The Home Depot currently has 2,193 retail stores in all 50 states, the District of Columbia, Puerto Rico, U.S. Virgin Islands, 10 Canadian provinces and Mexico. The Home Depot Inc also owns and operates Expo Design Center stores, THD Design Center stores and Yardbird stores (HD.com).
The Home Depot made a very important acquisition in 2006 when they signed a definitive agreement to acquire The Home Way, China’s first home improvement retailer. The terms of the deal were not disclosed, but it was estimated that buying control of the retailer would cost $100 million. (IHT Online) The Home Way provides Home Depot with an immediate retail presence in China with 12 stores in six cities, including Beijing. The Chinese home improvement market was valued at nearly $50 billion and had been growing at a compounded annual rate of 20% when the deal was made. Approximately 70%of home improvement spending in China is for the completion of interior space in new homes. This is a solid growth opportunity given Home Depot’s strength in merchandise and services geared to finishing out a home. Big-box stores make up only about 4% of the home-improvement business in China. The rest consists of smaller independent vendors who specialize.
Expansion in China is an important area of growth and helps establish a foothold in the global market for Home Depot. (Home Depot Online) Home Depot has proven in the past that they can flourish outside the United States and the opportunity in China is something that the world’s largest home improvement specialty retailer should be able to capitalize on. Ultimately, we believe that this project is value enhancing because China represents a $1 trillion market opportunity and expanded 10.2% in 2005 creating higher wages and increased purchasing power for consumers. (IHT Online)
In recent years, Home Depot has seen its customer service levels fall and with them the price of the average transaction. However, in 2008 same store sales should be positively affected because of their recent investment in customer service. This investment included the hiring of more than 2,500 licensed Master Trade Specialists in the plumbing and electrical departments. (Yahoo Finance Online) We believe that this investment project will be value enhancing because these specialists will provide both increased service to customers and training for associates which will increase sales.
B) Quantitative Analysis:
We determined that Home Depot’s investment in The Home Way was the most significant recent investment. However, there was not sufficient information to provide a valuation of the specific investment plan because the terms of the deal were not enclosed in the acquisition. Therefore, our group decided to provide a valuation of the entire firm of Home Depot.
In order to determine the WACC we first needed to decide on the appropriate Beta to use. These three websites provided an estimate of Beta as:
We determined that the Beta estimate from Value Line seems to be the most applicable of the three estimates listed above. Because the Home Depot is such a large company and its business is tied so closely to the housing sector, which is a leading economic indicator, its Beta would follow the market over the long term. In other words, the Home Depot closely follows the economy as a whole. The beta given by Yahoo, which is obviously an outlier, is probably the result of a short term beta measurement. Large swings in the S&P in recent months, coupled with the low volatility of The Home Depot are probably to blame. The beta estimate of one reflects the moderate systematic risk of The Home Depot and the fact that it has a great deal of exposure to the domestic economy, because the majority of its revenues come from the U.S. This beta is similar to those seen throughout the home improvement industry, of which The Home Depot is the dominant force.
The rest of the numbers required for the calculation did not require a decision between different statistics or estimates for the same category. We calculated the Weighted Average Cost of Capital for The Home Depot to be 8.294 %( refer to Exhibit 1).
Discounted Cash Flow Model:
We used the historical information in The Home Depot’s income statements and balance sheets for the time period from 2005-2007 to formulate our DCF Model (refer to Exhibit 3). With this data we were able to make projections seven years out to 2015. The calculation for sales growth was extremely tough, as we felt that we could not use one constant rate for the seven year forecast. This is due to the current downturn in the macroeconomic environment and the effect that it has had on Home Depot. Current expectations of sales growth for Home Depot’s 2008 fiscal year are negative. However, in the following years sales growth is expected to increase as the economy hopefully lifts itself out of its current situation.
We had to account for Home Depot’s prospective future growth rates going further. Issues that we considered in determining these growth rates were the possibility of the housing market ending its current slump, the prospects of Home Depot’s interests abroad, and the upcoming retirement of many baby boomers that could provide potential growth as they pursue new housing improvements.
We accounted for the fluctuations of the market by using different growth rates for the seven year time period. Currently, the market is down, so we were able to use a negative growth rate for 2008. In the following years, we were able to account for Home Depot’s possibility of regaining the sales momentum that it had experienced before the housing slump. In the next couple of years, Home Depot may experience potential sales growth due to its increased interest abroad and as one analyst asserted, the upcoming retirement of the baby boomers and the effect that they will have on the housing economy, especially new housing improvements. However, we did not grow sales at the excessive rates that they experienced in the late 1990s and the early 2000s, due to a near saturation of the market. Home Depot and Lowe’s Corp. dominate the market, but there are not too many prospects left in the U.S. Same store sales are down, as is the percentage of new store openings. Their main prospect left is to move abroad. Due to this, we projected Home Depot’s growth at a modest 7% for 2015 and in the years beyond at 5.5%.
