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Studying Home Depot . . . Step by Step

by Amy Buttell Crane

Editor's Note: Special thanks to Amy Crane for sharing her stock study on Home Depot. We remind readers that her comments are presented, not as an investment recommendation on any of the companies mentioned, but rather as an example of how investors are using NAIC stock study tools, together with their own personal assumptions and judgments, in the process of analyzing common stocks.

When The Home Depot, Inc. (NYSE: HD) opened its first store in 1979, no one could have predicted that the store, and the home-improvement concept itself, would be a smash hit with shoppers around the country and the world.

And what a success it has been. Home Depot ended fiscal year 1999 with 930 stores in three countries and $38.4 billion in sales. Last year, the company was added to the prestigious Dow Jones Industrial Average.

In this stock study, I'll discuss what makes Home Depot a successful business and take you step by step through my Stock Selection Guide (SSG) study of the company.

Home Depot is the world's largest home improvement retailer and the third largest retailer in the United States (behind Wal-Mart and Sears). The company's goal is to become a one-stop shopping solution for home improvement customers.

Through its well-known warehouse style superstores, Home Depot delivers 40,000 to 50,000 individual products. Stores are generally over 100,000 square feet in size. At the end of 1999, the mix of products by sales was:

• building materials, lumber and millwork - 24.7 percent;
• plumbing, electrical and kitchen - 26.6 percent;
• hardware and seasonal - 28.5 percent; and
• paint, flooring and wall coverings - 20.2 percent.

Home Depot carefully manages its relationship with its vendors and is constantly reevaluating its product lines and product mixes. No one vendor accounts for more than 5 percent of total purchases and a vast majority of merchandise comes directly from the manufacturer, eliminating middlemen.

Stores offer over 40 proprietary nationally recognized brands that are sold only at Home Depot stores. In 1999, Home Depot began selling General Electric water heaters in all of its stores, and in 2000, the stores began selling a new line of Thomasville kitchen cabinets.

At the end of the second quarter, 2000, there were 928 Home Depot stores in the United States, 57 in Canada, four in Chile and two in Puerto Rico. Home Depot opened its first stores in French-speaking Canada and Argentina in August. In the next 18 months, the company plans to open three more stores in Quebec, Canada and seven more stores in Argentina.

Other Businesses

Beyond the Home Depot brand, the company operates 17 Expo Design Centers and two Villager's Hardware stores. Expo Design stores sell products and services for renovation and home design projects. Through Expo Design, store customers can complete every facet of a home redesign project including selecting products and scheduling installation.

Villager's Hardware Stores are aimed at what the company describes as "the hardware convenience customer" in a more urban area with a smaller store format. The company opened the first two stores in New Jersey in 1999, three in 2000 and will open four in 2001 in a testing-phase of this retail concept.

In addition to its three store brands, Home Depot operates the following subsidiaries:

• Apex Supply Company, a plumbing supply wholesaler;
• Maintenance Warehouse, a direct-mail marketer of maintenance, repair and operations
• products primarily serving multi-family housing and lodging facilities;
• Georgia Lighting, a specialty lighting designer; and
• National Blinds & Wallpaper, a telephone mail order service for wallpaper and custom window treatments.

Expansion Plans

Overall, Home Depot plans to increase its store base by 21 to 22 percent, according to the 1999 Annual Report. The July 14 Value Line report (see page 6) projects that Home Depot will have a total of 1,113 stores by the end of this calendar year, 1,390 stores at the end of 2001 and 2,590 between 2003 and 2005.

For a look at how this plays out graphically, see the front page of my SSG (page 23). On this front page, I plotted the number of Home Depot stores since 1991 and added Value Line's projections as well.

Since Home Depot plans to increase its sales based to a large degree on future store openings, it's important to see how the company's store numbers compare with its growth in sales, pre-tax profits and EPS. The slope of the store numbers line is somewhat flatter than sales, pre-tax profit and sales, but it is fairly consistent over time.

In the second quarter, Home Depot's sales at stores open more than a year increased at a rate of 5 to 6 percent, far below the overall rate of sales, which increased 21 percent. Much of Home Depot's growth is being fueled by new store openings.

