Shrinking Orange (HD)

The management at Home Depot (HD) continues to cut expenses so that shareholders do not experience the pains of "deleveraging" - a normally positive term which describes paying off debt, but used here to describe the negative effects of expenses becoming disproportionately large as revenues drop. In an earlier post (March 2008), I complimented the management's sanity in their "reversion to the mean" graph which indicated that markets were overreacting. Well, the markets weren't; instead, management was simply hoping. This graph indicates what others have often said - that markets overshoot before they revert to the mean:




As is evident from the pronouncement at the bottom: "worst of correction behind us," the management has not learned the perils of unqualified pronouncements. A political "may" or "might" could be a good tool for their toolbox.

HD has undoubtedly been moving through a horrendous environment, but in a case similar to the Biblical Joseph and the Pharoah, HD has had nearly 15 fat years of growth before these two lean ones. But after pioneering the "big box" retailer in home building products, HD let a huge lead become an equal race with Lowe's (LOW). Now, HD and LOW have commoditized each other's businesses so that what remains is a real estate play.

HD has over 2,200 stores. These stores are primarily in the U.S., but are also in Canada, Mexico and, incredibly, China. (Think of the distribution advantages with all those empty containers going to China!) These stores are costly - with sizeable pieces of land, additional sitework and paving, topped by a 100,000 sq.ft. building that is filled with furniture, fixtures and equipment. Total costs exceed $20 million. As long as returns on these stores are high, which is the job of the operations, then it's no problem. But commoditizing competition and a difficult environment have combined to create mediocre returns.

In 1978, Warren Buffett wrote the following about BRK's textile mills: "As long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed." While HD has not moved pricing to direct operating costs, the decline in profitability to average real estate returns demonstrates that the prospects for superior returns on capital employed are, at best, cyclical and, at worst, historical. Perhaps HD could declare itself a REIT, drop its taxes and increase the dividend to shareholders.