The Home Depot Value Trap

I've written in the past that Home Depot (NYSE: HD  ) was a company to consider as an investment. It's an industry leader that's seen margins expand. It's been a victim of negative sentiment, given real estate concerns and worries about tapped-out consumers. And it has seen purchases from famous value investors.

But digging in and analyzing the company recently, I'm changing my mind. I think Home Depot is a value trap. Not one those "turnaround that never happens" kinds of value trap. This one's a bit different, so let me explain.

The catalyst
Home Depot has been on my mind, especially recently, as its price has been falling. What prompted me to take a bit of a deeper look was a press report that Goldman Sachs analyst Matthew Fassler recently downgraded the company, from "buy" to "neutral," citing management turnover concerns at a time when the big orange beast is working to get its stores in order. At the same time, he upgraded its big blue competitor, Lowe's (NYSE: LOW  ) , from "neutral" to "buy" in the belief that it stands to benefit more from a turn in the housing industry.

The view from Wall Street
To start my analysis, I wanted to see what other analysts thought about the company. Below is a table of the number of analysts rating Home Depot and Lowe's a buy, hold, or sell.

HD 10/16/06

HD 6/30/06

LOW 10/16/06

LOW 6/30/06

Buy

15

14

13

14

Hold

13

13

13

12

Sell

0

2

3

4

Data from Jaywalk.

Over the past six months, sentiment has shifted more toward "buy" for Home Depot. However, I think sentiment for both companies is still probably "hold."

The view from Main Street
Have you signed up to participate in our revolutionary new ratings service, Motley Fool CAPS? No!? Then get to it. It provides a great view of what those of us on Main Street think. In fact, here's what the CAPS community thinks about both companies, comparing "outperform" calls with "underperforms."

Total Players: OUT

Total Players: UND

All-Stars: OUT

All-Stars: UND

Home Depot

738

152

136

21

Lowe's

295

26

73

4



It looks like the CAPS community is a bit more bullish on the companies, especially Lowe's.

My view
Within CAPS, there's been plenty of talk about Home Depot Chairman and CEO Bob Nardelli's compensation and treatment of shareholders. And rightly so. But Nardelli is an execution guy-- he cut his teeth at the "Make Your Numbers" university of General Electric (NYSE: GE  ) . How do I know this? Ultimately, he was my boss when I worked at what was GE Power Systems. And although I never had the chance to meet him, his demand for performance was felt throughout the entire organization. So while I agree that he's probably overpaid (blame the executive compensation committees for letting this get out of control) and needs to work on his bedside manner with shareholders (perhaps with a call to Miss Manners), his abilities probably cancel out those negatives.

That's not what bothers me at Home Depot. What bothers me is that great execution seems to be priced into the stock. Here's what I mean.

I know Home Depot has been able to increase margins. I know that return on invested capital, adjusted for operating leases, has been rising -- albeit not as rapidly as in the past. And those are the marks of a great business with a competitive advantage. But stagnant adjusted free cash flow growth (66% at Home Depot and 80% at Lowe's, adjusted for growth capital expenditures) troubles me, especially when you see that it's growing at Lowe's.

Adjusted Free Cash Flow, in Millions

FY 2002

FY 2003

FY 2004

FY 2005

FY 2006

Home Depot

$4,809.38

$3,867.34

$5,148.96

$5,561.68

$5,164.46

Lowe's

$1,170.80

$2,202.80

$2,565.00

$2,487.60

$3,166.20

So to kick-start growth, Home Depot is getting heavier into the commercial-supply business with its acquisition of Hughes Supply. Believe me, I get it. Nardelli did this at GE as well: Expand the definition of your market, and you can grow. But I have to wonder whether the returns are really going to be there. Check out the ROIC comparisons, adjusted for operating leases, with MSC Industrial Supply (NYSE: MSM  ) , Applied Technology Industries (NYSE: AIT  ) , and Grainger (NYSE: GWW  ) .

FY 2002

FY 2003

FY 2004

FY 2005

FY 2006

Home Depot

15.0%

16.6%

16.9%

16.8%

17.5%

Lowe's

11.2%

13.3%

13.7%

14.3%

15.2%

MSC Industrial Supply

8.1%

11.9%

15.5%

19.6%

N/A

Applied Industrial Technologies

4.7%

6.2%

9.8%

15.3%

18.5%

Grainger

14.0%

13.9%

16.8%

19.0%

N/A

They certainly are high. And the space is fragmented, so there's opportunity for large players to capture efficiency benefits. But are returns going to stay that high as those competitors get bigger and bigger? I wonder whether gravity is going to pull them down.

My fear is that Home Depot will start to experience the "Red Queen Effect," in which it has to run as fast as it can (i.e., spend capital to achieve limited growth) just to stay in the same place. To me, that's not an enviable position to be in, and it's certainly not a reason to recommend the company at today's prices. With my valuation showing the stock between 10% undervalued and 10% overvalued, I think it is best just to sit on the sidelines and wait.

The Foolish bottom line
Here's why I think Home Depot is a value trap.

It creates value (its ROIC is significantly above its weighted average cost of capital), generates tons of cash, pays a dividend, and buys back shares. That's all great stuff. But all of that, in my opinion, is already priced into the stock. And with future returns dependent on significant capital expenditures that will keep incremental returns on invested capital flat -- Home Depot isn't anything like a Coca-Cola (NYSE: KO  ) that can continue to generate big incremental returns on invested capital -- it's not going to be difficult to generate excess returns that will drive up the value of the company. As such, it's not going in my CAPS portfolio, and it's not going into my real portfolio, either.

But Lowe's isn't that much different. While I agree that that it does have better growth prospects, as a value investor, I have to demand a higher margin of safety.

Again, great companies don't always make great investments.

Bring it to CAPS
You think I'm wrong? (It won't be the first time.) Have a variant perception? Feel much stronger about the prospects for Home Depot or Lowe's than I do? Then what are you waiting for? Follow the advice of my Foolish colleague Seth Jayson and " Bring It to CAPS" by signing up for our CAPS service and having your voice counted. I've done that with plenty of other companies. Just search for TMFHumbleServant to see my CAPS page.

Home Depot and Coca-Cola areMotley Fool Inside Valuerecommendations. Lead analyst Philip Durell has a variant perception on Home Depot, and you can find out why he recommended it by taking a free trial.

Retail editor and Inside Value team member David Meier does not own shares in any of the companies mentioned. You can view his profile here. The Fool takes its disclosure policy very seriously.


Read/Post Comments (0) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 510014, ~/Articles/ArticleHandler.aspx, 10/2/2014 5:07:56 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement