19 November 2008

HD: Financial Analysis through October 2008

Home Depot announced earnings for the 13 weeks that ended on 2 November 2008.  This post provides the initial GCFR analysis for the period, which was the third quarter of the company's fiscal year.

Our evaluation is presently incomplete because the press release did not include a Cash Flow Statement and because the Balance Sheet omitted certain details.  We had to estimate values for some items to compute gauge scores.

When Home Depot files a complete 10-Q, we will make any necessary adjustments to the analysis.

The Home Depot, Inc. (NYSE: HD) is the largest retailer of do-it-yourself merchandise, which includes building materials, home improvement supplies, and lawn and garden products.  The company competes fiercely with Lowe's (NYSE: LOW) and numerous smaller hardware and lumber retailers

Last year, the Home Depot Supply division, which served professional contractors, was sold to a consortium of private equity firms.  The price was $8.5 billion, or $1.8 billion less than the figure originally negotiated.  Management then executed a $10.7 billion Dutch Auction tender offer for Home Depot shares.

In May 2008, Home Depot announced "it will no longer pursue the opening of approximately 50 U.S. stores that ha[d] been in its new store pipeline."  A related decision was made to close 15 existing stores.  These two actions led to charges of $586 million.

Home Depot and its investors are now coping with the collapse of the housing market and the ensuing credit crisis.

The investors include RBS Partners, L.P., a fund associated with Edward Lampert, Chairman of Sears Holdings (NASDAQ:SHLD).  The fund reported that it owned 19.7 million Home Depot shares on 30 September 2008.  The stake didn't change from June.

Three months ago, the Overall gauge of Home Depot increased from 41 to 46 of the 100 possible points.  (Note that recent tweaks to the GCFR algorithms trimmed several points from the current and past scores).  See our analysis of the second quarter for details.

The rise in the Overall score was entirely due to a 17.3-percent decline in Home Depot's share price during the May-June-July quarter.  Our contrarian Value gauge, which is the largest contributor to Overall score, moves in the opposite direction of the share price.

Both Cash Flow from Operations and Net Income were lower in the second quarter.

Now, with actual and estimated data for the third quarter, our gauges display the following scores:

  • Overall:  43 of 100 (down from 46)

These scores are subject to change after we evaluate the 10-Q report.

Because Home Depot's corporate structure changed substantially in 2007, our gauge scores should be treated with an extra dose of skepticism.  GCFR numbers are determined in part by comparing current financial data with historic results, but the validity of some recent comparisons is questionable.  Caution is also advisable because of the state of the housing market.

Before examining the metrics associated with each gauge, we will compare the latest quarterly Income Statement to our previously communicated baseline

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.

($ M) 2 November 2008
2 November 2008
28 October 2007
Revenue 17,78418,000 18,961
Operating expenses
CGS  (11,790)(12,060) (12,622)
SG&A  (4,225)(4,140) (4,144)
Other (0)(0)
Operating Income 1,3231,350 1,764
Other income
Investments 00 0
Interest, etc. (151)(160) (125)
Pretax income 1,1721,190 1,639
Income tax (416)(443)
Net Income from
continuing operations
Discontinued operations 00 20
Net Income756
Shares outstanding 1,6871,687 1,815

Revenue was 6.2 percent less than in the year-earlier quarter and 1.2 percent below our our target.  We expected Revenue to decline by 5.1 percent.  Same-store sales were down a substantial 8.3 percent, but (only?) by 7 percent if a shift in the fiscal calendar is considered.  Trailing four-quarter Revenue fell 3.6 percent.

The Cost of Goods Sold (CGS) was 66.3 percent of Revenue in the quarter, which translates into a Gross Margin of 33.7 percent.  We expected the margin to be 33.0 percent.  It was 33.4 percent in the year-earlier quarter, so it appears the company is willing to give up sales to maintain profit margins.

Depreciation was 2.5 percent of Revenue, as expected.

Sales, General, and Administrative expenses were 23.8 percent of Revenue, compared to our estimate of 23.0 percent.  As it turned out, we over compensated for a second quarter SG&A overestimate by underestimating it in the third quarter.  More model refinements are needed.

