Home Depot's Capital Allocation

As I wrote in a post (1/3/2007), Home Depot (HD) has been attempting to make two wrongs equal a right for sometime. The first wrong, a poorly structured (at least from a shareholder perspective) employment contract, facilitated bad relations all around. The second wrong, a reactive removal of Nardelli as the CEO left HD with difficulty executing the complex business model Nardelli had constructed.

Now, HD has struggled with refashioning itself. The basic business platform generates a likely return on capital of 12%, creating adequate cash flows to build new stores, refurbish old ones and pursue business initiatives. Left to its own devices, this would indicate a growth rate of 7% plus inflation on an unlevered basis. Not bad.

But HD is trying to refocus on this business model. It is disposing of HD Supply for about what it paid, given that HD is getting cash back of $8.5 billion, keeping a 12.5% equity stake and guaranteeing $1 billion of debt. Overall, this is not a bad outcome. The purchasers will ultimately take the stock public and HD will cash out at that time without the business having been a management distraction. Thank you, Jamie Dimon.

The aggressive area seems to be the increase of debt in order to repurchase $22.5 billion of stock. HD has been extremely fortunate to have a market downturn, reducing by at least $1.2 billion the cost of its repurchase. The total is almost 290 million shares at $37 per share for a total cost of $10.73 billion. This is roughly 14% of the shares outstanding. Most of this cost will be covered by the $8 billion of sales proceeds from HD Supply. In addition, HD will be borrowing about another $12 billion to repurchase more shares. A downturn in the stock would be welcome as it would allow HD to dramatically shrink share count.

Another Saga of "Synergy"

A great business story is starting to unravel. In 1969, George Valassis opened a small home sales business that sold printing around Detroit. He had enough growth to purchase a printing press in 1971. However, he didn't have enough work for the press. So what did he do? To the dismay of paperboys since, he invented the coupon-insert-in-newspaper business, or in industry terms FSI (free-standing insert). Valassis grew rapidly and dominated the FSI business, until recently.

Over the time, Valassis has continued to search for other ways to get advertising dollars. This has accelerated over the years and recently culminated in the purchase of Advo - another great business story. Started in Hartford, Connecticut in 1929 by Paul Siegel, Advo specialized in delivering fliers door-to-door from retailers. Moving by fits and starts, Advo continued its growth into mailers for the large insurance companies. The growth reached a milestone when the United States Census Bureau purchased its mailing list for American households.

Both companies, Valassis and Advo have struggled with newspaper competition, changing technology and the search for better, more measureable results for their advertisers. Valassis made an acquisition of Advo in 2006, commenting on the multiple "synergies" that would be generated. As I have commented before in this blog, synergies seem to fail either because of illegal monopolies or an overpayment for an acquisition. This case seems to be the latter. But here is some truly destructive potential because of a huge (to me) amount of debt loading up the entire purchase price of $1.1 billion with an annual free cash of only about $100 million.

The stock (VCI) could be a real bargain, but the debtload looks too heavy. Here is a telling graph depicting the core weakness of the business which is servicing that debt:



It looks like Mama ain't using coupons as much these days!