Company Customers

The company designs its stores to appeal to three specific customer groups:

• Do-it-yourself: customers who do their own home improvement work. Home Depot provides well-trained staff to help these customers determine what they want, regular classes and how-to clinics in Home Depot stores and magazines and books written specifically for Home Depot customers.
• Buy-it-yourself: customers buy the material for home building projects themselves, but want professional installation. To meet this need, Home Depot offers design consultants and third-party contractors to perform installation services.
• Professionals: repair and remodeling contractors as well as general contractors and tradesman. The company offers specific additional services to increase sales to this group of customers.

Retail Web Site

In September, Home Depot launched the retail-selling component of its Web site. The company plans to use its Web site sales to compliment existing stores. Initially designed to serve six stores in Las Vegas, Nev., the company plans to gradually roll out this concept to seven stores in San Antonio and three in Austin, Tex. by the end of 2000.

The company offers its entire traditional inventory on the retail Web site and gives customers the option of picking up orders at a nearby store or having them delivered by United Parcel Service for a fee. These sales will be added to the sales of existing stores, eliminating any competition between stores and the Web site. And by linking existing store inventory to the Web site, the company avoids having to build a separate warehouse and maintain separate inventory for its Web site operation.

Designed to meet the needs of both do-it-yourself-customers and professionals, Home Depot describes its online stores as "a virtual orange apron." The site was also constructed to meet the needs of up to 20 million customers per day. Professional customers can both order and manage their credit accounts online.

When it is eventually rolled out in all of Home Depot's markets, the retail Web site should serve to further increase Home Depot's sales and its lead over its competitors.

The Competition

The home-improvement retailing market is fiercely competitive. Home Depot vies with national retailer Lowe's for market share, as well as with a slew of regional players.

For all this competition, the market is highly fragmented. The company itself maintains that it only has a 10 percent market share in the home-improvement retail market and aims to capture more market share in the coming years.

To see how Home Depot stacks up against Lowe's in key categories, I ran several comparisons in two of my favorite web sites, Quicken and MSN Money Central. In the SSG's tests of management quality -- pre-tax profit margins and return on shareholder's equity -- Home Depot came out on top of Lowe's and other home improvement retailers.

In comparing pre-tax profit margins, Home Depot has a 2.9 percentage advantage over Lowe's: Home Depot's most recent figures put it at 10 percent, while Lowe's comes out at 7.1 percent. These figures compare with an industry average of 8.9 percent.

For return on equity, Home Depot again edges out Lowe's. Home Depot's recent ROE figures are 18.9 percent compared with 15.2 percent for Lowe's. The industry average here is 17.6 percent.

SSG Section 1: Visual Analysis

Home Depot's EPS, pre-tax profits and sales lines trend steadily upwards since 1990. Setting trendlines with sales on top, pre-tax profit in the middle and EPS on the bottom shows us how companies move from top line growth with sales to generating pre-tax profits down to bottom line growth with EPS. Setting the price bars above the EPS line shows the relationship between Home Depot's stock price and EPS.

In the case of Home Depot, the three trendlines move fairly close together. A closer examination reveals that the earnings and pre-tax profit lines are moving at a slightly steeper incline than sales, leading us to believe that Home Depot is increasing pre-tax profit margins which is boosting the EPS growth rate.

The price bars show a jump in 1992, then a leveling out until 1996, when the share price began its move upwards to where it stands in 2000. We can see that Home Depot's stock has experienced significant price appreciation above its EPS growth rate.

This comes about as a result of price/earnings ratio (P/E) expansion. As Home Depot's earnings rose, investors became more willing to pay a higher price for the stock. We'll go into this in more detail in Section 3.

Click to enlarge.

Looking at historical growth rates, we can see that Home Depot's sales and earnings have grown at a strong rate of 28.8 for sales and 27.6 for EPS over the past 10 years. Breaking those growth rates down using Toolkit's Alt-G feature shows us the following cumulative growth rates (box above):

While sales growth has been fairly steady during the past nine years with a range of 25.1 percent to 28.8 percent, EPS has shown a marked upturn going from 26.7 percent in year seven to 40.8 percent in the most recent year.

Before setting my estimated future sales and EPS growth rates, I always look at analysts estimates. The 26 analysts covering Home Depot project a 23.9 EPS growth rate over the next five years.

Value Line analysts project a 19 percent growth rate for sales and a 21 percent growth rate for earnings between 2003 and 2005. Standard & Poor's analysts project an EPS growth rate of 23 to 25 percent over the next few years.

Click to enlarge.

