DECEMBER 2002
Home (Depot) For The Holidays
Stock Studies & Case Studies
by Mark Robertson, Senior Contributing Editor
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Home Depot (NYSE:HD) is ranked #5 in the Better Investing Top 100 for 2001. The company has also been at the top of the NAIC Most Active leader board since mid-2002. Home Depot was featured as the Undervalued Stock in the December 2002 issue of Better Investing. Participants are encouraged to read (or re-read) the undervalued feature. We may use this summary of the company as the study progresses. It sure seems like a fitting time to head Home (Depot) for the Holidays and complete a Stock Selection Guide (SSG).
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Over the next few days, we'll take a look at Home Depot and complete an SSG. If you're just getting started and want to better understand the important influences on a Stock Selection Guide, I'll try to help. I'll share some of my favorite sources for research and apply them to development of the stock study. Normally, I'd start with an assessment of quality and a cursory look at Projected Annual Return (PAR), but we're going to save that for last in this case. The company's position in both the Top 100 and NAIC Most Active charts suggests that scores of NAIC investors have regarded Home Depot as a quality company with promising expected returns.
Questions? Ask them on I-Club-List. If you're a little bashful and still have a question, send an email to markr@better-investing.org.
This session will focus on the finding the facts and developing a sales growth forecast. Session #2 will complete the Visual Analysis and Management Evaluation. Session #3 will develop a Projected Annual Return forecast for the company. We'll wrap things up with Session #4, demonstrating the calculation of a quality rating for Home Depot and taking a closer look at judgments made and the results.
Show Me The Data!
The last several issues of Better Investing have included the Value Line company report for the Stock to Study feature. Clubs can use the company report to complete their stock studies and compare results. It can be a very effective learning opportunity. But Home Depot was the Undervalued Feature and we don't have the Value Line page to lean on for this study. Or do we?
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Value Line is an outstanding source of SSG data for companies. So is our Online Premium Services. For purposes of this study, we'd like to lean on a resource that everybody has at their fingertips. Go to www.valueline.com and click on the Dow 30 button shown here. The address is one that many of us will add to our favorites list: www.valueline.com/dow30/index.cfm. A number of the NAIC most widely held companies are among the Dow 30, including Home Depot. Click on the PDF icon to download the Home Depot report. You may wish to print a copy to use to follow along.
The Straw That Stirs - Our Sales Growth Forecast
There are three major milestones (decision points) that we encounter during the preparation of an SSG. The first is building a reasonable expectation for expected sales growth. (The other two are expected profitability and price-to-earnings ratios, and we'll cover them later.)
We form our expectations for future sales growth based first on a look at the historical track record. Essentially we're looking at where the company has "been" and try to form some notions about where they seem to be headed.
The sales history is taken from the historical data and plotted as shown below:
Normally, I'd plot the sales history a little higher up on the page, but in this case I wanted the plot to be close to the growth lines for purposes of illustration and discussion. Note that the SSG software has calculated the historical sales growth rate to be 23.5 percent. This is done using what's known as a "best fit" or regression that seeks the "best line" through the data points. The slope of the historical trend, through this best line is 23.5 percent. The diagonal lines running from the lower left and labelled "5%", "10%", etc. are the growth lines. In the case of Home Depot, we note that the historical trend line plots between the 20% and 25% growth lines.
There's at least three things we need to talk about here.
First, a growth rate greater than 20 percent (particularly for a large company) is something that is quite rare. The fact that the historical growth rate exceeds 20 percent should prompt us to be extra careful with our projection going forward. In the words of Benjamin Graham: "Of primary importance, we suggest that the growth rate assumed, except in the most extraordinary circumstances, should not exceed 20 percent."
Second, Home Depot is a retailer and growth is a function of how many stores are in operation. If new store locations aren't being launched to increase sales, then the only way to increase sales is to sell more stuff. We can review comparisons of revenue growth rates to same store sales growth rates here: www.retailforward.com/freecontent/perf_sales.asp. Note the drop off between the two rates. Unfortunately, Home Depot isn't among the chosen for this list, but the tendency is fairly clear. For example, Walgreen shows a 12.1 percent sales growth rate, but only 7.0 percent for existing stores. In other words, as soon as there's a Walgreen store on every corner, the growth rate probably slows to something closer to 7.0 percent or so.
