DECEMBER 2002

Home (Depot) For The Holidays -- Session #4

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 last few days, we've taken a look at Home Depot and worked to 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. Session #2 completed the Visual Analysis and Management Evaluation. Session #3 developed a Projected Annual Return forecast for the company. We'll wrap things up during this session, demonstrating the calculation of a quality rating for Home Depot and taking a closer look at judgments made and the results.

Wrapping It Up, Risking Sensitivity

We've covered the Kahuna stuff: The 14 percent straw that's stirring this enterprise and the leadership 6 percent net margin expectation. The company merits respect and we've assigned (at least so far,) an expected P/E ratio (28.5x) that reflects considerable respect and expectation. This all adds up to a projected annual return of approximately 26 percent. (The Kahuna milestones are shown in bold in the accompanying figure. These are the judgments that you really want to get your arms around while completing a company study.) When a quality company generates that kind of expected return, it doesn't take much imagination to figure out why Home Depot has been near the top of the NAIC Most Active Leader Board for several months.

As I was gingerly relocating an ornament this morning to the top of the tree, the second light string from the top decided to antagonize me. You guessed it. But before I return to Home Depot for yet another string of Christmas lights, we've some housekeeping to do. Section 4 is unfinished, and we don't yet have any risk to compare our 26.2 percent reward to. There are a couple of other items, including measuring the excellence of this company by meting out a Quality Rating.

And then we're gonna get sensitive. It's the season, right?

Reiterating Risk, Redefining Risk?

What's a reasonable short-term downside expectation for the stock price? For purposes of calculating our upside-downside ratio (reward-to-risk ratio), we'll check the high and low P/E ratios that we derived yesterday. They're shown in the accompanying image.

The optimistic upside price is (37.5x)($3.00) = $112.50.

My intrepretation of the low price is "the price that could happen tomorrow morning if..." I think that's what George Nicholson intended. For a growth company like Home Depot, this will most commonly be produced by the minimum low P/E for the last 5-10 years when used in Section 4B(a). In this case, we'd use (15.6x)($1.56)= $24.30. We notice that this is within "biting distance" of the current price, $27.

This means either (1) A Wall Street tantrum is in progress, or (2) There's been a breach of expectation in some way, or (3) The AWOL CFO has been sighted leaving really, really big tips and sipping umbrella drinks while working on his tan at the Riviera. In this case, I vote for the Tantrum of the Lemmings. Yes, this behavior resembles a holiday riverdance. The analysts have been told that growth will slow and they still don't get it. Tantrums among the lemmings are highly contagious. This being holiday season... it probably means that we can count on a few flocks of them forming at parties, followed by their favorite whipsaw games. The whipsaws work in both directions. In this case, I'll generally sneak a peek at a price swoon of 20-30 percent as I consider a vote for 4B(e) "Other." (75%)($27.00) = $20.25. Holiday parties, tantrums and lemmings in full focus... I choose $20 as my feasible Monday morning low price.

Click to enlarge.

The high forecast of $112 and low forecast of $20 delivers an Upside-Downside Ratio of 12.2-to-1. I can only hope it's a tantrum in progress. (Grin) Under this set of assumptions, Home Depot is a "buy" up to $43.

Housekeeping, Continued

The quarterly block on the front side is for checking the most recent quarterly sales and EPS versus the same period a year ago. I pay very little attention to this and know several senior practitioners who rarely even fill it out. But the purists will want to see it. Here it is.

I think it's far more illuminative (see, Christmas lights on the brain) to compare trailing twelve-month (TTM) figures now versus what the TTM figures looked like a year ago. That'd be 58,522 (using Jim Bond's observation) versus 50,528... a comparison for sales at 15.7 percent. For EPS (and using 4th quarter estimates), it's $1.57 versus $1.29, for a comparison of 21.7 percent.

We find that Home Depot insiders own 3.8 percent of outstanding shares. Institutions hold 60.7 percent of outstanding shares. The company has relatively low long-term debt. In fact, cash assets (8/4/02) are approximately $6 billion. It seems like Home Depot could extinguish its long-term debt at any time. I'm not so sure we shouldn't replace the essentially unused dilution box with a cash flow characteristic. Better yet, perhaps a Quality Rating? (Grin) Home Depot cash flow for 2002 is estimated at $1.95 per share. Their "mortgage interest payment" is $75 million, or $0.03 per share. The A++ financial strength rating is NOT a gift or mistake.

Quality Rating

The basis of the Challenge Quality Rating calculation is provided by the article, Quality: A Measure of Excellence. By using industry benchmarks and a couple of Value Line ratings, this calculation is enabled for any company. The following table provides the quality rating for Home Depot, based on our assumptions and judgments made so far.

A Quality Rating greater than 65.0 places a company among the top 20 percent of all companies, an "Excellent" Rating. Home Depot, merits a top-tier rating, based on relative strength of sales growth, profitability, financial strength and predictability.

We visited this subject, with comparisons to other home improvement peers, in a BITS industry study entitled, Continuing With Maslow, Gimme Shelter. For more discussion and comparisons, readers may want to explore this industry feature.

Getting Sensitive About Kahuna Calculations

One of the most powerful attributes of using NAIC SSG software is that "what if" analysis can be performed. Some of you have already asked questions like, "What if we only use 13 percent sales growth?" For the next few minutes, let's take a look at a holiday smorgasboard of various SSG judgments. "What if Lowe's gets frisky and net margins plummet?" The following table provides the Value Line analyst's SSG, by virtue of the company report... our first cut at the SSG... and a series of variations. Note the effect on the quality rating and projected annual returns.

Click to enlarge.

The intent is to scan the table, noticing how changing certain factors affects the bottom line (PAR).

I'm not sure (yet) what to do about the expensing of stock options or dilutive effects. For now, I have to rely on Carrie. I'll take a closer look at Dan's question about expensing options and income statement effects. To tell you the truth, I'm still recovering from elimination of goodwill amortization. My simple reaction so far has been to hope that expensing options will wipe out the goodwill change and we'll be back to where we started. That'd be a poetic outcome, rather like watching lemmings chase their own tails. We'd be right back where we started. But I know and understand that the technology sector has used incentive options more... and would likely be more impacted when the posse figures out which canyon to storm and whom to lynch. For now, I tacked on a hundred million shares or so, in case Carrie is a little lean on the forecast. I have a little more homework to do on this.

In the last two lines, I've fixed the forecast for 2002. (Grin) Year-over-year sales have been running between 9 and 17 percent so far. I don't think the 4Q shortfall will be $2 billion. (Santa whispered in my ear. Plus, all those Christmas lights have to add up on a financial statement somewhere.) I think 2002 sales will be approximately $60 billion. Reducing the average P/E to 24.0x would be extreme, but I wanted to see what it looks like. If there really is a Wal-Mart emulation going on here... Wal-Mart's average P/E (with lower profitability) is 26-27x.

The next-to-bottom line would more closely reflect my personal SSG for Home Depot: Sales Growth = 14%, Net Margins = 6%, Future P/E = 27.0x. These judgments and assumptions deliver an "Excellent" quality rating and a projected annual return of approximately 24 percent.

I hope that you have enjoyed Home (Depot) For The Holidays and wish you and those close to you, a joyous holiday season! -- Mark Robertson.

Return to Session #1 - Building A Sales Growth Forecast

Return to Session #2 - Meting and Meeting Management

Return to Session #3 - Building A Projected Annual Return

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.