21 May 2009

HD: Financial Analysis through April 2009

Home Depot (NYSE: HD) earned $0.30 per share in the three months that ended 3 May 2009, up from $0.21 last year.  The latest results were announced in this press release.

This post provides the GCFR analysis for the period, which was the first quarter of the company's fiscal 2009.

The earnings announcement included an Income Statement, a condensed Balance Sheet, and some limited Cash Flow data, but no Cash Flow Statement.   We need some of the undisclosed details to compute accurate GCFR gauge scores; we estimated the missing data for this analysis.

We will adjust the scores after Home Depot files a complete 10-Q report with the SEC.

First, we present some background information.

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

The depressed state of the housing market has negatively affected Home Depot. The company decided in May 2008 to forgo 50 or so planned stores in the U.S. and to close 15 existing stores.  These actions led to pretax charges of $586 million.

Then, in January 2009, Home Depot announced it would discontinue its EXPO Design Center business.  The EXPO stores "offer[ed] products and services primarily related to design and renovation projects."  To account for store closure-related asset impairments, severance pay, and other related expenses, Home Depot recorded a pre-tax charge of $387 million.  Additional charges totaling $142 million are anticipated.

RBS Partners, L.P., associated with Edward Lampert, Chairman of Sears Holdings (NASDAQ: SHLD), owned 17.8 million Home Depot shares on 31 March 2009.  Berkshire Hathaway (NYSE: BRK.A), run by investing guru Warren Buffett, owned 3.7 million shares on this date.

After Frank Blake replaced Robert Nardelli (who will soon exit Chrysler) as Chairman and CEO in early 2007, Home Depot sold HD Supply, which serves professional contractors, to a consortium of private equity firms.   As part of  the sale, Home Depot invested $325 million for a 12.5 percent equity stake in HD Supply.  In fiscal 2008,  Home Depot recorded a $163 million pre-tax charge to reflect the reduced market value of its HD Supply investment.  It should also be noted that Home Depot has guaranteed $1.0 billion of HD Supply debt.

Home Depot repurchased $10.7 billion of its own shares after the sale of HD Supply.

Looking back to the quarter that ended 1 February 2009, we are reminded that Revenue dropped 17.3 percent and Net Income fell from a $671 million gain to a $54 million loss.  Although sales were weak, the loss was more the result of the EXPO charge and the reduced value of the HD Supply investment.

The GCFR Overall Gauge slipped from 35 to 34 of the 100 possible points when the results of 2008's last quarter were considered.  The Value gauge, at only 12 of the 25 possible points, was the strongest of the four individual gauges.

Now, with actual and estimated data for the first quarter of 2009, our gauges display the following scores:

  • Overall:  23 of 100 (down from 34)

These scores are subject to change after the 10-Q report is examined.

Because Home Depot has restructured substantially during the last few years, our gauge scores should be treated with an extra dose of skepticism.  The GCFR approach includes comparisons between current financial data with historic results, but the validity of these comparisons degrades when the subject company reorganizes.

Before examining the metrics associated with each gauge, we will compare the latest quarterly Income Statement to our previously announced expectations.

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.

Click here for a larger version of the spreadsheet.

Revenue was 9.7 percent less than in the first quarter of 2008.  The decline, though substantial, was less severe than the 17.3 percent drop experienced the preceding quarter.  We were too pessimistic with respect to Revenue in the first quarter because we expected the drop to be 12.3 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.  The Gross Margin was slightly higher, 33.9 percent, in last year's first quarter.  Our Gross Margin target was 34.0 percent. 

Depreciation and Amortization expenses were almost $50 million less than our target.  We had assumed that the $1.9 billion figure cited in management's guidance for fiscal 2009 would be distributed equally across the four quarters.  It's too soon to know whether the value in the first quarter signals that the annual total will be less (about $1.75 billion) or whether a greater share of the expense will be incurred later in the year.

Sales, General, and Administrative expenses were 25.0 percent of Revenue, which is greater than our estimate of 24.0 percent.  The additional expense could be due to "business rationalization" charges.

The results identified above led to a 34.6 percent increase in Operating Income relative to the year-earlier quarter.  However, the prior period was weighed down by a huge $543 million charge.  Excluding the special charge, Operating Income fell by about 23 percent.

Our estimate for Operating Income was too optimistic by 4.9 percent. 