This prompts the question, "So how many stores have they built? And how many stores does the Value Line analyst think they're going to build over the next few years?" The answer is shown in the following graphic.
Home Depot has been adding stores at a fairly healthy rate. The number of stores increased at annual rate of 19.7 percent from 1997 through 2002. With a forecasted number of stores of 2300 in 2006 (the 3-5 year forecast), the analyst expects store growth to slow to 10-11 percent annually. This should influence our sales growth forecast.
The third point is that if you squint at the sales historical trend, we see that it's trailing off in recent years. Some have referred to this condition as "the bends" and the symptoms for companies can be an awfully lot like the deep sea diver that surges to the surface. Those nitrogen bubbles in the blood stream aren't the start of a holiday party. When sales growth slows appreciably, P/E ratios contract and a stock can fall out of favor on Wall Street. The institutional herd is unforgiving even when there's nothing to forgive. A slowing of growth is natural as companies grow but investors and gurus can rarely seem to remember this. I believe that the Home Depot stock price chart is exhibiting this effect at this time.
Getting By With a Little Help From Our Friends
It's time to start forming a sales growth forecast for Home Depot.
We have some special help, from a recent exercise in sharing and comparing on I-Club-List. A group of NAIC practitioners posted their completed SSGs on Home Depot. The results were shared by the article, Homogenizing Home Depot. A quick trip to that article provides the first opinion that we'll notice. Fifteen people studied Home Depot and forecasted a consensus sales growth rate of 14.4 percent. The lowest sales growth expectation was 5.0 percent and the highest was 20 percent. Most of the sales growth forecasts were grouped closer to 14-16 percent. This should influence our thoughts as we make our own selection.
The second opinion that I like to check is the Value Line analyst's forecast. I'm not talking about the Annual Rates box on the lower left. I mean the four-year forecast (3-5 years in Value Line lingo) that's shown in the column on the far right of the company report page. Refer to the following figure. Note that I've removed the "early years" from the Home Depot history in order to focus on the more recent past. The sales forecast trend line has been drawn "through" the Value Line analyst's forecast for 2006.
Note that by removing the "ancient history" the historical sales growth rate drops to 19.0 percent. Drawing the forecast line through 114,000 (Don't get carried away with this, rough it!) in sales for 2006 provides a sales growth forecast of 16.8 percent. This is one person's opinion (the Value Line analyst) and should be used to influence our judgment.
To me, it's helpful to review expected sales growth rates for industry peers as I form my forecast. We've been maintaining a industry comparison chart at Industry Fundamentals. Scroll down to the industry group, Home Improvement Retail. Here we can make comparisons to Lowe's and Sherwin-Williams, among others.
A Sales Forecast Decision
Fourteen people chose 15.1 percent. The Value Line analyst has an expected sales growth forecast of 16.8 percent.
The average sales growth forecast for the industry is 16.3 percent. That's a healthy growth rate. One participant, the fifteenth chose 5.0 percent, and the overall average for the group is reduced to 14.4 percent. As a Home Depot shareholder, our family club hopes he's wrong. We hope the 20 percent forecast (the high of the group) comes true.
One of the things I've noticed over the years is that small differences at this point in the game actually make large differences in Projected Annual Returns. What's always bothered me is that it's difficult to see a difference on the SSG between 14 and 15 percent for future sales growth.
At this point, I'd choose 14 percent for my expected sales growth for Home Depot.
Session #1 - Questions and Answers
Nancy Isaacs: Fabulous idea, Mark. I just want to be sure I'm understanding the procedure. Do we read the posts at the NAIC Web Site with followup discussion on I-Club-List?
Mark: Sure. Ask away. I'm also thinking we could use the NAIC Forum conference room for a Q&A session next Monday night for anybody that's interested.
For those of you unfamiliar with I-Club-List, it is an email-based discussion list populated by scores of NAIC practitioners. Click on "Community" at the NAIC Web Site and then click on "I-Club-List" on the right sidebar. You may want to select "no mail: receive no mail from this list" under your settings unless you want to receive 50-100 emails per day.
Nancy: Here's the Toolkit historical growth chart for sales and new store growth for Home Depot and Lowe's. Based on this, your 14 percent sales growth projection seems reasonable. But look at the new store growth for Lowe's.
