Home Depot's Solid Foundations
Even though the shares have lost ground thus far in 2006, we think it's possible to build a strong case for Home Depot (HD; recent price, $39.22). First, we think that a low unemployment rate and robust wage growth should continue to propel the U.S. economy (and, more importantly, consumer spending) at a modest clip. Second, while we're slightly concerned with the recent rapid increases in housing prices, we believe demand will remain strong enough to avert a major problem.
Finally, we think the valuation is very compelling, with the shares trading below the broader market, despite sporting a higher growth rate and stronger balance sheet. The stock carries S&P's highest investment ranking of 5 STARS (strong buy).
Home Depot is the world's largest home-improvement retailer and the second-largest retailer in the U.S., in terms of sales. As of October 31, 2005, it operated 1,972 stores, including 1,913 Home Depot stores (of which 126 were in Canada and 49 in Mexico), 34 EXPO Design Centers, five Home Depot Supply stores, 11 Home Depot Landscape Supply stores, two Home Depot Floor stores, and seven Contractors' Warehouse stores.
NUTS AND BOLTS.
Home Depot stores sell a wide assortment of building materials, as well as home improvement and lawn and garden products. The company also provides installation services. Typical stores average 106,000 square feet plus 22,000 square feet of garden center and storage space, and stock 40,000 to 50,000 items, including brand name and proprietary items.
The flagship Home Depot stores serve three primary customer groups: Do-It-Yourself (DIY) customers, typically homeowners who complete their own projects and installations; Do-It-For-Me (DIFM) customers, homeowners who purchase materials and hire third parties to complete the project and/or installation; and Professional customers, consisting of professional remodelers, general contractors, repairmen, and tradesmen.
By product group, plumbing, electrical, and kitchen (29% of fiscal 2005 revenues) represents Home Depot's largest source of revenue. Hardware and seasonal (27%), building materials, lumber, and millwork (24%) and paint, flooring, and wall coverings (20%) make up the remainder.
We believe several factors bode well for the company in 2006, including a resilient consumer, the company's shift in focus away from the cyclical domestic housing market, a dramatic 2005 hurricane season, and an economy on solid footing.
Some economists and investment professionals have been quick to point to the national savings rate, which has now been negative over the past seven months, as a key indicator of the impending retrenchment of the U.S. consumer. While this lack of savings is justifiably a cause for concern and could become quite problematic over the long term, we think the near-term ramifications of this statistic may not be that significant at all. Because the savings rate excludes capital gains on investments, we suspect the recent wealth that was built up as a result of the stock market in the late 1990s and real estate boom over the last five years will continue to drive spending over the coming years.
In addition, the job market remains very healthy, in our view, so we think it's unlikely consumers will feel the need to drastically tighten their purse strings any time soon. Furthermore, while increased interest rates make refinancing a less likely option for consumers in 2006, we expect home-equity loans will continue to buoy spending. S&P predicts that consumer spending will increase 3.2% in 2006.
While the current status of the housing market has been well documented -- and a topic of discussion at many cocktail parties -- we foresee only a modest decline in new home activity in 2006. S&P economists predict an 8.8% decline in housing starts for 2006, following a 6.2% increase in 2005. We also predict that declines in real estate values may occur in certain geographic "pockets," but that, overall, little attrition will occur. We believe it may take several years for houses to "grow" into their current values, but we don't foresee a dramatic decline in overall prices.
Also, government spending on the reconstruction of New Orleans will be the most expensive such effort in U.S. history, with estimates ranging from $100 billion to $200 billion. We believe Home Depot will benefit substantially from this increased spending.
For Home Depot, the biggest development over the past year, in our view, has been the aggressive push by the company to expand its Home Depot Supply business in the $410 billion professional market. In July, 2005, the company acquired National Waterworks, the leading distributor of water and wastewater transmission equipment in the U.S. Then, on January 10, 2006, it agreed to purchase Hughes Supply (HUG; $46) for $3.47 billion (including the assumption of debt), which would be its largest acquisition ever.
While these acquisitions may appear puzzling to many investors, as they go well beyond Home Depot's core retail business, we believe these investments will ultimately prove to be net positives for the company. For one, both are expected to be slightly accretive to earnings. In addition, we believe they will reduce the cyclicality of Home Depot's business, which is strongly correlated with housing turnover. We're confident that Home Depot can properly integrate both companies.
We think international expansion is another major focus for Home Depot, and will likely be one of the future growth drivers for the company, as the domestic market approaches saturation levels. It has followed an acquisition-based strategy when first entering a new market, followed by organic growth. We expect continued organic growth to occur in Canada and Mexico, where Home Depot is the market leader, and expect the company to make an acquisition bid for a Chinese company sometime in the first half of this year.
