Stock of the Week: Home Depot

In the spirit of the Fool's mission to educate, amuse, and enrich, we're kicking off a new weekly series. Fittingly titled "Stock of the Week," this column will offer you a fresh, thoroughly vetted stock idea every Friday. Aside from reading the latest from Bill Simmons or your favorite celebrity-gossip blogger, I can't think of a more productive way to spend your Fridays at the office.

And since the Fool is all about investors writing for investors, it's only fitting that our first Stock of the Week is itself a do-it-yourself facilitator: Home Depot (NYSE: HD  ) .

A broken home?
You're probably familiar with the troubles Big Orange has faced over the past several years: poor corporate governance, brand erosion, fierce competition from Lowe's (NYSE: LOW  ) , and a series of ill-fated acquisitions. And that's before you even consider the company's recent painful results stemming from weak consumer spending and the construction concussion.

Extreme business makeover
Home Depot's results over the past few years have done little to inspire confidence. But over the past year, the company has undergone what amounts to a corporate version of Extreme Makeover: Home Edition. Changes came from the top on down, with the ousting of reviled chairman and CEO Bob Nardelli and several members of a board widely considered to be under Nardelli's thumb.

Nardelli's replacement, Frank Blake, has wasted little time in his quest to right the ship. In his boldest move, Blake announced a massive $22.5 billion share-repurchase program in mid-2007, largely to be funded by the sale of the amalgamated albatross that was HD Supply, along with cash on hand and a substantial debt offering. Despite not getting the best of selling prices, Home Depot managed to hammer three boards with one nail on the sale: The company narrowed its focus down to its core retail business, shed a lower-margin segment, and used those proceeds to scoop up beaten-down shares.

Management has also made several meaningful moves to improve the customer experience, starting with investing more cash on spiffing up its stores. Another key initiative has been to shore up personnel quality and contentedness. The company is hiring a legion of highly skilled tradesmen and craftsmen to help work store floors and train less-experienced associates. It's also expanding a store-level, revenue-based bonus program for hourly employees, and it's issuing restricted stock grants to store-level assistant managers. Finally, management is offering the potential for substantial margin expansion with its plans to improve on a currently lackluster supply chain.

An appraisal
Because of downtrodden results and skepticism about management's ability to lead Home Depot over the hump, shares of the home-improvement giant have fallen by more than 30% over the past year. Not surprisingly, its shares look cheap by almost any historical measure you can dig up. These figures reflect the kind of pounding the big retailers have taken lately.

Stock

Price-to-Sales

Price-to-Sales 5-Year Average

Forward Price-to-Earnings

Price-to-Earnings 5-Year Average

Home Depot

0.61*

1.07

12.9

16.3

Lowe's

0.82

1.25

13.6

19.8

Wal-Mart (NYSE:WMT)

0.66

0.84

14.8

21.5

Target (NYSE:TGT)

0.92

1.03

14.9

20.4

Costco (NASDAQ:COST)

0.41

0.38

19.1

23.3

Figures based on author's calculations.
*Excludes revenues from HD Supply.

Drilling deeper, I peg Home Depot's shares as substantially marked down on a discounted cash flow basis. In my model, I assume that revenues will drop substantially in 2008 before reverting back to mid-single-digit growth. I also assume that the company's supply-chain and inventory-management upgrades, along with the departure of the cumbersome HD Supply unit, will expand normalized operating margins up to 11% by 2010, and I think that number could prove to be conservative. Factor in the nearly $12 billion in repurchases still on the table and tie it all up with a discount rate of 10%, and I value Home Depot at roughly $34 a share, or about 23% above current levels.

Speaking of valuation, I've seen discussion that Home Depot could represent a unique real estate asset play. Despite leasing only 13% of its store locations and with most if its properties being in prime locations, this is far from a Sears Holdings (Nasdaq: SHLD  ) -like play. Unlike Sears, cash-pumping Home Depot lacks both a pressing need to monetize those assets and a capital-allocating virtuoso like Eddie Lampert pulling its strings. But although Home Depot is sitting on an immense swath of valuable real estate, don't expect that consideration to factor into the valuation anytime soon.

Potential termites
Like any good beaten-down stock, Home Depot carries its fair share of risks. A short-run threat to the Home Depot thesis would be a sustained economic downturn, particularly given its newly aggressive capital structure. Similarly, disappointing results in the company's international expansion efforts in Mexico, Canada, and China would put a damper on growth and could trip up the share price. Further, and crucially, Home Depot's new leadership must post measurable strides on heightening the customer experience and improving its back-end infrastructure. Achieving those two goals will prove to be no small feat.

Driving the last nail
Make no mistake: Home Depot is a true contrarian play, and investors lacking a strong stomach and a multiyear time horizon should sit this one out. Still, I'm confident that investors getting in at this price will eventually see market-beating returns, all while they enjoy having locked in a 3.3% dividend yield while the thesis plays out.

Check back with us next Friday for the next Stock of the Week. In the meantime, Fool on!


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