DECEMBER 2002

Home (Depot) For The Holidays -- Session #2

Stock Studies & Case Studies

by Mark Robertson, Senior Contributing Editor

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).

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.

Session #1 focused on the finding the facts and developed a sales growth forecast. This session 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.

The Rest of the Visual Story

So we've settled on a top-line (sales) forecast of 14 percent, until Nancy Isaacs finishes twisting my arm. It's time to turn our attention to generating an earnings per share (EPS) forecast for Home Depot's next five years.

I generally rely fairly heavily on preparing an Expected Income Statement (also known as the Preferred Procedure) for making a 5-year EPS estimate. Very similar to collecting opinions while building the sales forecast, I like to check a few opinions along the way.

A first opinion that's fairly easy to generate using our Value Line company report is to take that 4-year EPS forecast and plot it on the SSG, very much in the same manner that we checked the sales forecast in Session #1. The excerpts (EPS annual figures) are plotted in the accompanying graphic -- including that 3-5 year EPS estimate for 2006.

We find that the EPS growth rate for the last five years has been 20.2 percent and that using the Value Line analyst forecast, the EPS growth rate would be approximately 19.0 percent. With a sales growth rate of 14-16 percent, I need a pretty good reason to jump to 19 percent. Time for some other opinions...

A quick visit, for a second opinion, to Quicken's Analyst Ratings for Home Depot displays a 17.1 percent long-term EPS growth rate forecast. (Scroll down to the bottom of the page to see company, industry and market figures.)

So $3.74 for earnings at year-end 2007 (a 19 percent EPS growth rate) seems a little strong. We'll see what happens when we take a closer look with our Expected Income Statement tomorrow. For now, we've still got "railroad tracks." NAIC investors like it when the sales and earnings trend lines look like railroad tracks, starting at the lower left and proceeding "northeast" in consistent fashion. The tracks are a little bent during the last couple of years, but no derailment seems imminent so far.

Meting and Meeting Management

Mete them. Then "meet" them.

Our SSG contains a management report card that seeks railroad tracks and then presses on to measure two efficiency parameters: pretax return-on-sales (Section 2A) and return-on-equity (ROE, Section 2B). To mete something is to measure it. If it's important, it can be measured. The common denominator is obviously the word, "return." Return refers to profits that an enterprise enjoys after paying all of the bills. Value Line provides the bottom line as: Net Profit ($millions), Net Profit Margin (%) and the ultimate bottom line, earnings per share (EPS).

Pretax return-on-sales is derived from Net Profit Margin by restoring the taxes and permitting a look at profitability before taxes. The math is a little tangled. Think of it as starting at the bottom line and adding back the taxes. The one step calculation is (%Net Margin)/(1-%Tax Rate) = % PreTax Profit. For 2002, the numbers are (0.061)/(1-0.376) = 0.098 = 9.8%. Return-on-Equity (ROE) is calculated by dividing EPS by book value. The historical data and Section 2 results are shown in the accompanying graphics.

Check The Trends And Industry Comparisons

Both of these figures, Net Margin (%) and ROE, are industry-specific. I think it's important to note both the general trends -- which we like to be stable, increasing, or superior to their peers -- and also compare directly versus a peer group. In this case, Lowe's is obviously a necessary comparison.

Home Depot compares very favorably to all of the industry group companies shown in the table. Even if there is some deterioration as competition heats up, it would seem that Home Depot has an advantage should price-cutting materialize. It is during recessions and price wars that the weaker players in a field like this suffer the most. NAIC investors generally want the stronger companies -- leaders in their fields -- for this reason.

Check the trends in Section 2 and check the relative profitability positions within industries as we mete management efficiency in our search for promising leaders.

Who's Steering The Boat?

We probably don't check the helm enough. NAIC cofounder George Nicholson Jr., CFA, always encouraged us to check the biological aspects of management. For more on this subject, turn to: Hints on Recognizing Memorable Management.

On page 8 of the 2002 Proxy Statement (PDF), we find that Robert Nardelli joined Home Depot in 2000 as president and CEO and has assumed the role of chairman during January 2002. Mr. Nardelli was one of Jack Welch's "lieutenants" at General Electric prior to that. Use the proxy statement and letter to the shareholders to get a feel for who's navigating the choppy waters.

Continue to Session #3 - Building A Projected Annual Return

Return to Session #1 - Building A Sales Growth Forecast

Jump to Session #4 - Calculating Quality and Conclusions

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.