Will Home Depot Improve Your Portfolio?

Taking center stage right now is Home Depot (NYSE: HD  ) , the home improvement and do-it-yourself giant. After being a Wall Street darling for some time, both the company and the stock have taken their lumps in recent years. An awful housing market certainly had something to do with it, poor leadership may have had a part, and prior irrational exuberance over the stock was definitely in the mix.

But should Home Depot be on your buy list now? Let's take a closer look.

The nuts and bolts: Home Depot's business
Home Depot is a home improvement retailer, almost everyone reading this likely knows that. That's a start. But when thinking about a business as an investment, it's important to consider what makes this a better business than its competitors. Why do customers keep coming back? Is there any "special sauce?"

For a company like PepsiCo (NYSE: PEP  ) , which I've also been digging into, the answer is pretty obvious. The company has proprietary products like its namesake Pepsi cola, Ruffles potato chips, and Gatorade sports drinks. Taste preferences and brand loyalty keep customers coming back and competitors legally can't steal the recipes or use the brand names.

It's a little trickier for a retailer like Home Depot. I can go to Home Depot and buy a Weber grill, but I can also go to Lowe's (NYSE: LOW  ) , Target (NYSE: TGT  ) , or Sears (Nasdaq: SHLD  ) and buy the exact same product (or at least a substantially similar product by Weber). So what is it about Home Depot that creates exceptional value?

For me, it boils down largely to brand, customer experience, and efficiency.

The first two of those go hand-in-hand, for it’s the customer experience that creates a lot of the value for the brand. And it's that customer experience that has been blamed for a good chunk of Home Depot's problems in recent years. Right now the company has been focused on correcting that, an effort that has been largely focused on enabling employees to spend more of their time in customer service roles. It appears to be bearing some fruit as the company's net promoter score (a measure of whether customers would recommend Home Depot to friends or colleagues) has been steadily rising over the past two years.

The company has also been making strides on the efficiency side. This means making the best use of capital, making sure the right systems are in place to manage the company, the right products are in the right places, and money is getting returned to shareholders where appropriate. Return on capital started falling off a cliff between 2007 and 2008. In 2010, it was back to 12.8% and the company has a goal of getting it back up to 15%.

With all of that in mind though, in a word, the business success at Home Depot boils down to "execution." When you're a retailer selling substantially the same things as many other retailers, you absolutely need to be on your A-game.

Looking ahead: the risks and opportunities
It's impossible to ignore the housing market when talking about Home Depot, since it's hard to expect a home improvement retailer to have any sort of tailwind when the housing market is in the dumps.

Since I'm not going to pretend to have any magical insight into the near future for the housing market, I'll say that this is both a risk and an opportunity for Home Depot. A continued slump in the housing market would obviously provide some drag for the company, while a recovery would goose the business. Of course we shouldn’t assume that if the housing market is still muddling along that Home Depot is dead in the water -- faucets still break, lawns are in need of mowers, and people that are staying put in their homes may want to make the place more generally comfy.

Additionally, while it's important to be aware of broader industry dynamics, my interest is often piqued if a high-quality business can be bought at an attractive price because people are sour on the industry. I don't buy stocks with a plan to sell in six months or a year, so I don't need to see an immediate industry turnaround to get interested.

The more important risk/opportunity here is the issue of the execution. During CEO Bob Nardelli’s tenure at Home Depot, though the company grew substantially, the seeds of stumble were being sewn, as Nardelli hacked away at the all-important customer experience. Current CEO Frank Blake has been at the post a few years now and seems to have learned from Nardelli's mistakes and has the company moving in a good direction again.

The opportunity here is that if Blake can continue to make savvy moves, Home Depot can build a better relationship with its customers, which will serve it -- and investors -- well now and when the housing market and broader economy recover. The flip side, of course, is that there are a lot of competitors looking to eat Home Depot's lunch -- Lowe's most notably -- and if management starts slipping up again, those competitors will be there to capitalize.

Measuring up: The stock's valuation
When it comes to valuations, I like to think of it from the perspective of expected returns. That is, based on factors like earnings growth and dividend payments, how much can I expect to make per year when investing in this stock?

Home Depot has been bouncing back and analysts are expecting a lot more of the same -- they project 13% long-term earnings growth. I'm not willing to give the company quite so much credit and think that 8% annual growth is a more reasonable expectation (with 13% as a pleasant upside if it does happen). Combining that with my view that the stock will likely trade at a slightly higher earnings multiple than it does today and that the company will continue to grow its dividend at a 10% annual pace, and I come up with a 12% annual return for an investment in Home Depot's stock.

This is a pretty attractive return in my view and though there is room for downside --slower growth or a lower earnings multiple -- I think there is also room for substantial upside in those numbers.

My take
A retailing business like Home Depot is nice because it's relatively simple, but it's dangerous because it's highly competitive and has little that's truly proprietary. As far as retailers go, I like the position of both Home Depot and Lowe's since many of the products they sell are tough to pull away into the web of the Internet. I'm also intrigued by the refocusing under Frank Blake.

Mix that all together with a valuation which I consider pretty attractive, and Home Depot is a strong contender for my next buy. But I don't want to get too ahead of myself -- as I pointed out in my original article, I'm going to dig into all five stocks before making that final determination.

Hopefully I've given you a lot to think about here. As you digest this and dig into the numbers yourself, you should go ahead and add Home Depot to your watchlist to keep up with what's going on at the company in the meantime. Don't have a watchlist? You're in luck, you can start one for free by clicking here.

The Motley Fool owns shares of PepsiCo. Motley Fool newsletter services have recommended buying shares of Lowe's Companies, PepsiCo, and The Home Depot. Motley Fool newsletter services have recommended creating a diagonal call position in PepsiCo. Motley Fool newsletter services have recommended writing covered calls in Lowe's Companies. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Fool contributor Matt Koppenheffer owns shares of Target, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool’s disclosure policy prefers dividends over a sharp stick in the eye.


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