7/1/2010
By Brian Sozzi, Research Analyst

More Articles by Brian Sozzi

Discounts are the Theme for August Same-Store Sales

Little Guesswork Needed on this Stock

Government Needs to Stay Out of Private Markets!!

I recall writing a First Call note back in January 2007 when Home Depot (HD) announced the appointment of Frank Blake as CEO, ending the embarrassing reign of former General Electric (GE) executive Bob Nardelli.  At the time I reasoned that Blake, having a strong background in real estate planning and strategy in general, was the correct person to bring Home Depot into the new age of retail.  That new age included centralized merchandise planning, top-notch customer service, and a fresh looking store base that served to excite repeat, and attract new, patrons.  After all, the long running joke regarding Home Depot was that while the prices were lower than competitors, associates were non-existent to sell those products to the customers. 

On June 30, I had the pleasure of attending an informal analyst meeting hosted by Home Depot at the NYSE.  Over three years into Blake's leadership, amidst a horrific downturn in the U.S. housing market that weighed heavily on the home/commercial remodeling market, shareholders must be pleased.  Blake and his team, backboned by the impressively knowledgeable and impeccably dressed CFO Carol Tome (she is a walking Home Depot encyclopedia, having served at the company for 15 years), can boast the following achievements:

* New store growth curtailed, instead capital allocated to technology investments, store maintenance, and associate engagement training programs.
* A completely transformed supply chain, worked off an RDC (rapid deployment center) model.   The transition to smaller depots, which has been a three year undertaking, allows for less inventory investment among other attributes.  Combined with investment in merchandise forecast tools, Home Depot has reduced its markdown rate and overall, improved its operating cash flow generation potential.
* Net promoter scores (measure of customer service) continues to be on a defined uptrend.

And the numbers back up my claims that Home Depot is getting the job done...

Buy, Sell, or Forget?

Home Depot shares, though not hit as hard as Lowe's since April 26 (-22% Home Depot, -28% Lowe's), have been put through the ringer the last two months.  Fears on the topic of a double-dip in the economy, led in many respects by another leg down in the housing market, have called into question the sustainability of the positive trends in comparable store sales that began at home improvement chains in 4Q09.  For its part, Home Depot had positive comps in 1Q10 for the first-time since 2005, reflecting soft comparisons to prior years but also to consumers opening up to small remodeling projects.  Moreover, people who took advantage of the first-time homebuyer's tax credit and cash for appliances program aided in the stimulation of demand.  So, in light of all the risks brought on by a shaky housing recovery, should you as an investor nail down Home Depot shares at a 22% discount to the 52-week high touched on April 26?  I say the answer to that question is yes, and it's a direct result of where Home Depot's growth trajectory is situated (it's up) and valuation.  The stock is trading on the lowest P/E multiple to forward earnings (2011 ended) in the past five years, in spite of signs pointing to a demand recovery in remodeling (which believe it or not is not directly correlated with existing home sales).

Valuation Overview

* Current valuation: P/E of 12.5x 2011 ended EPS; 0.6x forward sales
* Historical valuation: P/E of 13.4x to 18.1x; 0.5x to 1.12x forward sales

Growth Drivers (Projected CAGR for EPS of 15% next four years)

* Efficiency extraction within new RDCs
* Improved vendor terms
* Greater internet connectivity
* Focus of capital on share repurchases
* Opportunities in Pro business around better understanding customer needs
* Opportunities with product categories to understand specific market dynamics
* Investments in technology equals fewer markdowns and localized assortments

Brian Sozzi
Wall Street Strategies