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Home Depot on a Solid Rebuilding Path

HD growing at a solid clip, and it's paying dividends


I recently cited investor Peter Lynch’s use of the term “stalwart,” in his book One Up On Wall Street, in reference to the performance of Energizer (NYSE:ENR). The term is sometimes applied to large-capitalization stocks that provide investors with slow but steady and dependable growth prospects. For me, that means a company growing at about 8% a year or more. Yet companies I think of as stalwarts also have the capacity for surprise. One company I just looked into still is growing at a rapid clip — much faster than I expected. The last time I found a stock like this, it was right under my nose. It was Walt Disney (NYSE:DIS).

This time, it’s Home Depot (NYSE:HD). I had expected to see really weak earnings results from the company during the recession. I was right. What I didn’t expect was to see Home Depot really struggle as far as far back as 2007, when the housing market was topping out. But even though the company saw earnings really get hammered during that period, the past two years has shown that what goes down can go back up. For all the home improvement that stopped a few years ago, it appears to have started up again, and I’m betting a lot of that is due to private equity scooping up distressed properties and renovating them.

How bad had things been for the company? Fiscal year 2006 earnings were $5.8 billion. They dropped 24% to $4.4 billion in FY 2007, and — holy get-whacked-with-a-2×4 — fell 50% in FY 2008. The good news about tanking earnings is that it makes ensuing year comparisons look great. Indeed, FY 2009 roared back 20%, to $2.66 billion, and FY 2010 another 25%, to $3.34 billion. Analysts are looking for another 13% this year and 14% next year, along with five-year annualized growth of 13%.

Stalwart? Nuh-uh. Growth company. Still!

I don’t need to tell readers about Home Depot. You know what it is, the products it carries and its pricing power. I also think any additional collapse in housing prices will now aid the company, as more distressed properties are renovated. That’s the reason for analyst optimism about Home Depot, as reflected in their estimates.

The next question was whether this bumpy recovery path for Home Depot harmed its balance sheet. In a sign of truly great management, Home Depot has decreased its outstanding long-term debt from $8.22 billion on Feb. 1, 2009, to $7.7 billion on Aug. 1, 2010. Since business had started to recover, the company obviously felt comfortable drawing down another $3 billion in debt, and the total debt service is at a blended rate of about 5.6%. That’s cheap debt.

How did Home Depot manage all this? Despite falling earnings, the company still generated tons of free cash flow. In FY 2008, its worst year of the past five, it still managed $3.65 billion in FCF! That bumped up to $4.2 billion in FY 2009 and in FY 2010, it was $4.49 billion. That cash flow not only kept the company easily afloat, but it still was able to pay $1.5 billion in dividends! That hasn’t changed. The company pays $1 per share in dividends each year, or a 2.9% yield.

Now that we know all these wonderful things, is Home Depot a buy, sell or hold? The company trades at 15 times this year’s earnings and 13 times next year’s earnings. With the growth rate mentioned above, that suggests to me that Home Depot is fairly valued at today’s price. That means you aren’t overpaying. In fact, a company as solid as this probably is deserving of a premium multiple. So you might even be getting a slight bargain.

It would be totally reasonable to expect a 15% total return annually going forward, including dividends, and that’s something you can build a foundation on.

Lawrence Meyers does not own shares of Home Depot, Disney or Energizer.

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