The figures identified above result in Operating Income 25 percent below the amount in the year-earlier quarter.  We estimated that Operating Income would be down 23.5 percent.  The actual result was worse than we expected because Revenue was lower andSG&A expenses were higher, partially compensated for by a better Gross Margin.

Non-Operating investment and interest expenses were $26 million more than last year.  However, the net expense was $9 million less than our expectation.  And, the Income Tax Rate was much lower than predicted:  35.5 percent vs. 37.2 percent.  While Net Income from continuing operations was down 29.4 percent,  it surpassed our prediction by 1.2 percent.  The better-than-expected tax rate turned disappointing Operating Income into earnings that exceeded our target, albeit by a small amount.

Cash ManagementOctober
3 months
12 months
Current Ratio1.21.31.1
LTD/Equity 56.3%60.9%65.0%
Debt/CFO 2.1 yrs (*)2.4 yrs1.9 yrs
Inventory/CGS 90.6 days88.0 days93.5 days
Finished Goods/Inventory N/AN/AN/A
Days of Sales Outstanding (DSO)7.6 days7.4 days12.3 days
Working Capital/Market Capitalization 5.3%6.2%2.6%
Cash Conversion Cycle Time (CCCT)
44.3 days41.0 days46.8 days
Gauge Score (0 to 25)1495
(*) Based on estimated Cash Flow from Operations in the most recent quarter.

Home Depot's long-term debt load increased significantly last year, but the amount of leverage has eased recently.  The inventory reduction, compared to last year, suggests that the company is deftly handling the sales slump.  The reduction inDSO and, to a lesser extent, CCCT are also signs of efficiency improvements, although some of the gains were given back in the most recent quarter.

3 months
12 months
Revenue growth-3.6%-2.9%-4.9%
Revenue/Assets 166%148%157%
CFO growth-17.2% (*)-28.5%-1.1%
Net Income growth -31.8%-28.9%-23.3%
Gauge Score (0 to 25)000
Growth rates are trailing four quarters compared to four previous quarters.
(*) Based on estimated Cash Flow from Operations in the most recent quarter.

Revenue is down moderately, and Cash Flow and Net Income have both decreased substantially.  Until recently, we would have given the company credit for improving Revenue/Assets.  However, we no longer believe this ratio is important if Revenue is falling.

3 months
12 months
Operating Expenses/Revenue 92.1%91.6%90.3%
ROIC 11.8%12.7%16.2%
FCF/Equity16.9% (*)8.7%13.6%
Accrual Ratio-0.6% (*)-20.1%-14.9%
Gauge Score (0 to 25)91014

The increase in Operating Expenses might be evidence of commodity price inflation earlier in the year.  We await an updated Cash Flow statement to get a better read on Profitability, but for a company in the midst of the housing slump, the ROIC and FCF figures don't look too bad.

3 months
12 months
5 year
P/E 13.312.213.115.2
P/E to S&P 500 average P/E 95.2%66.9%75.3%90.2%
Enterprise Value/Cash Flow (EV/CFO) (*)9.210.310.412.0
Gauge Score (0 to 25)131712N/A
(*) Based on estimated Cash Flow from Operations in the most recent quarter.

Home Depot's stock price ended October at $23.59, just a little less than the $23.83 on 31 July.  The shares fell further in November.  Per GCFR standard practice, the October closing price was used to calculate the Value gauge score.

Home Depot's valuation ratios can be compared with other companies in the Home Improvement industry.

3 months
12 months
Gauge Score (0 to 100) 434641

We need a 10-Q to see full financial statements, but we're encouraged that the drop in the Overall Gauge wasn't more severe.  Improving Cash Management efficiency is especially welcome at this time for a firm at the intersection of two weak markets: retailing and housing.

When announcing the third-quarter results, Chairman and CEO Frank Blake stated: “The housing and home improvement markets remain challenging."  Without identifying the details, Blake noted that the company is making the necessary adjustments.  He cut Revenue guidance for the current fiscal year to an 8 percent decline.  The previous projection was for a 5 percent drop.  Sales will apparently fall significantly in the fourth quarter, perhaps as much as 18 percent.

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