Description
Investment Summary
The Home Depot is a very well-managed and well positioned company that is the leader in the home improvement retailing industry with 25% market share in its core market. The company’s stock has languished over the past several years even as Home Depot has achieved a 5 year sales CAGR of approximately 12% and earnings CAGR of approximately 20%. Investors’ primary concerns regarding Home Depot are a weakening consumer, slowing housing market and the company’s Supply initiative. As will be discussed in detail below, these short term concerns are more than priced into the stock at the current valuation and are unlikely to have a meaningful impact on Home Depot’s business or intrinsic value over time.
Although Home Depot boasts an industry leading sales per square foot of approximately $380, is growing sales in the high single to low double digits, generates returns on capital of 25% and is likely to grow earnings per share at rates in the low to mid-teens, its share price does not at all reflect such growth and does not account for the quality of the company’s competitive position. At approximately 12X 2006 earnings, an investment in Home Depot at current prices represents an excellent risk/reward and is likely to generate annual returns in the high teens to 20% over a 3-5 year time period with minimal risk of capital loss.
The Business
Home Depot is the largest home improvement retailer in the United States, Canada and Mexico. The company has grown its store base from 512 retail stores in 1996 to 2,051 retail stores today, of which 87% are fully owned by the company. The company also operates 34 Expo Design Centers, which provide home decorating, remodeling and installation services for middle to upper income do-it-for-me (“DIFM”) customers, 11 The Home Depot Landscape Supply stores and two The Home Depot Floor Stores. In addition, after acquiring Hughes Supply in March, Home Depot is now one of the largest diversified wholesale distributors in the US, with over 900 locations.
The company’s founders, Bernard Marcus and Arthur Blank, built the company up to a certain point and then hit a wall with little progress in IT, infrastructure and professional management. Bob Nardelli, formerly of GE, came in about 5 ½ years ago and has dramatically refocused the company, most evident in the increase in return on capital, which has grown from 17.5% in 2000 to 25% today. Specifically, Nardelli and his team have been keenly focused on improving the company’s operational efficiency, IT infrastructure and merchandising strategy, and more recently have been focused on store resets and improving customer service.
The company’s primary strategy to date has been to focus on its core retail expansion through the construction of new stores. However, there is not as much scope for continued retail expansion as there was in the early years when Home Depot was massively taking share from smaller format stores. The company recently noted that they were roughly halving their new store builds over the coming five years and would generate additional growth from complementary opportunities such as Supply.
Home Depot is currently pushing hard in the Home Depot Supply business. This business involves selling to the professional and industrial markets, as opposed to do-it-yourself (“DIY”) retail. The company’s main platforms thus far are in water infrastructure (which is an attractive growth area) and residential Maintenance, Repair and Operations (“MRO”). Note that the only vertical Home Depot doesn’t currently have a presence in is industrial MRO, as prices for excellent companies in this vertical are currently too high. At a minimum, the acquisitions which the company has already made in water infrastructure and residential MRO should provide a decent double-digit return. Note that Nardelli learned at GE that acquisitions only work if you focus on them more after the close than before. He convenes a meeting each quarter on every acquisition done in the past two or so years to make sure it’s tracking according to plan. So far, the company has been extremely successful both at integrating add-on acquisitions and in not overpaying for them.
The main strategic impulse of Home Depot Supply is to use the extraordinary buying power that comes from the retail business to get better prices for these newer professional businesses. Home Depot can then use this lower cost of goods either to enjoy fat margins or to crush its competitors on price and gain significant market share. The increase in operating profit of acquired companies will be roughly half from sales increases and half from margin improvements.
Investment Considerations
Management: Home Depot’s Executive Management Team is comprised of CEO Robert Nardelli and eight Executive Vice Presidents that lead various functional areas across the organization. Nardelli became President and CEO in December of 2000 and has been Chairman since January 1, 2002. Nardelli joined the company following a successful career at GE. As President and CEO of GE Power Systems, his most recent position prior to leaving GE, Nardelli transformed the division into a $20 billion worldwide leader in the energy industry. He was successful in leveraging technology, driving innovative products and services, integrating strategic acquisitions and growing the company at a rapid pace. Note that Nardelli was one of the final candidates in line to succeed Jack Welch as the CEO of GE.
