High-profile homewreckers
By the time the Wall Street Wisdom hits the all-day, short-attention-span theater that is CNBC's market "journalism," I figure it's a pretty good time to consider doing the opposite of what the suited stock jocks are suggesting.
I've mentioned before that I happen to sit underneath the Fool jumbotron, and a couple of days back, I noticed some very important and intelligent talking head -- I know he was important and intelligent because of his nice suit and finely air-brushed makeup -- explaining that investors need to keep their money away from the likes of Home Depot (NYSE:HD) and Lowe's (NYSE:LOW).
The problem, as the Wise Man saw it, is that consumers are going to stop spending their money on home upgrades because of the rise in interest rates. We'll address the logic of this assumption in a second. First, let's note that the current "Dump Home Depot" crowd is a bit late to the lemming jamboree. The stock has already taken as much as a 20% skid off its highs over the past half a year, while Lowe's has fared a bit better.
This is, of course, exactly the sort of situation we like to watch at Inside Value. Few situations present investors with a better opportunity for risk-adjusted gains than a short-term pounding of a healthy, growing, cash-generating business. This is the reasoning behind the second half of the oft-repeated quip, "Be greedy when others are afraid." This is the mantra that should be ringing in your head, for instance, when you see UST (NYSE:UST) take a major drop on a minor earnings miss. Heck, I'm even starting to give IBM (NYSE:IBM) a second look as it continues to get clobbered, and I've been as critical as anyone about the firm's performance.
Unfortunately, as much fun as it is to do the opposite of what the Street tells us, not all stock beatings are undeserved. So I thought I'd take a short walk through the two firms' financials to see if the fears are well founded.
Does value start at home?
By almost every valuation measure, Home Depot is currently valued far below the levels it has enjoyed over the past half-decade. As the table below shows, the average P/E stands near a five-year low, despite consistent sales growth in the mid-teens and even better results on the bottom line.
| Home Depot | Current | 2004 | 2003 | 2002 | 2001 | 2000 |
|---|---|---|---|---|---|---|
| Price/Earnings | 15.7 | 15.4 | 24.2 | 32.6 | 47.6 | 52.2 |
| Price/Sales | 1.1 | 1.0 | 1.5 | 1.8 | 2.7 | 3.1 |
| Revenue Growth | NA | 12.8% | 11.3% | 8.8% | 17.1% | 19% |
| EPS growth | NA | 20.2% | 20.5% | 20.9% | 17.3% | 10% |
The picture at Lowe's is similar, though the current relative "discount" is not as pronounced and the absolute P/E is a good deal higher -- probably owing to the snazzier top-line growth.
| Lowe's | Current | 2004 | 2003 | 2002 | 2001 | 2000 |
|---|---|---|---|---|---|---|
| Price/Earnings | 19.5 | 20.5 | 22.1 | 27.6 | 24.2 | 31.1 |
| Price/Sales | 1.1 | 1.2 | 1.2 | 1.3 | 1 | 1.3 |
| Revenue Growth | NA | 18.2% | 18.1% | 20.3% | 15.6% | 18.1% |
| EPS growth | NA | 18.3% | 22.5% | 46.1% | 21.9% | 19.3% |
While both the companies look cheaper than usual, if it's OK with you all, I'm going to toss Lowe's back into the pond for now. Home Depot's position as market leader, its superior margins and returns -- see the table below -- and its lower relative price tag (with comparable bottom-line growth) make it the more attractive of the two. I'll revisit Lowe's if the market gives it an uglier haircut (perhaps something like my new pixie 'do).
| Net Margin | Return on Equity | Return on Invested Capital | |
|---|---|---|---|
| Home Depot | 6.8% | 21.5% | 19% |
| Lowe's | 6% | 20% | 15% |
Growth gone?
There are a few recent hypotheses about the fate of Home Depot. Exhibit A is analysts' short-term estimate downgrades based on weather and consumer reaction to gas prices. (Bring it on, I say. These are not material in the long term.) The major beef of the "dump Home Depot" argument is this: Interest rate increases mean that consumers will stop spending so much on their homes. The party is over, they say. The home improvement spending that's supported these two, and bulked-up earnings at toolmakers like Black & Decker (NYSE:BDK) and Stanley Works (NYSE:SWK), is about to take a permanent vacation.
Quite frankly, I find this to be naive as well. First off, I see predictions for long-term interest rates to settle in the mid-6% range. That's more expensive than recent historic lows, to be sure, but it's hardly the coming of the apocalypse -- unless maybe you live in a real-estate loony bin like the D.C. area, where 500 square feet of pain already fetches $425,000, but that's another topic.
