FOOL ON THE HILL
An Investment Opinion
Home Depot: Value Creation Despot Dale Wettlaufer (TMF Ralegh)
August 12, 1999
Home improvement retailer Home Depot (NYSE: HD) added another $1 5/8 to $59 3/8 today after pre-announcing smashing second quarter results. The Atlanta-based company said second quarter revenues rose 28% to $10.431 billion, outpacing the Q1 revenue growth of 25.7%. Once again, the company put up impressive and estimate-beating same-store sales growth, with an 11% year-over-year increase in same-store sales for the quarter. Comp-store sales advanced 9% last quarter.
With continual efforts to improve the merchandise mix resulting in higher per-ticket sales and the spreading of fixed and planned variable operating expenses over higher sales, Home Depot says it will show Q2 EPS of $0.44, up 42% from last year's Q2 net income results of $0.31 per share. Of 24 analysts' estimates in the I/B/E/S data, the mean estimate for the quarter was $0.39 with a range of $0.38 to $0.41.
With a company such as Home Depot, one might wonder how big this thing can get before that sheer size must slow down shareholder value creation. It's probably helpful for an investor to look at a couple different things when addressing that question.
First, many models start with topline forecasts, no matter what the intellectual worldview of the analyst. It's what happens after the revenue number that decides the effectiveness of the analyst's estimate of the value of the company. Coming up with a revenue-based model that is further driven by margins, without an integrated consideration of invested capital dynamics, is going to result in a sub-optimal analytical outcome. A discounted cash flow, for instance, that takes base year EPS, grows that at 18% per year, caps out at 12 times year-5 EPS, and is discounted at 12% to come up with a current per-share intrinsic value gives equal credit to any company that can generate that EPS growth. No matter whether a company can do that with heavy working capital and fixed capital investment or no incremental investment, under the EPS discounting regime, the net present value of a company isn't going to change.
Clearly, that analysis isn't going to increase the frequency with which you are right about what you're analyzing, as the intrinsic value of a company depends not only on the cash that is coming out of the business but the cash that is going into a business. In the case of the big-box retailers such as Wal-Mart (NYSE: WMT), Costco Companies (Nasdaq: COST), Toys "R" Us (NYSE: TOY), or Best Buy (NYSE: BBY), turnover of working capital and fixed assets is the major explanatory variable in analyzing return on capital, as traditional margin analysis early on in the competition between the big box retailers and the regional chains would have led you to identify as the most attractive those companies that would build the least relative amount of shareholder value in coming years.
Home Depot, for instance, was scoffed at by many potential backers when founders Bernie Marcus and Arthur Blank laid out their plans to carry big inventories, price low every day, support that with extraordinary service, and maximize fixed asset turns. Though you wouldn't have to look any further than Wal-Mart or Sol Price's Fed-Mart for a good idea of how that worked, Marcus and Blank definitely had to struggle against the current of static, financial orthodoxy. Few potential financiers could get across the gap that lower prices would drive sales per square foot higher and net working capital and fixed capital investment as a percentage of sales lower. Traditional, margin-driven analysis would show that if you just raised your prices some, you'd make up in margins what you would lose in gross profit dollars under the low-price model of thinking.
The collateral benefits to pricing low every day are manifold, however. As the people at Dell Computer (Nasdaq: DELL) have said so many times, you don't put margins in the bank, you bank operating dollars. Probably the biggest strategic blunder you could have made in retailing in the 1980s and 1990s would have been to ask "How can we hit our goals by holding the line on prices and margins?" One of the better strategic questions you could have asked would have been "How can we reach our shareholder return goals and deliver better prices to the customer?" Well, fast forward to 1999 and you still have some companies asking the first question and you still have Wal-Mart and Home Depot, among others, asking the second. Heck, you can open Barron's almost any Saturday morning and watch that publication's writers miss that very issue in their regular assaults on Amazon.com (Nasdaq: AMZN).
What we have in a Home Depot is clearly a company that was unafraid to price low, get to scale, use that scale to offer product lineups (in terms of stock keeping units, SKU combinations, and pricing) that competitors couldn't touch, and keep the customer coming back with great service. Once you've got that scale, then you can use your massive financial resources to finance the further buildout of the concept across the U.S., the hemisphere, and then the globe. Acting as your own investment bank, you also finance young concepts such as Home Depot's EXPO Design Centers and Villager Hardware projects. The simplest way of seeing that is to look at the company on the basis of cash-in versus cash-out. Whether you want to look at Economic Value Added, Cash Flow Return on Investment, Shareholder Value Added, or any other regime that takes into account the concept of economic profits, you can see why this company has been able to expand so rapidly and grow its shareholder value so much.
Over the last two years, the company has increased its return on capital at a very impressive rate. Without capitalizing operating leases, return on capital has expanded from just over 15% at the end of Q1 fiscal 1997 to about 17.7% today. Expanding margins (resulting from competitive advantages in merchandising and service offerings, the spreading of capital, fixed, and operating costs over growing revenues, among other variables), and increased capital turns have resulted in these higher cash returns on capital. In addition, cash flow at the margin is growing faster than invested capital, which is manifested in a return on marginal invested capital (ROMC) above trailing returns on capital.
This measure compares changes in net operating profits after taxes to changes in average invested capital. For the trailing 12-month period ending in Q1 fiscal 1998, ROMC was 17.8% compared with return on invested capital (ROIC) of 15.7% for that period. For the trailing 12 months ending in Q1 fiscal 1999, ROMC shot up to 28.3%, compared with the trailing 12-month ROIC of 17.7%.
The upshot is, absent macroeconomic shocks, this company is undervalued in the sense that it can still outperform the vast majority of publicly traded companies over a five-year period. If the return on marginal invested capital holds and the company can keep on plowing back cash into the business in new geographies and in new concepts, it wouldn't take much time for this company to go from "expensive" looking on the basis of P/E or market implied competitive advantage period to being pretty cheap. Without assuming a wholesale change in financial asset prices over five years and assuming the company can execute, the value of this company should be materially higher five years from now.