Nardelli’s compensation has been the target of much negative press lately. Obviously Nardelli is extremely well paid, and although his compensation package is not ideal from a shareholder perspective, it has a negligible impact on the company’s intrinsic value. While I certainly do not advocate egregious management compensation packages, to his credit, Nardelli has done an excellent job optimizing and growing Home Depot’s business, as well as positioning the company extremely well for future growth. Despite generating robust sales and earnings growth over the past several years, Home Depot’s stock price has languished. Of course, Nardelli can’t control the stock price, but there is clearly a disconnect between shareholder returns and Nardelli’s compensation to date. He does own 5.3MM shares of restricted stock and options though, and is highly incentivized to improve the current share price.
Although the Executive Management Team has over 50 years of collective experience at Home Depot, the majority of the team has been with the company for five years or less. The team is extremely strong operationally and highly focused on the details of their respective divisions. Tom Taylor, who was promoted in August 2005 to his current position of EVP, Merchandising & Marketing, has the most tenure of any Executive Management Team member, while the overwhelming balance of the team is comprised of talent that has been recruited over the past few years from outside of the organization. Several members of the Executive Management Team are former GE employees that were recruited to work at Home Depot by Nardelli following his arrival at the company. Of the eight current EVPs, four worked with or for Nardelli at GE. Below is a list of the Executive Management Team and tenure with Home Depot. It is worth nothing that management maintains a maniacal attention to detail in all aspects of its business and that Frank Blake is among the great strategic minds in all of retailing.
Name Position Joined HD
Robert Nardelli Chairman, President & CEO 2000
Francis Blake* EVP - Bus Dev & Corp Ops 2002
Joe DeAngelo* EVP - Home Depot Supply 2004
Robet DeRodes EVP & Chief Information Officer 2002
Dennis Donovan* EVP - Human Resources 2001
Frank Fernandez EVP - Corp Secretary & GC 2001
Carl Liebert* EVP - Home Depot Stores 2003
Thomas Taylor EVP - Merchandising & Marketing 1983
Carol Tome EVP & Chief Financial Officer 1995
* Denotes former employee of GE
Industry: The US Home Improvement industry is highly fragmented. According to data from the Home Improvement Research Institute and Home Channel News, the total market size is approximately $720BN. Although Home Depot and Lowe’s dominate the sector from a consumer recognition standpoint, they currently account for only approximately 17% of the total market (11% for Home Depot and 6% for Lowe’s), leaving significant opportunity for Home Depot (as well as Lowe’s) to gain market share. Other players in the market include hardware stores, lumberyards, home décor dealers, paint stores, building products companies, carpet and flooring companies, discounters and department stores. Home Channel News projects that the top 500 home improvement retailers represent only about 1/3 of the total US market, implying the next largest 498 players all share approximately 16% of the total market. The data is quite promising for Home Depot as it embarks on further market share gains over time, taking full advantage of its scale and favorable cost position.
When dissecting the overall market further, Home Depot has a much stronger position in its core US DIY segment, which is an approximately $310BN market, including services. Home Depot garners roughly 25% market share, 78% higher share than its next largest competitor, Lowe’s, which maintains roughly 14% market share. Once again, after Lowe’s, the competition falls off precipitously and there is no other market participant that garners more than 5% of the US DIY market.
The largest market opportunity for Home Depot is Supply, which accounts for approximately 57% of the US Home Improvement Industry, or $410BN. With $11.5BN of projected Supply revenues in 2006, Home Depot garners less than 3% of this sizeable market. According to the most recent information available from Home Channel News, the top 20 pro supply dealers account for about half of the sales of the top 350 dealers, which themselves account for only about 15% of the total Supply market. (Note that most pro competitors generate less than $1BN in revenues.) Given the substantial fragmentation of the Supply industry, Home Depot is very well positioned to gain market share, similar to the opportunities it had in the early 1990s on the retail side when it aggressively rolled up market share in the DIY market.