I also reference the PERT-A Worksheet and Graph before setting my SSG projections. EPS, pre-tax profit and sales trends are all down over the past four quarters on a trailing 12 months basis (see box above).

The only trailing 12-month trend that's up in the PERT-A is pre-tax profit as a percentage of sales, which shows a steady upwards trend from the third quarter of 1998 at 7.7 percent to its present height at the second quarter of 2000 at 10 percent.

The PERT-A trends tell me that Home Depot's strong growth is slowing somewhat down to a more sustainable growth rate. The company is huge, with a market capitalization of $125 billion and can sustain growth rates over 25 percent a year for only so long.

Taking all of these factors into consideration, I'm going to project a sales growth rate of 20 percent and an EPS growth rate of 20 percent for the next five years. Home Depot's aggressive expansion plans in the United States and abroad will drive its growth. While same-store sales are slowing a bit, Home Depot is still generating repeat sales from customers, and is bringing in attractive new products.

The Preferred Procedure

When the trendlines are arranged properly, it's easier to see how the Preferred Procedure can help set an EPS growth rate based on sales, pre-tax profit margins, taxes, preferred stock dividends and shares outstanding. See my accompanying preferred procedure illustration below.

Click to enlarge.

Click to enlarge.

The Preferred Procedure starts with my EPS growth rate of 20 percent, which means that in five years sales are projected to grow to $95,636.1 million. This is the same number on the upper right-hand corner of the SSG at the end of the broken red trend line. Moving down the next step is to calculate the most likely pre-tax profit growth rate over the next five years. The average is 8.4 percent.

Since Home Depot has a long history of increasing its pre-tax profit margins, I'm going to choose the most recent pre-tax profit growth rate of 10 percent, achieved in the second quarter of 2000. This is just a fraction above the 9.9 percent growth rate of 1999.

Once profit margins are subtracted from sales, we're left with a figure that expresses the company's expenses, which is $86,072.5 million. Expenses include employees' salaries, monies spent to purchase products, expenses related to new store openings, etc.

The tax rate is the next step. Here, I'll rely on Value Line's projection of a 39 percent tax rate for the next five years. The tax rate subtracts $3,729 million. Home Depot has no preferred stock, and so there is no deduction here for preferred stock dividends.

This leaves us with $5,833.8 million. This is Home Depot's five-year projected sales rate after expenses and taxes. We divide this money by the company's shares outstanding to get the earnings per share or EPS rate. Dividing $5,833.8 million by 2,310 million shares gives us a projected EPS of $2.53 in five years.

The figure of 2,310 million shares comes from Value Line's projected share growth out to 2003 to 2005. That, in turn, gives us a projected EPS growth rate of 20.4 percent, just slightly above the projected sales growth rate of 20 percent.

Since 20.4 percent is just slightly above my initial projected EPS growth rate of 20 percent, I'm going to stick with my initial projection. The Preferred Procedure has confirmed that I'm on the right track with my EPS growth rate.

SSG Section 2: Evaluating Management

As we've seen in Section 1, Home Depot has steadily increased its pre-tax profit over the past five years. In Section 2 (page 24), we see the pre-tax profit expressed as a percentage of sales. The 1999 figure of 9.9 percent is well above the five-year average of 8.4 percent. Home Depot executives regularly review their purchasing contracts and seek every savings possible when negotiating with vendors. Since Home Depot has so many stores and a big brand name, it is frequently able to negotiate exclusive deals with product manufacturers and significant volume discounts. These are some of the factors that allow the company to continue increasing its profit margins.

Section 2B is the percentage earned on equity (also know as return on equity or ROE). This tells us whether management is earning a steady or increasing return on investors' money. Home Depot's 1999 return on equity is 18.2 percent, above the five-year average of 16.5 percent.

SSG Section 3: P/E History

As we saw earlier in the visual analysis, Home Depot's price has grown due to an increase in EPS and P/E expansion. The average high P/E has risen from a five-year low of 30.7 in 1996 to 69.8 in 1999. Low P/Es have expanded in tandem, rising from 21.2 in 1997 to 35.8 in 1999.

When looking at high and low prices and P/Es for retailers such as Home Depot, it is important to remember that retail businesses generally run their fiscal year from Feb. 1 to Jan. 31. Such a fiscal year allows retailers to account for the entire Christmas holiday selling season in one fiscal year, rather than over two fiscal years, as would be the case if a Jan. 1 to Dec. 31 fiscal year was used.