Furthermore, the predicted, negative impact of increasing interest rates on Home Depot's top line is unclear, and possibly backwards. I suspect I could find a smart-looking character in a suit to make the following, plausible, counterargument: If consumers can't spend as much on a new home due to those interest rates, doesn't it stand to reason that they'll be more likely to settle for an existing home? And existing homes need, you guessed it... home improvement. (Just ask my wallet.) Furthermore, the increasing costs of moving will likely have an effect similar to what is already happening here in D.C., which is to convince more people to stay put and remodel their existing homes.
The final flaw in the bear thesis is that Home Depot's growth is tied to initiatives that extend beyond end consumers with fickle fiscal fingers. Home Depot is now selling directly to home builders in many markets, and operates distribution channels for contractors, housing and hospitality management firms, and other third-party retailers. But even if you accept the idea that the home-improvement market will cool down, Home Depot has plenty of room to increase its share. Currently, the firm estimates that it has only 12% of the existing U.S. market. Initiatives like appliance centers, tool and equipment rental, and contracting services offer other growth opportunities. Home Depot is also exploiting newly acquired expansion opportunities in Mexico and will soon try the same in China.
In summary, analysts are predicting EPS growth in the range of 12%-13% annually for the next few years. I think the firm could well do much better than that. But since hubris can be fatal (just ask any of Shakespeare's leading men), I'm going to assume that Home Depot will actually underperform those expectations.
Valuation
I'll be the first to admit that putting a price tag on Home Depot isn't easy. Traditional "value-guy" metrics and estimates, like a straightforward discounted cash flow (DCF), won't hold up well. That's because Home Depot is still spending so much on growth.
For example, cash flow from operations was a hearty $6.9 billion in 2004, but of that total, $4.7 billion was plowed back into the business for capital expenditures (capex) and acquisitions. Taking $2.2 billion as our strict free cash flow (FCF), and plunking the rest of Home Depot's numbers into our handy Inside Value DCF calculator yields an unsavory result. Assuming conservative earnings growth, 10% per year for the coming five years, then 5% and a 3% terminal rate, we arrive at an intrinsic value of only $21. Bummer, shares are about $37 each.
But is it really fair to judge Home Depot this way? Another approach would be to give the firm a "free pass" on the growth-oriented capex. Essentially, we sort of pretend that the money spent on growth is as good as plain old cash -- and with a 19% return on capital, and the idea that Home Depot won't need growth capex at these levels in perpetuity, that's arguably a fair bit of valuation "cheating." (Just be aware that we are fudging things a bit here.)
To do this, we need to calculate FCF subtracting only maintenance capex. How could we come up with this fake capex? A couple of shortcuts give very similar figures. Home Depot estimates that 80% of its capex is for growth, which would leave $5.52 billion in adjusted FCF. If you simply add back depreciation and amortization -- the GAAP surrogate for capex -- you arrive at $5.58 billion. Let's use the smaller number. Using the same growth and discount rates as above, this time our DCF calculator comes up with an intrinsic value of $53 per share, or a 30% margin of safety at today's prices.
The truth, of course, is somewhere in between these two. Coincidentally, if you give Home Depot the free pass for only the new store portion of capex (about 65%), you get an intrinsic value around $43, and this is about the level that shares reached back in the more bullish days of November and December 2004. Since then, the only thing that has changed to any great degree is investor sentiment. Hmmm.
The Foolish bottom line
Unfortunately for fans of finite math and firm answers, the bottom line on Home Depot still involves some tough judgment calls. Most important from my seat is that this remains a great company with staying power and ample growth opportunities, and these days, shares suffer from what I consider to be a short-sighted public misconception. I see a safe, undervalued company and am considering taking a position as soon as the Fool's rules will allow. A cheapskate can only resist some bargains for so long.
In the meantime, if you're interested in seeing some solid value picks, or vetting your own watchlist with a smart and picky community of stock watchers, consider taking a no-obligation trial of Inside Value -- for free. It doesn't get any cheaper than that.
For related Foolishness:
- Learn the keys to finding other dirt-cheap dream stocks.
- Need to get wood? The Internet can help.
- Last quarter was good to both Lowe's and Home Depot.
Seth Jayson estimates that he'll need to make 100% on any Home Depot stock purchase if he wants to regain what he's spent there over the past few years. At the time of publication, he had positions in no firm mentioned. View his stock holdings and Fool profile here. Fool rules are here.