According to the US Census Bureau, expenditures for residential improvement and repairs have grown at a CAGR of approximately 5.5% over the past 10 years and are projected by the Home Improvement Research Institute to grow at greater than 4% over the next 5 years due to increasing home ownership rates, strong demographic trends (55+ demographic is expected to increase at a rate of 2.6% through 2010) and increased penetration of the home improvement industry by home improvement retailers (73% penetration in 2003, up from 61% penetration in 1998).
Despite investor perception to the contrary, over a 40-year time period (1965-2005), the market for residential improvements and repairs has actually grown at a steady 7% clip, with a high of 20% and a low of -7%. After analyzing this data in further detail, it is clear that overall home improvement expenditures are not directly correlated with the ebbs and flows of the housing market and have been strong in both good and bad housing times, despite the market’s great fear that this is not the case. For example, housing starts declined by over 60% from 1972-1975, while total expenditures for residential improvements and repairs increased approximately 40% over this same time period. Between 1978 and 1982, housing starts once again decreased by approximately 60% while expenditures increased 20%. And, in the late 1980s when housing starts again declined approximately 55% from 1986 to 1991, expenditures for residential improvements and repairs increased by almost 15%. Of course, past results are not a guarantee of future results. However, at 12X P/E, the risk of a home improvement spending slowdown is likely more than priced into the current valuation, thereby providing investors with a significant margin of safety.
Competitive Position: Home Depot has a very strong competitive position within the home improvement industry. The company has grown its core US DIY market share from about 10% in 1996 to approximately 25% today. Home Depot’s main competitor, Lowe’s, has also impressively grown its market share from roughly 4% in 1996 to approximately 14% today, although it still lags Home Depot by a larger margin than it did 10 years ago with respect to market share.
Home Depot’s business model has many advantages that provide it with a competitive edge. The company has the most desirable store locations of any home improvement retailer, is innately focused on operational efficiencies, has spent meaningful investment dollars on technology initiatives, has leveraged its size to demand lower prices from its suppliers and has successfully established an international footprint.
Home Depot has literally built a sustainable competitive advantage through building its big boxes on the most desirable (and subsequently most profitable) real estate across the country. Since Home Depot was the first big box home improvement retailer to expand nationally, the company bought or leased the most desirable plots of land on which to build its stores. This strategy has helped the company produce industry leading sales and profits. Home Depot generates sales per square foot of approximately $380 and EBITDA per square foot of approximately $62 versus Lowe’s sales and EBITDA per square foot of approximately $328 and $43, respectively. Even as Lowe’s continues to aggressively build new stores, they simply don’t have the option to build on the same prime lots which Home Depot already occupies.
Of course, Mr. Market is more concerned with same store sales, as opposed to cash flow margins per store or per square foot. Comps for Home Depot’s older stores have trailed Lowe’s same store sales by roughly 3% over the past 5 years, as Home Depot has averaged approximately 2.5% comps versus Lowe’s 5.5%. Needless to say, I am more concerned with cash generation, profitability and valuation than with same store sales, although I realize that Mr. Market is not.
With respect to operational prowess, Home Depot is constantly reassessing the optimality of its store operations. Carl Liebert is entirely focused on improving efficiencies and there is an enormous emphasis on making costs more flexible, particularly in finding good part-time labor during the summer and on weekends. Nardelli has stated that there are still improvements to be made that were “normal for retail but we weren’t normal,” speaking to the way the company was run before he took the reigns in 2000. Initiatives which management are currently focused on include improving store merchandising, enhancing customer service and giving store managers more autonomy to optimize store operations.
Technology has been a top investment priority for the last several years at Home Depot, concurrent with the appointment of Robert DeRodes as CIO. Prior to DeRodes’ arrival, Home Depot had generally underinvested in technology, and as a result, the company has been behind its competition with respect to IT and faced the significant challenge of automating and centralizing its systems to bring them up to industry standards. Although major strides have been made in this area in terms of implementing enterprise-wide technology capabilities in human resources, finance and merchandising (of which the benefits have started to emerge), there remains an opportunity for significant improvement.
