Tuesday, August 7, 2012

Home Depot Looks Good Value

Home improvement retailer Home Depot (NYSE: HD) reported results that initially disappointed the market but affirmed that a slow gradual recovery is in place for the stock. In summary, I think this stock is trading on an attractive evaluation, albeit in a marketplace where housing is still bouncing along the bottom. Meanwhile, Home Depot has been improving margins and generating significant amounts of cash.

In short, it is attractive on its current "GDP nominal growth" trajectory but also has a potentially powerful upside kicker in an improvement in the housing market. I will argue that much of this performance is mirrored by its largest rival, Lowe’s Companies (NYSE: LOW).

Home Depot Q1 Results
A brief overview of the numbers
  • Revenues of $17.81bn vs. estimates of $17.93bn
  • Diluted EPS of 68c vs. estimates of 65c
  • Full year revenue guidance of $73.64bn vs. estimates $74.11bn
  • Full year EPS guidance of $2.90 vs. $2.91
It’s a "beat" on earnings but a "miss" on revenues. Furthermore, the full year guidance – albeit raised -- is below analyst estimates. So what went wrong?

Actually, nothing really!

This was always going to be an unusual quarter for Home Depot because of the atypical winter weather in the US in 2011-12. Warm weather tends to encourage earlier construction activity and management was quick to guide analysts that revenues had been pulled forward into this quarter from Q2.

Moreover, this year's Q1 comparison is also flattered because of the harsh winter in 2010-11, which we can see in the Q1 2011 negative comparables in the chart. The current Q2 analyst estimates look achievable, even though it wil be missing some orders pulled forward into the current quarter.

Nevertheless, the numbers are indicative of a company that has got back to revenue growth over the last two years. In fact, for a longer term perspective, it’s worth noting that the housing market actually started turning down in 2006, well before the financial crisis hit the broader economy. We can see that in the gross margin evolution of the company. It has been progressively improving, even though gross profits are still not at the housing boom levels.

Housing Ready to Make a Comeback?

I think the global economy is looking for a snapback in US housing but over the last two years it has flattered to deceive. Government incentives have caused blips, which haven't caused traction, the banking industry hasn’t disappointed by producing its usual incompetency with the "robo-signing" scandal, shadow inventories remain high, prices are bouncing along the bottom and new housing starts remain low.

But that’s the good news!

My point is that the margin and profit growth of Home Depot in the last two is there for all to see. And it has been achieved without a meaningful bounce in housing. Indeed, management was keen to point out that, so far, the housing market is not producing anything more than GDP type growth. Frankly, I don’t think this is a tenable long-term position. At some point, if housing starts keep trending below new household formulation, there will come a time when housing activity increases again.

One possible indicator of this is with the type of metric that Home Depot discussed on the conference call. Management stated that they felt that its professional customers were likely to grow quicker in a recovery than consumers. However, overall professional is still slower but with one key exception. Larger professional customers are growing quicker than consumers and the rest of the professional segment.  Also, it is a sequential improvement, which suggests a trend is developing.

I suspect that this is an early sign of recovery. It may indicate that work is picking up, but not yet at the scale, whereby the larger players are outsourcing to the smaller companies. If it does migrate to the smaller professional market in future quarters then investors will have good reason for optimism. Something to look out for.

 Turning to rival Lowe's, this company is also experiencing a turn in fortunes as demonstrated here.

Note that Lowe’s Q4 numbers extend to the end of January whilst Home Depot reports on the calendar year. Also, Lowe's reported weaker comparables in Q1 2011 due to the weather effect previously discussed. However, it has had positive comparisons ever since the end of 2009.

So What Next for Home Depot?

I think the stock is attractive. Margins are rising and the trailing free cash flow generation is at $5.79bn, which represents 6.8% of its Enterprise Value. This is cheap for a business forecast to generate mid teens earnings growth over the next two years. In addition, these forecasts are likely to not include too much by way of analyst assumptions over a housing recovery.

In my experience, analysts do not make big macro calls and, instead, favor a linear trend growth model to forecasting. In a sense, this is why Home Depot missed analysts' forecasts for revenues in the current quarter. Analysts saw the strong growth generated by the warm weather and then extrapolated it out into more positive expectations for the quarter.

No matter, the numbers were consistent with a business making a recovery and with the upside kicker of a possible housing recovery (which will cause analysts and management to raise estimates) Home Depot has a lot of upside potential. In addition, even if the housing market doesn’t recover to more than GDP growth, the stock still looks good value.

This is more of an analysts "miss" than anything to significant to do with the company's execution.

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