Monday, July 10, 2006

Home Depot Looking Cheap

For those who have been following the management of my personal portfolio, you know that I have been in a selective buying mode as the markets continue to move lower. Recent purchases have done alright, but the overall portfolio has endured some pain... nothing can really be done to escape a broad-based market downturn when you have a well-diversified portfolio.

In any case, I've been eyeing shares of Home Depot (HD). The shares are trading at levels that I believe are simply too cheap. My opinion is that shares are severely undervalued, and while they may continue to fall in the near-term, there is a sufficient cushion embedded into the current price that the reward far outweights the risk.

The company continues to generate monstrous operational cash flow. Operating cashflow sits at roughly $6.9B annually. In addition to a nice increase in its dividend (shares are currently yielding ~1.7%), HD has also been buying back its own shares. The shares have been punished as many are overweighting the effect that the housing slowdown and the expected consumer spending pullback will have on the company's earnings.

It is true that as new home sales decline, Home Depot will suffer somewhat. But, a large part of Home Depot's sales are due to home improvement and renovation. These are likely to remain strong despite fewer new home sales. Additionally, Home Depot Supply, which currently represents 5% of Home Depot's total sales continues to show incredible amounts of growth... triple digit growth.

A couple of non-fundamental issues are clouding the company at the moment. First, is the ongoing bickering over the CEO's pay. Yes, Nardelli is probably overpaid. Yes, I think people should be aware of his overcompensation. But, really... $25MM is hardly material to a company generating the sales numbers of Home Depot. Is this something that should be followed? Definitely. But, does it actually affect how the company is valued? Probably not.

A executive-related issue facing the company is the recently announce resignation of Tom Taylor. Taylor was the Executive Vice President of Merchandising and Marketing. From my research, I learned that he was a strong leader who basically got the job done. He had a cutthroat attitude, which made him a formidable foe. Additionally, he always made sure to take care of even the smallest problems, sometimes personally. While this is clearly a negative, perhaps new blood will inject new ideas into the company and help the company in different ways.

Last fiscal year, Home Depot made $2.72 per share. For the current fiscal year, a conservative estimate of Home Depot's earnings would be right at around $3.00 a share. This is what CSFB currently estimates HD's earnings, which accounts for a slight decrease in same-store sales and minor compression of margins. CSFB also believes that at current depressed levels, the market is embedding a dismal EPS of $2.92.

The fact is, Home Depot is trading at less than 12 times the current year's estimated earnings. It should not be trading so cheaply. As mentioned earlier, the company has been increasing their dividends and buying back shares. This is indicative of the quality of earnings that the company produces. You can play with the numbers all you want, but in the end, a dividend distribution cannot be faked.

Currently trading at $35, I think I'm going to start building a position in Home Depot starting this week. The shares might not do much in the near-term, but that's fine. I don't mind building a solid-sized position over the next 2-3 months.

So, who's with me?

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