There are a multitude of IT initiatives that are either being developed now or are in the process of being rolled out which should lead to further cost savings and margin enhancements. At the store level, the continued rollout of self-checkouts, back-end scanned receiving technology and auto-replenishment functionality should drive improvement by reducing error rates, reducing shrink, improving in-stock levels and deploying labor more efficiently. The company is also in various stages of developing and deploying enhanced merchandising and ERP systems, particularly in inventory and supply chain management.
One of the company’s most important competitive advantages is its buying power. Given Home Depot is the industry gorilla, it receives market-leading pricing and terms from its suppliers. This provides the company with a meaningful cost advantage versus its competitors (especially versus mom-and-pop retailers). In Home Depot Supply, the company can further leverage its scale with vendors as well as take best prices and terms with overlapping customers. The company’s pricing policy is to price just where they will win the business, but not so low that they will immediately crush all others. Management figures that by doing so, its competitors will eventually die over time, while the company can sustain high margins.
On the international front, Home Depot has successfully established its footprint in Canada and Mexico over the past ten years through both acquisitions and organic growth, and has firmly entrenched itself as the market leader in both countries. As of March 31, 2006, Home Depot operated 141 and 56 stores in Canada and Mexico, respectively. As the largest home improvement retailer in both countries, Home Depot can leverage its size to receive market-leading prices and terms from its suppliers as well as pick prime real estate on which to build its stores. The home improvement market is very attractive in both countries. In Canada, the household penetration is 57,600 households per big box home improvement store, and in Mexico the penetration is 513,000 households per big box home improvement store. These penetration rates compare with rates in the US of about 35,000 households per big box home improvement store. This data supports Home Depot’s opportunity to further expand and penetrate markets in Canada and Mexico. It’s also worth noting that company recently announced it would formally create a business development operation in China.
In sum, Home Depot appears to be benefiting significantly from its superior store locations, operational prowess, investments in IT, economies of scale and strong international presence, as demonstrated by its consistent growth, industry leading financial metrics and substantial market share gains.
Price: Home Depot’s valuation is quite attractive, with the stock trading at roughly 12X 2006 EPS, 8X 2006 EBIT and 7X 2006 EBITDA with a free cash flow yield of approximately 6%. The current price does not give the company credit for its dominant competitive position as a world-class retailer and strong future growth, particularly in Supply. Instead, the market is focused on near term uncertainties surrounding a weakening consumer, slowing housing market and Home Depot’s Supply initiative. Management continues to focus on operational efficiencies, invest in world-class IT and spend an increasing amount of human and economic capital on the Supply market. These initiatives along with its already high returns on invested capital (25%) should continue to pay dividends in the future, evidenced by consistent sales and earnings growth.
Although an investment in Home Depot currently provides a very attractive risk/reward, buying five year at-the-money LEAPS may be even more attractive. Purchasing LEAPS not only takes advantage of Home Depot’s cheap stock price, but also takes advantage of low current interest rates and the historically low Volatility Index (VIX). Assuming maturity in five years and a 14X P/E multiple at exit, at-the-money LEAPS will juice returns by approximately 7% per year over the comparable return on the stock while adding only a moderate amount of additional financial risk. Home Depot’s business model, which is relatively stable and growing, lends itself well to owning five year LEAPS.
RISKS - for a detailed discussion of risk factors, see Home Depot Part II
Slowing Housing Market
“Death of the Consumer”
Poor Customer Service
Cannibalization
Higher Energy Prices
Conclusion
Home Depot has a striking collection of factors that make it a great company and a great investment. It has an extremely strong competitive position in an attractive industry that is growing, is run by a focused and savvy management team, generates high returns on capital and is currently trading at a price which represents a significant discount to intrinsic value.
Catalyst
Although this investment is not at all “catalyst” based, there are a number of catalysts which may increase the stock price. Among them are:
1. the successful integration of Hughes and subsequent strong growth in the Supply business;
2. large activist investors successfully encouraging leveraging the balance sheet and buying back more stock;
3. continued strong sales and earnings growth despite high energy prices and rising interest rates;
4. increased international penetration, particularly in China, India and other large international markets;
5. improved execution in its flooring business, which currently represents about 10% of DIY sales;
6. further penetration into the Supply business through an attractive and accretive add-on acquisition.