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VL Project 06: 5 Keys HD

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By OnTheRivet
January 13, 2006

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Key 1: Is it a good business?

If you follow M*'s ratings, they give Home Depot a wide moat. I would agree with this assumption. Home Depot and Lowe's are creating a duopoly in the retail segment in the hardware store industry. Reviewing Home Depot's number from the metrics presentation we can see several bright points. Let's highlight a couple.

Link to metrics:

First there was a 5 year calculation of Home Depot's return on equity (ROE) using the du Pont method with breaks down the ROE into components. The ROE has been remarkably stable at around 20%. Expanding profit margins are offset by increased financial leverage and slow capital turnover.

The other two returns on capital posted were return on assets (ROA) and returns on invested capital (ROIC). The ROA for Home Depot at mid to high 12% is a sign that they are earning their cost on capital with out the need of financial leverage. The return on invested capital which I spent much time posting before has been adjusted downwards since my original post to an average of 14.9% for the past 6 years. However the latest returns on invested capital are above 16% which is a combination of slowing in capex and expanding profit margins. If you consider that the weighted average cost of capital for Home Depot is less than 11% then Home Depot is creating value to its shareholders. That is always the sign of a good business.

Secondly there is the cash conversion cycle. Once again the numbers look pretty good for a large retailer like Home Depot. Home Depot is able to convert its inventory into cash in 60.2 days. In other words it takes Home Depot 75.6 days to sell through its complete inventory and another 7.5 days to collect the cash from those sales. However offsetting that is that it doesn't have to pay for that inventory for 23 days. So the net effect was in 2004 it took 60.2 days to monetize its inventory into profits. The best year in recent times was 2001 where the cash conversion cycle was 52.5 days and the worst was the next year at 62.1 days.

From a balance sheet perspective, Home Depot looks pretty good. They have low debt to capital ratio (8.2%) and low debt to equity (8.9%). So they are conservatively financed. Also note that they don't have much off balance leverage in terms of operating leases. At 5.6 billion that's roughly half of what CVS has in operating leases. Also they do not have an off balance sheet retirement obligations.

From a margin perspective, they have been increasing their margins across the board for 6 years. Gross margins have expanded from 29.7% to 33.4% where operating and profit margins have followed suit.

Lastly lets look at some of the revenue growth and corresponding invested capital growth. Revenues have averaged over the past 6 years (5 calculated in the metric post at 13.9%) at 16% and the invested capital has grown at 17.6% (13.9% for 5 years). However the trend has been a significant slow down since 1999 where revenues grew at 27% and invested capital grew at 36%. These numbers are the numbers that I look at closely because moving forward it is these numbers that generate both a free cash flow valuation model and a residual income model. The bottom line is that the trend points to a slowing in growth due to saturation and less opportunities to expand in its core business. This is qualitatively evident by the recent announcement its purchasing Hughes Supply (HUG)

So to wrap this up, Home Depot is a solid company financial and operationally speaking ie using a historical quantitative approach. Given its wide moats and ability to earn economic profits I believe Home Depot is a good business.

Key 2: What's it worth

I posted an EVA valuation model with some initial generic assumptions. Subsequently I added a bearish outlook.

Links to two valuations using the residual income model


There are two parts to a residual income model, the initial capital invested and its growth and any economic value added and its duration.

The first part is the invested capital, which I posted tables in length. Unfortunately I only calculated through 2004. To estimate a current IC value I used the 5-year average IC growth of 13.9% to generate the ending 2005 IC number. From there I assumed growth in invested capital would slow at a modest pace from 14% to 5% in year 17. If Home Depot never added any economic value in profits i.e. EVA neutral then this is the growth in the value of the company. In Home Depot's case this is not the issue. How is that? Home Depots invested capital estimated for mid 2006 is 42.81 billion. If you put ROIC = WACC then the intrinsic value for Home Depot after debt and debt equivalents are netted is $17.37. This means that roughly $24 dollars is attributed to economic value creation in the future.

To see that economic value we can look at it in two ways. The first way is the ROIC-WACC spread, which in this case I set to a fixed 5.57% spread (16% - 10.43%). This isn't real world but a start. The second assumption I made was that Home Depot would be able to keep this spread to eternity, which is seen in the terminal value calculation. If I set the terminal spread to zero then the intrinsic value drops from $41 dollars to $33 dollars. We currently have assumed it can maintain its spread forever, which assumes Home Depot has a competitive advantage that will never go away. This might be true but unlikely. The second way that economic value can be created is by the growth in invested capital while maintaining an economic profit. We have done this by assuming that Home Depot can invest in profitable new ventures through new store openings and acquisitions for the next 17 years at a slowing pace. If we valued Home Depot with no new projects to invest in but maintained its economic profit spread the value would be $27.50. So you can see there are two drivers of the added value, growth in invested capital and the economic profits of that invested capital

So with growth in invested capital slowing and maintaining its competitive advantage in the form of the 5.57% spread, Home Depot is valued at $41.64. I don't think this is a conservative number but a rather average estimation of Home Depot's value. What do I mean? For instance, what if we have a recession in the next two years caused by a slowing economy and decline in the housing market? The leverage in Home Depot will come to visit in the form of reduced margins. These reduced margins will cause economic profits to disappear and probably a slowing of future capital expenditures i.e. invested capital. The combined could be estimated easily in the model (see link above).

In a bearish mode, I could easily make Home Depot worth only $33.50 if any of the risks I just mentioned come to fruition. Further risks were mentioned by Jack, regarding a move into newer businesses outside their core competency. This could lead to a lowering of economic profits, etc.

Key 3: Current Price

The current price of Home Depot is $42.55

Key 4: Identification of Effective Catalyst

I don't see any specific catalyst. Home Depot seems to be firing on all cylinders and I believe the stock price reflects it. If there were any catalyst to speak of they would be negative and of the macro variety which were represented in the bearish scenario.

Key 5: Margin of Safety

The biggest margin of safety Home Depot has is its wide moat in the industry which its beginning to share with Lowe's. The balance sheet is in good shape which means any dividend is safe. However the dividend at less than 1% doesn't give much of a floor. The valuation model puts Home Depot fairly valued at $41 assuming a rosy scenario and more like mid $30's with a bearish outlook. So I don't see a huge margin of safety in Home Depots stock price.

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