07 June 2009

HD: Financial Analysis through April 2009 (Update)

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 operates over 2200 "warehouse-style" stores.

We have already posted an initial analysis of Home Depot's financial results, which included earnings of $0.30 per share, for the three months that ended 3 May 2009.  This period was the first quarter of the company's fiscal 2009.

Our earlier evaluation of the first quarter was incomplete because Home Depot's press release did not include a Cash Flow Statement and the Balance Sheet omitted some details.  Since we didn't yet have all the data required to compute exact GCFR gauge scores, we used some estimates to produce the first set of scores.

Home Depot has now filed a 10-Q quarterly report with a complete set of financial statements, and we used the data in the 10-Q to update our evaluation and scores.

This post reports on the update.

Over the last year, in response to the weak retailing environment and the depressed housing market, Home Depot has taken substantial steps to consolidate operations and reduce capital outlays.  The first step was to terminate plans to open about 50 planned stores in the U.S. and to close 15 existing stores.  The second step was to exit the EXPO Design Center and a few other peripheral businesses.  These actions led to asset impairment, severance, and other charges over $1.1 billion.

The company is also working to reduce inventory costs by streamlining distribution of products to stores.  The key element of this strategy are regional Rapid Deployment Centers -- the sixth opened recently  -- that receive mass deliveries from manufacturers and dole out the products to 100 or so area stores.  This distribution model is similar in form to Wal-Mart's exemplar of efficiency.

The 10-Q did not change our evaluation of the quarter's Income Statement, including the comparison with our previously announced expectations. (Click here to see our normalized depiction of Home Depot's Income Statements for the last nine quarters.  Please note that our presentation, which we use for all analyses, can and often does differ in material respects from company-used formats.)

Although the 10-Q included some additional Balance Sheet items, these details did not alter our analysis in any material way.   However, the newly disclosed Cash Flow from Operations was substantially higher than our estimate.  At $1.7 billion, CFO was down 18 percent from its value in the first quarter of 2008.  We had mistakenly estimated that CFO would fall closer to 50 percent, to about $1 billion.

When the Cash Flow data was factored into the analysis, the Profitability gauge increased one point and the double-weighted, contrarian Value gauge rose two points, compared to the scores reported in the preliminary analysis.  The Overall gauge, thus, turned out to be 5 points higher than our original estimate.  The following is a list of the updated gauge scores:
  • Overall:  28 of 100 (down from 34)

A handful of the financial metrics we estimated earlier did need to be adjusted to reflect the Cash Flow data in the 10-Q.  We also made one unrelated adjustment to our handling of the special charges.  For completeness, we repeat the tables below with revised figures highlighted in red text

Cash ManagementApril 20093 months prior12 months prior
Current Ratio1.21.21.2
LTD/Equity 53.7%54.4%64.0%
Debt/CFO2.2 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)

Better-than-estimated Cash Flow from Operations provides more liquidity to cover debt.  We had estimated that Debt totaled 2.5 years of CFO, and now we know that the correct number is 2.2 years.  The difference was not substantial enough to change the Cash Management score.

GrowthApril 20093 months prior12 months prior
Revenue growth-9.3%-7.8%-1.9%
Revenue/Assets 156%167%151%
CFO growth -6.4%-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.

Although CFO has fallen, the steepness of the decline was much milder than our -17 percent projection.

ProfitabilityApril 20093 months prior12 months prior
Operating Expenses/Revenue 92.6%92.6%91.1%
ROIC 12.2%11.9%15.0%
Free Cash Flow/Invested Capital 13.2%12.8%7.5%
Accrual Ratio -3.1%-3.7%-17.4%
Gauge Score (0 to 25)8810

Better-than-expected CFO translated directly into better-than-expected FCF.  Our FCF estimate had been 11 percent of Invested Capital, and we now know that it was a more robust 13 percent.

The Accrual Ratio compares CFO to Net Income, and lower figures (more negative) indicate there is more Cash Flow to back up earnings.  This is a measure of earnings quality.  We had estimated the Accrual Ratio at zero percent (CFO and Net Income in balance), but we now see that CFO exceeded Net Income.

These two changes combined to add a point to the Profitability score.

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) 10.48.510.9
Gauge Score (0 to 25)8

When the company's Enterprise Value is supported by more Cash Flow, the company is less expensive to purchase.  The EV/CFO ratio was originally estimated at 11.8.  The recalculated 10.4 ratio helped increase the Value gauge score by two points.

Readers should be aware that the Value gauge metrics were calculated with the $26.32 price at which Home Depot shares closed at on 30 April.  If we were to substitute the 5 June closing price of $24.17, the Value gauge would pick up another 3 points.

OverallApril 20093 months prior12 months prior
Gauge Score (0 to 100) 2834

The changes lifted the Overall score from our preliminary estimate, but the score remains in weak territory.

Business conditions were weak in the quarter.  Revenue fell 9.7 percent.  It is interesting that the Revenue decline in the first quarter can be broken down into a 2.6 percent decline in comparable store customer transactions and an 8.2 percent decline in the average customer "ticket."  A few less customers are buying, and the buyers are spending much less.

Net Income appeared at first glace to grow at a robust 44 percent in the quarter, but it would have declined if last year's non-recurring charges were excluded.

Good cost control, however, is plus that will serve the company well in the future.  In addition, strong Cash Flow will enable the continuation of investments to improve efficiency and customer services (yea!).

The reaction of our Value and Overall gauges suggest that the share price mostly likely got ahead of fundamentals in the first quarter.

Full disclosure: Long HD at time of writing.

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