In the Non-Operating area, the net interest expense was approximately $25 million more than we anticipated.  The income tax rate essentially matched the predicted 36 percent level.

Overall, Net Income was up 44 percent (remember last year's special charge).  Our estimate was too high by 9.3 percent.

Now for the gauges:
Cash ManagementApril 20093 months prior12 months prior
Current Ratio1.21.21.2
LTD/Equity 53.7%54.4%64.0%
Debt/CFO (*)2.5 years2.1 years2.2 years
Inventory/CGS 95.1 days86.4 days97.0 days
Finished Goods/Inventory N/AN/AN/A
Days of Sales Outstanding (DSO)7.5 days5.7 days12.1 days
Working Capital/Invested Capital 10.2%7.7%7.6%
Cash Conversion Cycle Time42.7 days50.5 days43.9 days
Gauge Score (0 to 25)
(*) Based on estimated Cash Flow from Operations in the most recent quarter.

The Cash Management metrics are surprisingly stable given the state of the economy, the weak retail sector, and the housing crisis.  Debt has decreased slowly, but steadily, since 2007's restructuring and massive share repurchase.   The inventory reduction, compared to last year, suggests that the company is handling the sales slump as well as could be hoped. 

The small rise in the score was due mostly to the increased Working Capital ratio and the lower CCCT.  The up-tick in Debt/CFO was a drag on the score, but this ratio was estimated, and it needs to be confirmed by the 10-Q.

GrowthApril 20093 months prior12 months prior
Revenue growth-9.3%-7.8%-1.9%
Revenue/Assets 156%167%151%
CFO growth (*)-17.2%-3.5%-14.4%
Net Income growth -31.7%-45.1%-24.9%
Gauge Score (0 to 25)01
Growth rates are trailing four quarters compared to four previous quarters.
(*) Based on estimated Cash Flow from Operations in the most recent quarter.

Revenue, Cash Flow, and Net Income are all down substantially.  Until recently, we would have given the company credit for improved Revenue/Assets.  However, we no longer believe this ratio is germane if Revenue is falling.

ProfitabilityApril 20093 months prior12 months prior
Operating Expenses/Revenue 92.8%92.6%91.1%
ROIC 11.8%11.9%15.0%
Free Cash Flow/Invested Capital (*)11.0%12.8%7.5%
Accrual Ratio (*)0.0%-3.7%-17.4%
Gauge Score (0 to 25)7810
(*) Based on estimated Cash Flow from Operations in the most recent quarter.

The increase in Operating Expenses is indicative of the difficult retailing environment and some restructuring charges as Home Depot adapts.  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 estimated ROIC and FCF figures don't look too bad.  The rising Accrual Ratio signals weaker earnings quality.

ValueApril 20093 months prior12 months prior
P/E 18.416.113.1
P/E vs. S&P 500 P/E 107%93%71%
Enterprise Value/Cash Flow (EV/CFO) (*)11.88.510.9
Gauge Score (0 to 25)6
(*) Based on estimated Cash Flow from Operations in the most recent quarter.

Home Depot's stock price actually (and surprisingly) increased from the end of January through the end of April by 22 percent, from $21.53 to $26.32.  A surging share price, combined with weak operating performance, tends to wreak havoc on the Value Gauge!

Although the share price is back under $24, the April closing price was used to calculate the Value gauge score, per GCFR standard practice.

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

OverallApril 20093 months prior12 months prior
Gauge Score (0 to 100) 23

In this first quarter of fiscal 2009, Home Depot's Revenue fell 9.7 percent.  Although a Revenue decline can easily lead to a lower Gross Margin (cutting prices to boost sales is a common tactic), the Gross Margin for Home Depot in this quarter only slipped from 33.9 to 33.7 percent of Revenue. Unless there were special factors at play that invalidate the comparison, we would infer from this that Home Depot did a good job holding the line on costs.

Net Income was up 44 percent in the quarter, but the results of the earlier period were depressed by store closing and related charges.  If adjustments are made to exclude non-recurring charges, Net Income fell 16 percent.

The Cash Management gauge inched up, and the Growth and Profitability gauges slipped a point each.  These changes weren't especially significant.  However,  the Value Gauge score plunged from 12 to 6 points because the weak business performance was combined with a soaring share price.  Since the Value gauge is double-weighted, the Overall score also dived.

Full disclosure: Long HD at time of writing.

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