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By ArrogantDonkey
August 25, 2006

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Feedback requested - I've been looking at this all morning after looking at it for a long time last month. I think HD is a really difficult idea in so many ways (mentioned later) and an active discussion might be helpful. So...

Here's a detailed write up on HD.

Here is another writeup on HD:

8/25/06, 33.41, 69226/75344, 11.2/12.2, 8.9/9.7, pb=3.3 (2.55 w/gw), ni=6169, cf=7743, cex=3765
1. Is the stock still attractive priced relative to earnings? Price was down slightly from last evaluation.
2. What is happening in the company to make earnings go up? Company is reinvesting more into the stores � step in labor.
Story is unchanged, Price Unchanged

SUMMARY
Little changed in Q2, with weaker comps (-0.2% vs. +0.2% in Q1), especially later in the quarter, and a drop in margins. Housing slowdown fears continue to buffet the stock, with the valuation at 10-11x the various 2007 estimates. Even if HD reports flat earnings at about 3.00 next year the multiple would equal 11x. I believe patience is required here, though keep in mind the comment in the last evaluation: I have a **% position and realize that this stock could get worse before it gets better, and any movement higher than 2% should probably wait for time to pass more than stock movement, but five years from now if the company achieves a modest 10% growth rate the stock ought to be a lot higher than here.

New News:

Comps were down in Q2 vs. up slightly in Q1

Company is reinvesting 350m into the store to improve customer experience during a tougher macro involvement

Change in guidance to lower end of 14-17% sales growth and 10-14% EPS Growth

Q2 Review
Sales up 17%
Gross profit up 13% with supply having a lower gross margin rate
SGA better
Operating income up 12%
EPS up 9%
Share count down 4%
Tax rate up due to change in Canadian taxes
Softness in transactions in 2nd part of quarter
Stores
Sqft up 6.3% yoy

MIX
Retail up 5.1% with comps of -0.2% at 22.6b
Supply at 3.5b
Ticket up 4.2% to $59.98
Per store inventory was flat to last year
Home Depot supply is 36% infrastructure, 43% construction, 16% maintenance, 4% repair/remodel, 2% intl
CapEx of 3.8b now due to increased investments in stores

BUYBACK
Bot 58m shares

FORECAST
Low end of 14-17 sales, 10 to 14% EPS
GS at 2.97 and 3.24; Argus at 3.01 and 3.49

INSIDER TRADING
Some decent size sells in the upper 30s-40

7-12-06, 34.1, 72360/76426, 11.9/12.6, 9.3/9.9, PB=2.6, NI=6075, CF=7743, CEX=3765

CATEGORY
Stalwart

SUMMARY
How one looks at HD revolves around a simple question: Is this a stalwart or is it a cyclical? The company has the history of a fast grower, with rapid store growth and expanding margins. It has morphed into stalwart growth rates in recent years as the retail business has become saturated, and the company has taken a new direction into serving the professional markets. This makes an easy situation (dominant retailer expands across the country) into a hard situation (mature retailer expands by 4 to 5% a year and makes numerous acquisitions which cannot be evaluated appropriately). Thus, this becomes a trust me Bubba situation as far as capital allocation is concerned. A more sinister view of HD is that this is a company that will be hurt by a housing slowdown with negative growth in retail at the same time the company can't be trusted to allocate capital � a dreaded cyclical, in other words. The supply business in particular may add even more cyclicality to the business. Offsetting all of this are three huge positives � 1) along with Low, HD dominates this space, 2) the balance sheet because most locations are owned is in great shape, and 3) the company generates a lot of free cash flow. I have a 2% position, believing in the stalwart argument, which suggests that buying at such a low PE ratio is a good idea. However, any increase in these shares should be more time dependent than price dependent (barring a 20% drop) to allow the story to develop. I do think the company is more than capable of achieving a 10% growth rate over the next 5 years.

BUSINESS
At the end of Q1 2006 HD operated 2051 home improvement stores and has made recent acquisitions to expand its supply business (business to business customers like home builders, professional contractors, plumbing, etc). The company is now reporting data for both segments (in Q1, sales of 19376 for retail, 2132 for Supply). About 10% of retail locations (197) are in Canada (4b USD in 05) and Mexico (top 1b USD in 06). Top States in 05 are: Cal (199), TX (165), Fl (133), NY (93), and GA (74). About 97% of the stores are owned.

