24 December 2010

HD: Financial Gauge Analysis for the October 2010 Quarter

Home Depot (NYSE: HD) earned $0.51 per diluted share on a GAAP basis in the October-ending third quarter of fiscal 2010, up 24.5 percent from $0.41 in the same three months of last year. 

A previous article examined Home Depot's Income Statement for the latest quarter in some detail.  Reported earnings were $0.04 better than the $0.47 per share we had forecast.

We have now updated the various financial metrics we use to analyze Cash Management, Growth, Profitability and Value.  This post reports on the metrics for Home Depot and the associated financial gauge scores.  The metrics were calculated using data from Home Depot's current and historical financial statements, including those in the latest 10-Q report.

Before getting into the details, we will take a step back to introduce the subject of today's analysis.

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 has 2,244 retail stores, of which 88 percent are in U.S. states or territories.  Home Depot also operates in Canada, China, and Mexico.

Home Depot earned nearly $2.7 billion in fiscal 2009, nearly 18 percent more than in 2008.  Revenue slipped 7 percent to $66.2 billion.  Fiscal 2009 ended on 31 January 2010.

The market value of the company is currently close to $60 billion.

Home Depot competes with Lowe's (NYSE: LOW), cooperatives such as Ace and True Value, and a multitude of smaller hardware stores.  These rivals took advantage several years ago of lapses in Home Depot's customer service, which had deteriorated.  Frank Blake, who took over as Chairman and CEO in early 2007, has made improved customer service a high priority.  The company's current investments in technology upgrades are evidence that this effort continues.

A big drop in sales in 2008 affected most retailers, and stores dependent on the housing market were doubly challenged.  Home Depot chose to consolidate operations and reduce capital outlays.  The first step, announced in May 2008, was to relinquish 50 planned stores in the U.S. and to close 15 existing stores.  The second step, taken in January 2009, 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.

Additional background information about Home Depot and the business environment in which it is currently operating can be found in the look-ahead.

In summary, Home Depot's latest quarterly results produced the following changes to the gauge scores:

The current and historical values for the financial metrics that determine the gauge scores are listed below, with some brief commentary.  Readers are encouraged to verify these figures and calculate others as they see fit using the filings available at the SEC's web site and elsewhere.  Caution is suggested when comparing Home Depot's results before and after the company's restructuring in 2007.

Cash Management31 Oct 201001 Aug 201001 Nov 20095-Yr Avg
Current Ratio1.
LTD to Equity45.8%39.7%44.7%45.9%
Debt/CFO (years)
Inventory/CGS (days)
Finished Goods/InventoryN/AN/AN/AN/A
Days of Sales Outstanding (days)
Working Capital/Revenue4.9%5.0%4.6%4.4%
Cash Conversion Cycle Time (days)47.646.647.645.8
Gauge Score (0 to 25)6767

The Cash Management gauge remained in the 6-to-7 point range, where the score has been stuck for the last year.  The financial metrics that determine the score have fluctuated only modestly.

Home Depot's Long-term Debt has generally been declining for the last few years, but the amount increased in the most recent quarter from $7.73 billion to $8.75 billion.  The debt rise was almost entirely due to actions to refinance $1.0 billion in maturing debt.  The latest debt amount is just slightly higher than last year's total.

Similarly, the latest spike in the Long-term Debt to Equity ratio merely brought this key measure back to where it had been a year earlier.  Debt to Cash Flow is up slightly.

In the continuation of an encouraging trend, Home Depot held about three days less Inventory than it held last year, when the Inventory amount is determined by the cost of the goods that comprise the Inventory.

Days of Sales Outstanding has been steady recently, but the longer term trend hints at improving cash efficiency.

The Current Ratio has been remarkably steady for many years.  It's less than we might otherwise prefer, but Home Depot has shown in can operate for long periods of time with rather modest amounts of Working Capital. 

Growth31 Oct 201001 Aug 201001 Nov 20095-Yr Avg
Revenue Growth1.9%-0.6%-10.9%-4.9%
Operating Profit Growth-9.5%-12.9%-19.7%-12.1%
CFO Growth-17.6%-0.2%0.7%-8.6%
Net Income Growth31.7%21.9%-22.4%-14.3%
Gauge Score (0 to 25)17714
Revenue, CFO, and Net Income growth rates compare the last four quarters to the four previous quarters.  The Operating Profit rate is the annualized rate of growth in Operating Profit after Taxes over the last 16 quarters.

The Growth gauge was the big winner in the latest quarter, rising 10 full points.  The gain was powered by stronger Revenue growth.

Revenue in the October quarter increased 1.4 percent, from $16.4 billion last year to $16.6 billion in the most recent three months.  This modest rise was enough to turn the trailing-year Revenue growth rate from negative to positive.  Revenue as a percentage of Assets also racked up a nice gain.

Certainly, the most favorable number above is the 31.7 percent Net Income growth rate.  The rate benefited from special charges in the prior year that made the last four quarters appear comparatively better.

Cash Flow from Operations in the last four quarters was down 17.6 percent from the prior year amount. In the first nine months of the current fiscal year, Cash Flow fell from $4.7 billion to $4.0 billion.  The company attributed the decrease to "changes in inventory levels and other net working capital items."

Profitability31 Oct 201001 Aug 201001 Nov 20095-Yr Avg
Operating Expense/Revenue91.8%92.0%92.6%91.0%
Free Cash Flow/Invested Capital12.3%15.3%15.7%11.5%
Accrual Ratio-0.9%-3.1%-5.5%-1.6%
Gauge Score (0 to 25)911119

The Profitability gauge score slipped two points.  It was adversely affected by the weaker cash flow numbers cited above.

Operating expenses relative to Revenue, exclusive of special charges, has been fairly stable on a trailing-year basis.  However, the expense ratio is slightly above its long-term average.

Return on Invested Capital has become a bit more profitable in the last several quarters, but this ratio is still considerably below percentages attained several years ago. 

Free Cash Flow relative to Invested Capital weakened in the last quarter because Cash Flow from Operations turned down.  The FCF ratio, which has benefited from reduced Capital Spending, remains above its long-term average.

The negative Accrual Ratio is actually a favorable result, but it has a more beneficial effect on the gauge score when it is falling.

Value31 Oct 201001 Aug 201001 Nov 20095-Yr Avg
P/E vs. S&P 500 P/E
Enterprise Value/Cash Flow (EV/CFO)13.310.69.311.0
Gauge Score (0 to 25)0178
Share Price ($)$30.90$28.51$25.09-

The increase in Home Depot's share price, which is the result of investors anticipating a recovery in industries related to home construction, has squeezed the backward-looking Value gauge.

Although nowhere near its highs, the Price/Earnings multiple is above its level during most of the last handful of years.

The EV/CFO, which is similar in its way to a P/E ratio, has spiked upward because Cash Flow from Operations has weakened.

The Price/Sales ratio is not far from its long-term average, but it's also more expensive than it was last year at this time.

A rise in the Value gauge is dependent on further improvements in sales, cash flow, and earnings.

Overall31 Oct 201001 Aug 201001 Nov 20095-Yr Avg
Gauge Score (0 to 100)22223030

The Growth gauge was the big winner during the third quarter, but the other category gauges didn't keep pace.  This prevented any upward movement in the Overall gauge. 

Improvements were noted for Revenue/Assets and Inventory.  On the other side of the ledger, Cash Flow was weak, and the Net Income growth rate was boosted by special charges in the year-earlier period.

Full disclosure: Long HD at time of writing.

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