Cost of Goods Sold, Net Working Capital (NWC), S, G & A expenses, and depreciation were forecasted relative to sales over the three year historical period. There were no deviations over this period and the projections were in accordance with Home Depot’s gross and operating margins. Capital expenditures were calculated relative to depreciation over the past three years and tax expense was computed using the company’s tax rate of 35%.
With these projections, we were able to forecast an income statement (excluding interest) for the years 2008-2015. We then subtracted out from earnings before interest after taxes (EBIAT) additions to NWC and PPE, and added back depreciation. This calculation provided us with the free cash flow (FCF) for 2008-2015. Then, we discounted the FCF at the rate provided by our weighted average cost of capital (refer to Exhibit 1). We calculated a terminal value of the cash flows, using a growth rate of 5.5% going forward.
The total value of the assets was calculated by adding up the present value of the free cash flows and the present value of the terminal value. We subtracted out the total debt of the company from this amount, which provided us with a total equity valuation. The share price of $35.61 was calculated by dividing the total equity by the 1.69 billion shares outstanding.
We feel as though the prospects for Home Depot look much better in the future than they do today. The share price that we calculated at $35.61 for Home Depot indicates that the stock is currently undervalued based on our projections. We believe that the worst of the sub prime crisis is over and do not expect Home Depot to experience rapid growth until the U.S. housing market is completely turned around. However, once this happens new housing projects will be pursued in the U.S. and Home Depot will be able to focus more on their expansion abroad. If these factors occur then Home Depot will be considered a potential value stock.
II. Financial Policy
As a result of the deterioration of the housing, residential construction, and home improvement markets in the last few years, the management of Home Depot decided to rehabilitate its capital structure to finance its investments. Looking at the transition from FY2006 to FY2008, long term debt jumped from $2,291 million to $10,983 million. This led to its total debt/equity ratio increasing from .152 in FY2006 to .758 in FY2008. In 2004, Home Depot’s capital structure was comprised of 96.3% equity and only 3.7% debt. Today, these numbers have changed drastically, with equity making up only 60.9% and debt at 39.1% of the capital structure (EXHIBIT). This highly leveraged capital structure has been effective since Home Depot has not had any trouble covering interest payments for its debt holders. In fact the interest coverage ratio for the firm is 11.64%, which means that Home Depot is holding enough cash to handle this increase in interest payments and leave options open in regards to other potential uses of cash. Cash reserves have been steadily declining at Home Depot over the past two years, from $793 million in FY2006 to $445 million in FY 2008. This decline is a result of management’s aggressive payout policy in terms of increased dividends and share repurchases as well as the increase in interest payments.
In order to thoroughly analyze Home Depot’s current capital structure one must compare it to its closest competitor, Lowes Companies Inc. Home Depot and Lowes comprise about 86% of the Home Improvement Retail Industry, with market capitalizations of $50,257.23 million and $38,036.40 million respectively (EXHIBIT). Lowes maintains a less levered capital structure than the one currently in place at Home Depot. Lowes total debt/equity ratio is .415 and equity makes up 74.3% of its capital structure. In FY2008, Lowes had $5,576 million in long term debt, which is considerably lower than the $10,983 million at Home Depot (EXHIBIT). Home Depot is has more leverage than Lowes and we feel that this is a positive for Home Depot in regards the present value of tax shields. As a result of the increase in long term debt, present value of tax shields have increased from values of $1,566 million in FY2006 to 4,332 million as of February 2008 (EXHIBIT). We like this value in comparison to the present value of tax savings provided by the debt structure at Lowes (EXHIBIT) because it shows more of a focus on returning cash to shareholders and keeps management in line. The current debt level could be increased in the future to enhance the present value of tax savings and add to the potential capital for investments in China, but for now it would not be wise for management to increase the leverage of the firm in the face of declining sales in 2008.
Another major reason for Home Depot’s increase in leverage was due to management’s decision to increase the share repurchase plan that began in 2002. In 2007, the Board of Directors approved additional repurchases of common stock totaling $22.5 billion, which brought the total amount of potential shares to be repurchased from the inception of the plan to $40 billion. Of the $22.5 billion in share repurchases, $12.5 billion would be financed by new debt issuances (FOOTER). Home Depot is currently trying to fight off its abysmal 2007 where same-store sales dropped 6.7%, the worst drop ever for the firm. Yet these struggles are expected to continue through most of 2008. As a result, management has stalled this share repurchase plan in order to reserve the necessary cash to maintain its commitment to interest payments and maintain the current level of dividends.
Dividends have been a part of Home Depot’s payout policy since 1987. They grew steadily from $0.02 per share in 1992 to $0.40 per share in 2005 due to payout ratio that hovered between 10% and 15%. However, there was a shift in policy in 2006 and 2007 as dividends grew to values of $0.68 and $0.90 respectively. This was a result of an increase in payout ratios to 24% in 2006 and 40% in 2007. (EXHIBIT) This aggressive increase in dividends has increased pressure on management to generate the cash flows necessary to continue these payout policies in the years to come. The last option, for Home Depot, in order to free up cash would be to slash dividends as it would signal poor future earnings potential to the market. Management is working hard to fight through the housing slump by leaving dividends for 2008 at the 2007 level, $0.90.
