Wednesday, November 14, 2007

you can build it, but can they help?

The current mess that is going on in the U.S. real estate/credit market is scary indeed. Like any other asset class, it is clear that housing markets can become overheated, bursting bubbles, just like stocks. All that excitement led financial institutions get pretty loose with their lending qualifications as well. It makes one glad to have their net worth diversified into shares of large, boring companies as well as boring Canadian real estate.

One company that really capitalized on the housing boom in the U.S. was Home Depot (HD). Whether you were flipping a bungalow in Sacramento, California, or building a ranch in Charlotte, North Carolina, Home Depot was probably close by to offer their wide array of home hardware. Their customer service leaves much to be desired, but they are located everywhere, the price is usually right, and they know how to keep the shelves stocked.

The company was able to grow earnings by over 20% per year in 2003, 2004, 2005, and 2006. That is a pretty good clip for any retailer. The stock actually doubled from $21 in January of 2003 to a peak of around $44 in 2005. But then something happened, perhaps the market saw what was coming ahead as the stock didn't do much of anything after early 2005. We all know what happened next as the housing bubble burst. Housing prices are in decline in many market in the U.S. and less homes are being built. Home Depot's stock has subsequently tanked down to $29. Their earnings and revenues are now in decline, as you might expect. I've watched this all play out intently, with my hesitant eye on Home Depot every since I peered at the company's financials.

Did I mention that fundamentally this company is extremely strong, and has a squeaky clean balance sheet? Home Depot has also been an amazing dividend grower since 1987. So is it time to buy this value play? Or is this a value trap? If you have a long term time horizon then you may want to give this company a second look.

Why?
  • Earnings growth has been exceptional for a long time.
  • Dividend growth has followed suit for a long time.
  • This company has a proven history of success in retailing.
  • Lowes is a strong competitor, that can't be discounted.
  • The stock yields 3.1% with a low pay out ratio.
  • The company has very little debt.
  • They are buying back shares, like they want to go private.
  • The P/E is under 12x.
  • Return on Equity and Assets are both over 20%
  • The pay out ratio of dividends is only 24%
  • HD has a small play on China
  • They have great real estate, and a decent brand.
  • Americans, some day will start building, rennovating, and loving their houses again...

It is hard to find much fault with the company fundamentally. However, there is one lingering risk; they are involved in this industry that built up so much overcapacity that it collapsed upon itself. How long does it take for this growth to get humming again. Home Depot will eventually have some pretty easy prior-year comparables to go up against for earnings and revenue growth. What is the immanent catalyst short-term though? That is the clincher, as noted by S&P in their latest research report.

This stock could languish for years, how long could you stand holding a flat or declining stock.......? They are currently willing to pay you 3.1% to wait, that is more than their closest competitor...

If you are a long term investor though, I'll bet that when the U.S. housing debacle becomes a distant memory, you'll be glad you picked up a few shares of this company.

9 comments:

Thicken My Wallet said...

HD is trying to make a strong push in to China. Its earnings growth will most likely depend how well they can expand in this market.

Dividends4Life said...
This comment has been removed by the author.
Dividends4Life said...

MG: It's ironic that the Home Depot is about .5 miles closer to my home than Lowe’s, but I will drive by it to shop at Lowe’s. I would love to buy Lowe’s, but could never make the numbers work. So I own HD, but shop at LOW.

Best Wishes,
D4L

telly said...

I'm with dividends4life, I prefer to shop at Lowe's rather than Home Depot myself. However, I don't own shares in either one.

Lowe's is great if you don't really like shopping. Everything is well organized so they make it easy to find what you need and get out. Hmmm....maybe that's why the numbers don't work as well...

MG said...

Any opinions on the stocks?

I have actually never bee inside a Lowes, but I will be soon...

telly said...

mg,
I'm not entirely comfortable with my valuation methods (thus the reason I'm about 90% indexed!) but I think HD is cheap under $30.

You have a Lowe's opening near you eh?

Obviously it's important to be able to evaluate a business but when I think of Peter Lynch's advice of considering businesses you frequent, I always think LOW and SC. Even as a non-shopper, I find I spend a lot of money at both places.

MG said...

If Lynch is right then I should back the truck up with Costco.

Dividends4Life said...

MG: My model has HD rated as a 5-Star and selling at steep discount to 3 of my 4 valuation models. I have LOW at a 2-Star but selling at a greater discount to the same 3 of 4 models as HD.

The difference in the Stars between LOW and HD are the company's dividend policies. HD has been strong and growing, while LOW has been spotty.

As always, just one man's opinion.

Best Wishes,
D4L

optionsnut said...

This and others make for interesting plays.

Why not pick up the shares and collect the 3%. Then sell covered calls on these shares every 2-4 months and pick up another 5-10% or more in either downside protection or income if the stock trades sideways?

I like some like BMO, or PFE for this strategy since they have fatter yeilds.

DH