Description

Home Depot is the world’s largest home improvement retailer, and the second largest retailer in the the US.  Home Depot operates 2,268 stores, primarily in the Home Depot format and primarily in the US, but also including 257 stores in Canada, Mexico and China.  Home Depot stores average 105,000 square feet, plus 23,000 square feet of outdoor garden area. Home Depot has 237mm sq feet of selling space and generates about $318 psf in annual sales.   Home Depot’s total enterprise value is 51bb and TTM revenue was 74bb.

Tdylan409’s thorough 2006 Home Depot writeup covers Home Depot’s story up to when it was run by Bob Nardelli, the Chrysler bailout supplicant.  Nardelli made several big mistakes – the costly rollup of distributors of industrial products into HD Supply, a distracting unrelated business; underinvesting in stores and employees and neglecting merchandising; and buying back billions of dollars of stock at very high prices.

Home Depot, under the well-regarded new CEO Frank Blake, has moved away from the excesses of the past.  Blake steered Home Depot towards its original customer-service oriented culture, sold the HD Supply unit, and restored executive pay to normal levels while increasing incentive pay for associates. In response to the housing and credit crisis, Blake suspended the remaining $10bb of buybacks, drastically reduced store growth both to conserve cash and to reduce cannibalization, and redeemed all of HD’s commercial paper with longer-term funding.  Blake has also instituting a restructuring of Home Depot’s supply chain, which if successful should free up a lot of working capital.  He has continued to heavily invest in employees to improve customer service, both in terms of compensation and “aprons on the floor” as they call it, and in case of a prolonged recession they can cut operating expenses significantly here.


The housing crisis

The biggest issue for Home Depot is of course the collapse of the housing market and the accompanying recession.  The housing slowdown began in July 2006 (the peak in the Case-Schiller index). For that fiscal year HD’s revenue was 79bb, EBIT was 8.8bb, and operating margin was 11.2%.  For the last twelve months, revenue was 74bb (-6%), EBIT was 5.3bb (-40%), and operating margin was 7.2%.  As housing continues to collapse, sales and ebit are likely to continue to fall.

The total US home improvement market was about 309bb last year, and has grown consistently over the last 15 years with the exception of 2007.  Home Depot had about 23% of the US market, followed by Lowe’s with 16%, and the rest shared by much smaller competitors (third largest is Menard’s, a private midwestern chain).

Home improvement sales correlate with private investment in housing, which fell precipitously from a bubble peak of over 6% to 3.5% of GDP in Q208, far below the long-term median of 4.4% (a gap of about 142bb in annual spending).  Post WW2, private investment in housing during recessions has hit the following lows as a % of GDP:

1953 5.1%
1958 4.8%
1970 4.0%
1975 3.8%
1982 3.2%
1991 3.4%
2001 4.6%

for an average of 4.1%, vs the current 3.5%.  Another macro factor to consider is that even with the large number of new homes built since 2000, overall the US housing stock is relatively old (median year built is 1973) meaning that repair, maintenance and replacement expenditures should be consistent or even growing on a per-house basis.  The home improvement industry, which includes both maintenance (20%) and renovations (80%) has cyclical elements but is never going to go away, nor is Home Depot likely to lose its leading position in the next decade or more.


Valuation

The investment case for Home Depot is as follows:  in the third year of a huge downturn in the housing market, Home Depot is trading at 9.5x TTM EBIT of 5.3bb and 8.5x TTM EBITDA-maintenance capex (discussed on HD’s conference calls).  Looking across the housing trough, which began in mid-2006, and assuming Home Depot returns to normal sales levels of around $350/psf and margins of around 9%, Home Depot should be generating 7.6bb of EBIT, implying a stock price of around $37.  Home Depot also says it will complete the remaining $12.5bb of its 2007 share buyback when credit markets stabilize.  Assuming the share buyback results in a 25% reduction in shares outstanding (if it is executed around current prices) normalized EPS for Home Depot in 2-3 years should be around $3.40, implying an equity price of around $40.00 at a 12x multiple.

The above does not count merchandising, customer service and inventory/logistics improvements that are underway at Home Depot that could push operating margins back to as high as 11%.  In which case, including the share count reduction, earnings would be around $4.00 a share, implying an equity value of around $48.00.

There is also theoretical downside protection from Home Depot’s large number of owned stores and land, for which tdylan cites prior management estimates of value at 50bb-60bb.  In the current environment, we have to assume that real estate is worth far less and is difficult, but not impossible, to leverage or spin off into a REIT, but still has some realizable value.

The worst downside case for Home Depot is with 11bb in debt, in a horrible recession they could have difficulty servicing their debt (not totally implausible as 80% of their sales are renovations).  I don’t think this is particularly realistic.  The biggest risk is how long it takes for Home Depot to recover (or for the stock market to decide Home Depot is recovering) – if it is next year then this is a good or even great investment, if it is 4-5 years then this is a pass.  So buying HD now requires an opinion on when the economic recovery starts and when does the market anticipate it.

Risks:

 prolonged recession and no near-term recovery for HD

  greater competition from Lowe’s

  debt

Catalyst

Catalysts:

-- cheapness of stock is realized as market begins to anticipate recovery

-- resumption of share buyback

-- improving operating margins