The management of Home Depot is doing an excellent job maintaining its different objectives while withstanding the fall in sales that the credit crunch and housing slump are causing. Though dividends will remain steady and the share repurchase plan is on hold for 2008, management is handing its levels of debt and cash well in order to maximize the present value of tax savings while minimizing risk of financial distress. In our opinion, this will set them up well for growth, most notably in China, in the coming years as the market improves. The shareholders will reap the benefit of management’s prudent actions now through increased payouts in the future.
IV. Corporate Governance
The majority of Home Depot’s stock is held by institutional and mutual fund owners. Institutions make up 66.09% of owners, while mutual funds own 1.74% of the 1.69B outstanding shares. Insiders and 5% owners currently own 2.41% of the shares, of which the five major direct holders include two directors and three officers. David Batchelder, a Director since 2007, owns almost 2% of shares indirectly through Relational Investors, LLC.
The Board consists of 15 members, 13 of which are independent according to the company’s definition found in the corporate governance policies. The majority of the Board is comprised of independent members, which is a provision of the new Corporate Governance Guidelines. The two members who are not considered independent are Francis Blake, chairman and CEO, and Milledge Hart. The independent members also select a Lead Director annually to act as a liaison between non-management directors and the Company’s management. (HD Corporate Governance Guidelines)
The background of the members of the Board, which includes 13 men and 2 women, consist mostly of directors who have held or currently hold executive positions at other companies. The experience ranges from PepsiCo’s Frito-Lay to Otis Elevator Company, which Home Depot believes includes, “various backgrounds and professions in order to maximize perspective and ensure a wealth of experiences to inform its decisions” (HD Corporate Governance Guidelines).
While the Board is comprised of directors with a range of professions, the current CEO, Frank Blake, is a former GE executive just as the former CEO, Bob Nardelli. Blake’s experiences and skill set very closely resemble Nardelli, especially when it comes to his lack in retail experience. These similarities were a cause for concern at the announcement of Blake as the new CEO, considering Nardelli’s failure to bring up the stock performance over his six year tenure. The main difference between the two executives is seen in their management style, where Nardelli was considered by many to be autocratic and the creator of a “culture of fear,” Blake has taken a friendlier approach with employees and shareholders, which is hoped to be translated to a more approachable sales staff and better performance in the stores. (“Renovating Home Depot”)
The directors’ compensation is composed of a required two-thirds annual retainer of the Company’s equity to align interests of non-management directors, as well as a stipulation that shares of Company stock cannot be sold until the non-management director retires from the Board or for one year after withdrawal. (HD Corporate Governance Guidelines)
Executive compensation has been a more controversial matter in recent years. It is important to note that a number of changes were made regarding corporate governance after the resignation of Nardelli, who stepped down in response to concern over his excessive compensation package. The shareholders filed suit claiming Nardelli’s compensation was misaligned with the company’s stock performance. Nardelli’s golden parachute severance package went up to $210 million despite the poor performance. In response to the suit, Home Depot agreed to 13 corporate governance changes, and significantly scaled back executive compensation. (HD 10K) As shown in the executive compensation summary table of the 2008 Proxy, Frank Blake’s reported annual salary is just over $1M with bonus based on achievement of financial goals and performance measures and no provision for severance pay. These changes are important in ensuring a similar disagreement doesn’t occur and for keeping the shareholders’ interests aligned with management in the future. (Morningstar)
Overall, Home Depot’s corporate governance is in good shape but only since the changes instigated after Nardelli’s resignation. The company has made an effort to better align shareholder and management interests. These changes have been made in the form of incentive and performance based compensation for both directors and executive officers, changes to the Board to use majority voting in director elections, a requirement for two-thirds of the Board to consist of independent directors and a provision to allow shareholders to ask questions and receive answers from the CEO and other executive officers, among others. Shareholders will likely be on the lookout for any wavering from these policies on executive compensation, especially during the poor performance years when share price is projected to be low and sales continue to fall. If Home Depot can continue to monitor corporate governance and keep the shareholders informed there will be no reason to doubt the company’s practices.
Exhibit 1 – WACC Calculation
1 Beta recorded by Value Line
2 From a UBS research report on the market risk premium over the past 12 years
3 Cost of Equity = CAPM Calculation: Ce=rf+Beta*(rm-rf)
4 Cost of debt = YTM of latest debt offering by Home Depot
5 Weight of Equity: Total Equity / (Total Debt + Total Equity)
6 Weight of Debt: Total Debt / (Total Debt + Total Equity)
Exhibit 2 – Historical Sales Growth
(numbers in millions)
2 Year Sales Growth
9 Year Sales Growth