SATURATION
The 05 annual report says they will open 400-500 stores in the next 5 years. Supply adds a new dimension to the story and company's emphasis on this growth path is the natural direction for a mature retailer like this one. (in 05 they opened 21 stores in Canada and 10 in Mexico)

RECENT RESULTS � Q1 2006
Q1 was strong again with 13% sales growth and 21% operating income growth, with slightly higher gross margins with much better SGA, though some of this was a one-time benefit from Expo last year. The company finished its acquisition of Hughes Supply in March 30 and supply represents 6% of operating profit. They bot 565m in shares, or 14m. Comps were probably flattish with ticket up 4.3% to $60.75. Selling sqft was up 6.4% in the quarter.

FORECAST
Sees 14 to 17% sales growth in 06 which includes acquired growth. The 2010 targets are 9-12% sales growth, 10-14% EPS growth, 400-500 new stores openings, 50b in cash flow, 17 to 20b in CapEx

UPCOMING SALES COMPARISONS
Very difficult: Q2 05 and 04 was 4.0, 4.8, Q3 3.6, 4.5, Q4 5.5, 4.6

STORE METRICS
Store average 105k sqft. My normal numbers don't work due to the addition of supply.

HISTORICAL CASH FLOW, CapEx, and Buybacks.
In the past thee years the company did 11935 in CapEx vs. 19117 in cash flow (net income plus d/a). For 5 years, 18077 vs 27492. The CapEx numbers don't include acquisitions. They have bot 9.7b in shares in the past 5 years.

THE FOUR VARIABLES
1) Margins, including trend and level. Margins at the highest level since 1996 (per VL). Margins have been trending higher in recent years.
2) Top Line growth. Sales growth in the past 5 years starting latest year: 12, 13, 11, 9, 17
3) Level of saturation. The company is only targeting 20 to 25% sqft in the next 5 years though this doesn't include additional supply purchases.
4) Balance Sheet. 2.6b in cash and 6.6b in debt added from the acquisition. In 05 they did 3.9b in CapEx with 66% for new stores, 10% for remodels, 9% tech, and 15 misc (they opened 179 stores). The 5 year target suggest 3-4b in CapEx a year. Trailing cash flow is 7.74b.

MANAGEMENT
CEO got 2.2m salary, 7m bonus, 3.0m other, 14.7m stk, 590k options, 2.4m long term payouts, 539k options. Options at 5 year average of 1% with a 38% cancellation rate.

Two Minute Drill

Why I'm Interested in the Company

� Low valuation. If the company can maintain margins and achieve 10% to 14% EPS growth then clearly the stock is significantly undervalued.
� Consistent Record. Company has the record of a stalwart with terrific margin increases
� Lots of Free Cash Flow. The company should be able to self-fund its own growth. Most real estate is owned, so the balance sheet is very strong.
� Heavy Buyback Plan. This has been an emphasis of the company. The dividend is modest (60c) but growing.

Pitfalls

� High Margins. They are vulnerable to a sales decline
� Average Ticket is Rising. This is not a bad thing as HD adds more expensive categories and products but it could leave the company vulnerable to consumer behavior � lower transactions and lower ticket being the worse scenario
� Growth is Dependent on Unproven Supply. This area has a lower margin and it is extremely difficult to evaluate whether this is a good use of capital.
� Bad Publicity. Perhaps a short-term thing but HD has been enormously stupid in their dealings with shareholders.

What Has to Happen for the Company to Succeed

� Maintain margins. This is the big wild card in the evaluating this business
� Be successful in Supply. Again, this is a tough thing to evaluate
� Use excess cash for buybacks. Again, assuming margins remain stable, buying shares remains a logical thing to do at this valuation.

Is this stock an obvious winner, based on changes to the key variable?

No. You have peak margins and a slowdown in housing at the same time management is a bit more opaque on results. Plus, the company has acknowledged retail saturation with a brand new strategy.

Is the business worth buying regardless?

Yes. I think this is a dominant retail selling at an acceptable price.


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