Since Value Line only provides calendar year prices, I went to the MSN MoneyCenter Investor Web site to get the fiscal year prices. Once I got the fiscal year prices for the last 10 years, I replaced the ones Value Line had given me in my Toolkit data screen. The P/E ratio is the price of a company's stock divided by the EPS. So, changing the high and low prices is going to change the high and low P/Es.

While I believe that Home Depot is a well-managed growth company with attractive prospects for growth over the next five years, I don't believe that investors will continue to pay such a high price for a company with declining growth rates.

Home Depot can be called a "category-killer." It has a business that other home improvement retailers can only hope to emulate. It also has a strong history of store expansion and of successful introductions of new products. I believe that Home Depot will continue to grow and command a fairly high P/E multiple -- just not P/Es in the 50s and 60s.

During 1998 and 1998, Home Depot's P/E really took off. Investors, expecting great things in the future from the company, were willing to pay higher and higher prices for the stock, expanding the P/E to new heights. So, I'm going to knock out the high and low P/Es for 1999 and 1998 as outliers and use the averages of the 1995, 1996 and 1997 P/Es as a basis for projecting future share price.

This gives me an average high P/E of 33.9 and an average low P/E of 22.3. The back of my SSG doesn't show my outliers. If I had left the outliers in, this would have affected the relative value and projected relative value calculations in Section 4.

Projecting future P/Es and future high and low prices can be somewhat of a shot in the dark. To double-check my average high and low P/Es, I'll take a look at Value Line's future P/E projections. On the far right-hand side of the Value Line sheet, Value Line lists projections out to 2003 to 2005 for all the data items given, including the average annual P/E ratio.

In the commentary on the July 14 Home Depot sheet, analyst Carrie Galeotafiore notes that she expects the market to accord Home Depot a lower P/E ratio in future years. In the projections, Value Line estimates that Home Depot's P/E during the period 2003 to 2005 will be 28.

When I average my future high P/E of 33.9 with the future low P.E of 22.3, I get a five-year average future P/E of 28.1, which is just a fraction higher than what Value Line projects for the company's future P/E.

SSG Section 4: Evaluating Risk and Reward

Using the average high P/E of 33.9 times my five-year EPS of 2.49 gives a forecast high price of 84.4. For the forecast low price, my average low P/E of 22.3 times the trailing 12 months earnings -- shown in black type under the Current P/E ratio in Section 3 (9) -- is 25.2.

These numbers gives me price ranges of:

Buy: 25.2 to 40

Hold: 40 to 69.6

Sell: 69.9 to 84.4

The price on Sept. 27 of 52.25 is in the hold zone. When I started working on this study two weeks earlier, the price briefly touched 48, which is lower, but still in the hold zone. This shows how volatile stock prices can be over the short term.

The upside/downside ratio is 1.2 to 1 and the current relative value of 128 percent confirms that Home Depot does not look like a buy at this price. Given the strong quality of the company and the prospects for future growth, it is worthy of being placed on a watch list for consideration should the price decline into the buy range.

Section 5: Five-Year Potential

In Section 5, the SSG gives us the compound annual return we can expect from an investment in Home Depot at the current price of 52.25. As expected from the upside/ downside ratio and relative value, the compound annual return of 10.4 percent comes in below the NAIC standard of 15 percent a year.

A Final Note

I believe Home Depot is a strong company that is well positioned for further growth. As a current shareholder, I continue to watch the company's share price closely for temporary declines when I might be able to pick up more shares at a better price.

I've also taken advantage of Home Depot's direct purchase plan, which allows shareholders to purchase an initial stake in Home Depot directly from the company. Although the plan does have some fees, it is a convenient and fairly easy way to purchase small amounts of Home Depot stock regularly.

So that's my analysis of Home Depot. The resources I used in my study are shown in the accompanying chart (see bottom of page 7).

Use these as well as your favorite research sites to do your own analysis of Home Depot to see whether or not it might make a good candidate for your portfolio in the future.

Click to enlarge.

Click to enlarge.

Amy Buttell Crane, a free-lance writer based in Erie, Pa., writes about mutual funds for BetterInvesting Magazine Amy is the author of the second edition of BetterInvesting's Mutual Fund Handbook. She also has taught stock and fund investing classes.