to a certain extent. The punishment applied in the stock market to Home Depot shares, especially since the completion of a large-scale tender offer, is perking up the double-weighted Value Gauge to a level that bears watching.

In addition to the remarks above, readers might be interested in the following information tidbits gleaned from the Notes to the Financial Statements in the 10-K report.

1. The company recognizes more than $30 million of "gift card breakage" income annually.

2. The company takes in over $3 billion in "service revenue" related to home improvement projects. The figure includes labor and material costs.

3. After an internal probe of the company's processes for granting stock options, retained earnings were decremented by $227 million to reflect previously unrecognized expenses. External investigations are continuing. The amounts involved appear immaterial for all years considered.

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