I notice that the sales growth for each is declining a bit but that Lowe's growth rate is higher. And with regard to new store sales, Lowe's is showing an increasing trend compared to HD's declining trend. Where I live, Lowe's are popping up all over the place. Not only will they provide competition for sales, but I'm wondering if there will be stiff competition for trained employees. I guess I'm concerned that the HD growth rate may decline somewhat faster than historically due to the fierce competition. In other words, I think it's more than the law of large numbers in this case.
I wonder if the 14 percent is a bit aggressive. I'd be more comfortable with 13 percent. What do you think?
Mark: I think you're very thorough. (Grin) I was actually gonna cover this in Session #4, but since you asked, let's do it now.
I agree, the competitive field is intensifying and Lowe's is showing no signs of backing off. I do believe that the impact of a "bloodbath" will deliver more impact on the profitability side of things. Potential future price cuts and the wage wars that you cite make it hard to justify the increased net margins forecasted by the Value Line analyst. I do believe that the drivers and dynamics of continuous home improvement are pretty much in place. Our residence continually sends us to either Home Depot or Lowe's just to maintain shelter. Maslow, are you listening? I'm still comfortable with 14 percent, vs. the 16.8 percent from the Value Line analyst, 19.0 percent from the SSG historical trend and yes -- the fact that a decrease in sales growth is natural doesn't make it any easier to buy this company. As I said, our club did buy it, and we'll continue to monitor the Value Line sales forecast rather diligently. The historical sales growth forecast vs. actual was part of Homogenizing Home Depot. The accompanying graphic shows this characteristic for the last few years. To answer your question, we always revisit the "14 percent" figure every three months. When Carrie (the Value Line analyst) drops below 16.8 percent, we'll probably reduce our sales growth expectation below 14 percent in our portfolio management dashboard.
Jim Thomas: I believe Nancy's sales growth numbers for Lowe's are through the fiscal year ending 2001. All the other numbers shown (new store growth for LOW and both sales and store growth for HD) are through fiscal year ending 2002. When I adjust the number's to include Value Line's FY 2002 sales estimates for Lowe's, its sales growth numbers are even higher than Nancy has shown.
Dan Hess: Mark has already responded to Nancy's post, and I have difficulty disagreeing with 14 percent sales growth, since that is what I have on my SSG, but that will not stop me from commenting. (Grin)
"The 14 percent projection seems reasonable." Well, maybe. Nancy's sales chart shows me two key things: (1) New store expansion is slowing percentage-wise. (2) Percent sales growth only slightly exceeds new store growth, i.e. same-store sales are low in the 1 percent range.
Home Depot has indicated a 20 percent increase in new stores this year while Value Line shows an average increase of 11.5 percent over the last 5 years. Thus, if Home Depot is not able to improve the sales growth [at existing stores] this suggests that growth could slow to the 12 percent range over the next 5 years.
It seems to me that we need to project some improvement in efficiency [sales/sq-ft] over the next 5 years in order to achieve the 14 percent growth. I consider the Bob Nardelli actions in this area critical to achieve this and I include this [expectation] in my 14 percent projection. However, I do believe that about 2 percent of this is at risk.
Regarding the impact of Lowe's and the increasing competition: Nancy has some valid points. But let me offer the following:
- HD has better margins and ratios than Lowe's for most every category except growth. Lowe's still has a lot of improvements to make to catch up to HD.
- In 2001, the average HD store sales were $40.2 million while Lowe's were $29.7 million. While same-store sales are growing faster than HD, they still have to grow another 25 percent or so to catch up. In essence, Lowe's is having to improve to the HD standards in this area.
- Lowe's has 733 stores in 2001 versus 1333 for HD. This means Lowe's has more room to expand geographically as HD may face saturation in some areas. HD seems to be recognizing this and working to expand into areas like their urban stores, contractor focus, expansion into flooring, Expo stores, appliance expansion, improved distribution and international expansion, etc.
I would also be more comfortable at 13 percent, however, I plan to stick to 14 percent. (Grin) At least I can blame Mark if this does not happen. (Big Grin)
Mark: I'll stop at Home Depot on my way home from work tonight. Surely we need yet another string of those @#$?@# Christmas lights! Rest easy, Mr. Hess. I'm doing my part to boost HD sales.