In fact, according to an unconfirmed report in the Financial Times on Feb. 13, Home Depot is in talks to buy up to a 49% stake in Chinese retail chain Orient Home, for more than $200 million. We expect the company to work diligently on securing a foothold in China's $50 billion retail home improvement market.
At its annual investor and analyst meeting on Jan. 19, Home Depot announced that it would open between 400 to 500 new stores over the next five years (with total square footage growth of 40 million to 55 million). This is a significant deceleration from the rapid pace at which Home Depot had previously been opening stores, and indicates to us that the company believes the U.S. market is nearing saturation. We view positively this difficult decision by HD to slow new store growth, and believe it will relieve some of the pressure on same-store sales results from stores in overlapping markets.
Furthermore, we think this decision should free up the cash that Home Depot will require to grow in the Professional and international markets. While we expect Home Depot to finance the majority of its expansion plans from the significant cash flow it derives from operations, we do think it's likely that the company will assume a greater debt load in order to accomplish all of its objectives.
We're projecting EPS of 56 cents in the coming January quarter (results to be released on Feb. 21). Overall, we expect the company to earn $2.67 in fiscal 2006 on sales growth of approximately 11% and a 0.6% improvement in operating margins. Fueled by acquisitions, we expect fiscal 2007 sales to increase about 15%, driving EPS to $3.05.
In our view, the quality of Home Depot's earnings, as indicated by our proprietary Standard & Poor's Core Earnings per share model, is high. In the absence of pension-related adjustments (the company doesn't have a defined benefit pension plan), the main impact to earnings quality comes from the expensing of stock options.
After deducting stock-option expense, we arrive at S&P Core EPS of $1.78 for fiscal 2004 and $2.19 for fiscal 2005, representing a divergence of 5.3% and 3.1%, respectively, from GAAP-based EPS for the two fiscal years. This differential compares favorably with that of other constituent companies of the S&P 500.
We see Home Depot's earnings quality improving further, as the company has already begun expensing options. Therefore, our estimates of option expense in fiscal 2006 and 2007 are for un-expensed options granted in previous years. Our S&P Core EPS estimate for fiscal 2006 is $2.63, indicating a 1.6% impact to our operating EPS estimate of $2.67. For fiscal 2007, we have incorporated the unexpensed stock options into our operating EPS projection of $3.05.
BALANCED BALANCE SHEET.
Recent selling pressure has Home Depot shares approximately 3.5% lower since the start of 2006. We believe that a strong January-quarter and robust guidance will help fuel investor enthusiasm in the shares once again.
The shares are currently trading at 14.7 times our fiscal 2006 EPS estimate and 12.9 times our fiscal 2007 EPS estimate, below the S&P 500 and well below the stock's historical average of 22 times. Home Depot shares have historically traded at nearly a 15% premium to the broader market due, we think, to the company's above-average sales and earnings growth, along with its strong balance sheet. Currently, the shares trade at a 15% discount to the S&P 500.
We believe the company has one of the stronger balance sheets in our specialty-retail coverage universe, with over $1 billion in cash and manageable debt levels. In addition, its asset base is formidable, with the company owning 86% of its stores, a huge point of differentiation in the world of retail, in our opinion. Lastly, the company's commitment of returning cash to shareholders is exemplary, we think. Home Depot has returned nearly $13 billion over the past five years in the form of dividends or share repurchases, or approximately 58% of the company's cumulative earnings.
Our discounted cash-flow (DCF) valuation suggests an intrinsic value of $52 for Home Depot, about 33% above the recent price, and approximately 17 times our fiscal 2007 EPS estimate.
In general, we view Home Depot's corporate governance positively. Several of the practices that we view positively are: the expensing of stock-option grants, the lack of a poison pill, and the fact that the nominating and compensation committees are entirely comprised of independent outside directors. Furthermore, 10 of the company's 12 board members are independent outsiders, which we believe promotes a greater amount of objectivity and reduces conflicts of interest. However, we do view executive compensation as excessive, given the stagnant stock price over the past five years.
MICRO AND MACRO RISKS.
There are several risks to our recommendation and target price, in our opinion. First and foremost, a modest decline in real estate values would likely adversely affect Home Depot. With U.S. savings rates near (or below) zero and a rather flat stock market, we believe consumers will be much less apt to spend on home-improvement projects should their net worth decline. Rising interest rates could be a catalyst to the bursting of a housing bubble, as many recent mortgages have been financed as interest-only or adjustable rate mortgages (ARMs). These rising rates would have the effect of driving up mortgage payments, thus reducing discretionary income.
Non-macro-related risks include currency movements and poor execution while entering new growth markets such as China. In addition, acquisition risks exist if Home Depot overpays for an acquisition or fails to integrate it properly and cost-effectively.