Do I understand the business?
Home Depot is the largest US home improvement retailer. HD operates big-box stores and has an impressive online format as well. The company has rights to exclusive brands and also sells tools and other goods using the umbrella term “house brands”. The company also operated in Canada and Mexico along with small ownership stakes in other DIY companies internationally.
Does the company have a sustainable competitive advantage?
For the most part, it is not all that easy to buy a refrigeration on Amazon or get the best price at a local appliance store. Scale and focus has helped this company overcome those obstacles. While there is competition in Lowe’s and others, Home Depot, at least from a quick channel check of local stores, seems to being doing it the best. The CEO himself says that the culture and values of the business are its competitive advantage.
Is the company run by exceptional Management?
Serving as CEO and President of Home Depot since 2014 is Craig Menear. Minear has been with the firm since 1997, previously overseeing merchandising and the supply chain as an Executive Vice President and Senior Vice President. Prior to that he held positions at IKEA and Home Emporium. It is clear that he has a holistic understanding of the home improvement business.
The CFO, Carol Tome, has been with Home Depot since 1995. Heading up the real estate and business development duties as well as the day to day CFO grind, Carol has received many accolades. In 2012 she was ranked by The Wall Street Journal as the #2 CFO in the country.
Next in line is Ann-Marie Campbell. Working as a cashier in 1985 she has worked her way to EVP of US Stores. One would have to assume her longevity gives her unique insight into the changes the business has faced and may be useful in sizing up those that lie ahead.
Is there positive insider ownership?
According to GuruFocus, HD has insider ownership of 2.7%. This is quite high compared to Lowe’s at 0.38%. To put this in perspective, AAPL id 0.19% and WMT is 1.2%. Side note: while various websites show the disposition of shares by officers, it seems as though it has to do with option executions tied to salary.
Does the Company have significant Market Share?
Home Depot reported sales of $95 Billion for the fiscal year ended 1/29/17. Lowe’s was closer to $65 Billion for the same period, according to MarketWatch. As the leader in the space, HD indeed has significant market share.
Is the Graham Ratio acceptable?
Why use the Graham Ratio? In the current environment share buybacks are occuring widely and constantly. A share buyback increases Earnings per share which lowers the P/E Ratio. Concurrently, the retirement of shares lowers the book value per share. Ths inflates the P/B ratio. By multiplying the P/E by the P/B, some of this noise is eliminated and washes out.
Home Depot has been buying back shares at a healthy clip, accoring to GuruFocus. This may be a reason it has a P/B of 89 while Lowe’s sports a 15x. At any rate, HD is not cheap.
It carries a Graham Ratio of 7 times its largest competitor. Share buybacks or not, this is unacceptable.
Even though it looks like management bought back 50% of the outstanding stock (1,184,000,000/1,167,000,000), this is an enormous, albeit distorted, ratio.
Is their EV / EBITDA acceptable?
This is more along the lines of believable- HD is slightly more expensive than LOW at 15x vs. 12.5x. This is known by some as the Acquirer’s Multiple because it views the company’s valuation from the point of view of a private investor. Cash is used to pay off debt and with that, you are left the Value of the Enterprise. Next, slide a proxy for operating earnings, Earnings before interest, taxes, depreciation, and amortization, below it to create a valuation multiple.
Is the Return on Invested Capital acceptable?
Based on quarterly data that is annualized, HD proved to return 38% on it’s invested capital for the period ended in October. To continue this relative analysis of behemoths, LOW returned 19%.
What is the trend in their 5-year earning growth?
According to Nasdaq, HD presents a 5 year EPS growth rate of 15%. This could be elevated by the large volume of share buybacks the company has taken part in, as referenced above. LOW edges out the industry leader, negligibly, at 16%.
Is their price to Free Cash Flow acceptable?
With gurufocus carrying the weight of this checklist, they share with us a reading of roughly 24. In the spirit of competitive judgement, LOW wins the prize for value to free cash generation at 19.
Is their Debt / Equity Acceptable?
No company ever went bankrupt without having debt. This measure is to help understand if a business is gearing itself to the point of becoming overextended. Debt to equity for LOW is 2.8. Home Depot is rolling the dice at 10x. Could the buy-backs be financed through long-term debt? If so, this isn’t exactly an opportune valuation for management to be engaging in this activity, one would think.
To reiterate a tired point, the buy back activity pushes down the book value of equity, so the next measure may prove more important.
Is their interest coverage ratio acceptable?
Despite the high level of debt compared to it’s possible heir apparent of market share, Home Depot covers it’s interest payments 14 times over. LOW can only say that for 10 times.
The last two indicators, taken in concert, provide a neutral outlook for HD’s balance sheet strength.
Is their Quick Ratio acceptable?
The measure that shows a businesses ability to meet short-term obligations makes HD shine in a relative sense, but not necessarily in an absolute one. HD would be in a crunch if cash flow was interrupted at a ratio of 0.39 while LOW is struggling with a quick ratio of 0.12.
What is the trend of the Days Sales Outstanding?
Although it has only ranged from about 5 to about 7, DSO has been climbing from 2009 at a steady and reliable rate upwards. This does not bode well for the firm. LOW has no A/R. On HD’s balance sheet A/R consists of 5% of it’s assets. while it is only 3% of WMT’s.
What is the trend of the Days Payable Outstanding?
According to Morningstar, the flow of payable period has been on a downtrend besides the trailing twelve months. This last year is better than any ratio since 2008, which is a saving grace. LOW has a much longer amount of time to pay, so this is a negative.
Is there short-term negative sentiment?
With the new Tax Plan in place, Home Depot decided to give all of its employees a bonus. If anything, this is quite positive sentiment. This, along with a nice increase in the going price for a share has made it especially difficult to find an entry- if one were to be interested.
Are there significant barriers to entry?
An online presence has helped keep silicon valley competitors out of the household durable good market for the time being. Augmented reality, with the ability to virtually place an image of a refrigerator or set of cabinets through the screen of a smartphone and into your kitchen, may press the firm if it does not chose to keep up in this venue. Otherwise, the supply chain that Home Depot has strengthened over years should keep physical retail entrants at bay.
Are there high switching costs?
There are not high switching costs. Without a membership fee, a consumer can drive on over to Lowe’s or swipe their smartphone to price a good somewhere else. When this is the case a strong brand, experience and reputation are all that is keeping a customer there.
Is there significant brand loyalty?
This is highly subjective so it should be left as in-line.
Do non-recurring items recur?
According to Nasdaq, there were no non-recurring items for the last few years. This bodes well for the quality of earnings.
In sum, HD has pros and cons that balance each other out. Whether this will mean under-performance, out-performance or market-performance we can not speculate. What is important is that a good deal of bases are covered before the trigger is pulled for purchase or sale. We know that the company is not very cheap, but that buybacks may be influencing this. We know that the company has well-regarded management who produce a higher than average ROIC but carry higher than average debt.
In the end, if a decision is to be made, we know what we are in for. Home Depot is a market leading home improvement retailer that does a number things well but may be at risk during the cyclical downturn that recurs in business.