Dan: I do agree with Mark that the competition from Lowe's will have more effect on margins. I should add I view both as well-run companies, and have bought shares of both as their prices have fluctuated up and down over the past several years. For a while, Lowe's provided a better return and now HD seems to be more likely [undervalued.]
Mark: We can now call him, Noah Hess. (Very Big Grin)
Tami DeAngelis: I just gave the "heads up" about this wonderful idea with our entire chapter email list. I sincerely hope you have some comments from Tulsa, Oklahoma and perhaps some participants on Monday night. Count me in.
Mark: Thanks, Tami. Would you like me to send some snow to Tulsa to get the troops in the full holiday spirit? (Grin) Good to hear from you.
Jim Bond: ... Look at VL's estimates: They missed the 3rd Q Sales by overestimating by $515 million. Yahoo shows the 4Q average estimate of 5 analysts is for $13.6 billion in sales. VL's estimate for 4th Q sales is $15.65 billion, a mere $2 billion discrepancy with 5 Yahoo analysts. The high estimate for the Yahoo analysts is $14 billion in sales. If I'm estimating HD's 2002 I would not use VL numbers.
Mark: Nice catch, Jim. Perhaps Carrie and Home Depot have a hotline to the North Pole and Santa intends to bring an extra $2 billion their way in December? (Grin) But you're right, when the 3Q results and if the 4Q numbers fall short of what's shown here, we won't have to squint to see the "bends" any longer.
Diane Graese: Having just done a study on these two (and purchased HD shares) here's another set of interesting numbers. The growth percentages mask what I find so interesting in the plain numbers. Lowe's actually started with more stores than Home Depot. And their biggest growth came from buying Eagle [Hardware]. It is very clear that Lowe's could double just by opening up next to every Home Depot (although I personally don't think they have the cash flow/debt capacity to do so.) If you have trouble visualizing Home Depot expansion, compare their number of stores to Wal-Mart (PDF). You will see there are plenty of locations where Home Depot doesn't exist. I believe Home Depot has watched Wal-Mart make mistakes in foreign locations and will be all the wiser for having watched and waited.
Dan Hess: An interesting set of numbers, Diane. But sometimes a store is not a store. (Grin) In 1992, Lowe's broke down their stores by sq-ft calling them small (8810 SqFt), medium (23980 Sq Ft) and large (72110 Sq Ft). In 1992 the small stores contributed 23% of sales, medium stores 37% of sales and large stores 40% of sales. This sort of shows the Lowe's transition from the small contractor yards they used to have to the equivalent of the big orange boxes of today. HD did not start with small contractor yards and even though I do not have 1992 numbers for them, I suspect they started with much larger stores. Thus the store count comparison of 214 to 303 may be somewhat misleading. Perhaps a total square footage may be more appropriate. In 1992, Lowe's had total store square footage of 14.2M. This was an average of 46800 per store. By 2002 the average store had grown to 108,000... with new stores now about 121,000 sq-ft for a total of 93.6M sq-ft. Thus the square footage growth from 1992 to 2002 was 559% while store growth was 186%. Thus I would suggest Lowe's really is growing faster than HD even though HD is opening more stores every year than Lowe's.
I do not have the numbers for the Eagle acquisition, but I wonder if their biggest growth in store square footage was due to the Eagle acquisition. Somehow I sort of recall Eagle had smaller stores with Lowe's mainly acquiring them to get a footprint in a new geographic area.
I agree with this since HD clearly has a much stronger balance sheet as well as cash flow. I view the Lowe's expansion encompassing sales growth but also improving their margins which are still inferior to those of HD. I also believe they are trying to "copy" Wal-Mart's success. ...they are trying to broaden their business... in much the same way Wal-Mart continued to grow after their geographic expansion approached saturation into area like grocers.
Continue to Session #2 - Visual Analysis (EPS) and Management Evaluation
Jump to Session #3 - Building A Projected Annual Return
Jump to Session #4 - Wrapping It Up, Risking Sensitivity
This presentation is not intended as an investment recommendation on any company mentioned herein, but rather to serve as an example of how investors are using NAIC stock study methods. Neither NAIC nor the presenter of this material make recommendations with respect to the purchase or sale of securities. You are urged to make your own decisions based on your own investigations and analysis.