Inside Wall Street: Home Depot is a home run

The world's largest do-it-yourself retailer puts profitability before growth.

By Gene Marcial Oct 9, 2012 10:59AM

Bathroom remodel copyright Digital Vision, PhotolibraryShares of Home Depot (HD), which have been climbing steadily since mid-2009 despite the housing debacle and recession, have wobbled in recent days.


After closing Friday at a new 52-week high of $63.20 a share, the stock slipped to close at $61 Monday and remained under pressure Tuesday.

 

Time to worry? Not at all, although some investors who are getting edgy over the stock's persistent advance think a pushback is overdue.


One of the worriers is Michael Souers, an analyst at S&P Capital IQ, who rates Home Depot a "sell." But he's the only one among 31 major analysts tracking Home Depot who recommends selling the stock. Eighteen of the other analysts rate it a "buy," and 12 recommend a "hold."

 

Home Depot's shares have rallied "on the heels of improving housing data, but we think they are overvalued" at more than 18 times estimated earnings of $3.33 a share for fiscal 2014, according to Souers. He says that is a significant premium to the price-to-earnings ratio of both the S&P 500 and Home Depot's key peer, Lowes (LOW). Souers expects the company's sales to fall short of consensus forecasts in the October quarter.

 

On the other hand, the bulls appear more convinced that the stock is nowhere near overvalued, and believe it has become even more undervalued. Alan M. Rifkin, analyst at Barclays Capital, raised his price target to $70 a share on Oct. 8, 2012, from $60 on Sept. 14, 2012, according to Bloomberg. "Our upside scenario assumes either acceleration in the housing market or further acceleration in same-store sales trends," says Rifkin. He rates the stock as "overweight" because Home Depot has "significantly improved" shareholder returns and achieved more stable earnings growth.

 

As an example of its regard for shareholders, Home Depot in September announced the shutdown of its remaining big-box stores in China. Such a move is unusual among U.S. companies, most of which would like nothing better than to do business in the populous country, but it didn't surprise Wall Street. This "highlights Home Depot's strong focus on returns as, by our estimates, the big-box stores weren't profitable," argues Rifkin.

 

The company doesn't plan to exit or abandon the China market, but will seek "profitable formats" in the country and continue to operate its sourcing offices in Shanghai and Shenzen. It recognizes that China is too big to ignore. Closing the big-box stores simply suggests, says Rifkin, that Home Depot isn't willing to sacrifice returns for "unprofitable growth."

 

"Home Depot isn't only the world's largest home-improvement retailer, but also the world's most profitable home-improvement retailer," notes Matthew J. Fassler of Goldman Sachs, which hosted a teleconference for Home Depot at Goldman's Global Retailing Conference in September. Home Depot has been a "terrific story on many twists and turns over the years," says Fassler, and on the whole, the company has been "on an exceptionally good run" over the past several years.

 

He credits Home Depot's continued success to efforts to reinvent itself and "grow in many interesting and unconventional ways." Outwardly, he says Home Depot is a company that looks like what it has always been. But inwardly, it really has been reinventing itself in ways that were quite constructive -- and have yielded very strong returns," says Fassler.

 

Home Depot continues to provide a hefty dividend yield of 2%. It operates a chain of more than 2,200 retail warehouse-type stores in the U.S., Canada, Mexico, and China, selling a wide array of home-improvement products for the do-it-yourself and professional customers, as well as for the home-remodeling markets.

 

Peter S. Benedict, analyst at Robert W. Baird, is confident that Home Depot is a sound long-term investment: It has slashed new-store growth, exited non-core businesses, and refocused on improving the productivity of its core "orange-box" stores. That has enabled the company to maintain strong underlying fundamentals, he says, generating positive same-store comparisons in nine of the past 10 quarters -- despite the severely depressed housing market.

 

Home Depot's emphasis on investing in customer services, merchandising, processes/tools, information technology and supply chain have positioned it towards gaining market share, expanding margins and "returning significant cash to shareholders even absent a robust recovery in the housing market," says the analyst.

 

"We expect trends to remain in positive territory," says Benedict, "as core maintenance/repair categories and small-ticket do-it-yourself projects continue to fare well." And another piece of positive news for investors: Home Depot has the resources to return significant cash to shareholders. Benedict figures cumulative free cash flow through fiscal 2015 will total $26.5 billion. Assuming a 50% dividend payout ratio and no additional debt, dividends and buybacks will equate roughly to one-third of today's market cap of $88.15 billion. That, indeed, is a compelling shareholder-return profile.  


Gene Marcial wrote the column "Inside Wall Street" for Business Week for 28 years and now writes for MSN Money's Top Stocks. He also wrote the book "Seven Commandments of Stock Investing," published by FT Press.

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