Focus on Home Depot as a Value Play

Forget about the CEO's pay; question why the share price doesn't reflect solid fundamentals.
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The corporate watchdogs are howling about another excessive pay package for an executive who has delivered shoddy stock returns. The executive under fire counters by pointing to his superior performance by any fundamental metric.

Could this be the time for a value-minded investor to swoop in and exploit the disconnect?

Forget for a moment all of the questions being raised about how the compensation committee on

Home Depot's

(HD) - Get Report

board of directors arrived at Chairman and CEO Robert Nardelli's compensation package, from which he gleaned $245 million over his five years with the company even as the stock dropped 12%.

Forget, too, the symbolic slap in the face Home Depot gave its shareholders when no members of its board aside from the chairman showed up to face them at its recent annual meeting, and that Nardelli gave short shrift to the concerns of the people he works for.

These items may be troubling on many levels, but from a pure investment standpoint, their significance is negligible at best. The more pressing question concerning the underlying value of the home-improvement chain lies in why its shares have lost value in recent years while its fundamentals have soared. Home Depot's stock looks far cheaper than Nardelli's pay is rich.

"Home Depot has shown terrible corporate governance lately, but investors have to separate corporate governance from valuation," says Morningstar analyst Anthony Chukumba. "If I'm a shareholder, I'd much rather have the CEO act like a jerk at the annual meeting and pay me a fat dividend than serve me tea and cookies and then fritter away my investment."

While its shares declined over the last five years, Home Depot nearly doubled its sales, to $81.5 billion from $47.5 billion. During that time, its annual earnings climbed from $1.10 a share to $2.72 a share in 2005. It returned nearly $13 billion, or approximately 59% of its cumulative earnings, to shareholders in the form of dividends and share repurchases.

For the first quarter of this year, Home Depot's earnings rose 19%, beating Wall Street's EPS estimate by 3 cents. Home Depot's shares, however, dropped on the day it reported results, because sales fell a bit short of expectations.

The company also halted its practice of reporting quarterly same-store sales. The move means it's difficult to make comparisons to Home Depot's chief competitor,

Lowe's

(LOW) - Get Report

, which reported a 5.7% jump in same-store sales for the quarter. Credit Suisse First Boston analyst Gary Balter estimates that Home Depot's same-store sales rose about 1%.

While Home Depot faces saturation in North America with its 2,065 retail stores, Lowe's has only 1,250 stores. Its growth prospects appeal to investors, who have bid up the stock 173% over the past five years, and its stronger comps suggest it may be advancing on its rival in terms of market share.

At around $63, Lowe's trades at more than 15 times Wall Street's earnings estimates for the company for 2006. By the same measure, Home Depot trades at $38, around 12 times estimates. Meanwhile, fears about the effects of rising interest rates on consumer spending and the slowing housing market are weighing down the valuations of both companies. But even though the economy is facing a slowdown, Home Depot shares look particularly cheap considering its long-term prospects.

"Home Depot is no longer a growth stock," says Chukumba. "It's a value stock, and investors are slow to make the shift in the way they view it. The same thing is going on at companies like

Microsoft

(MSFT) - Get Report

and

Wal-Mart

(WMT) - Get Report

. Growth is slowing, but the returns on capital are still excellent. The market has yet to appreciate this."

Based on Morningstar's valuation, using a discounted cash-flow method, Chukumba puts Home Depot's fair value at $44, a 16% premium to today's price. Meanwhile, Matrix USA rates it a strong buy based on its high returns, low price and low risk profile.

Nardelli, who came to Home Depot in 2000 from

General Electric

, hasn't managed to raise the company's stock price, but he has increased its returns on capital from 17.5% to 25%. With sales averaging $380 per square foot, the retailer leads its industry, and its recent shift toward the supply business has the potential to drive more growth.

Despite all of these attributes, votes for the company's directors at its May 25 annual meeting showed less than full confidence from its shareholders. All of the directors except one were supported by roughly 60% of the votes cast. Only Angelo Mozilo, the chairman and chief executive of

Countrywide Financial

, who joined the board in February, garnered over 90% support.

The weak backing of Home Depot's board reflects recent criticism about Nardelli's compensation and the way in which the annual meeting was conducted. Aside from the lack of attendance by other directors, Nardelli reportedly refused to answer most questions posed by shareholders, who were given limited time to speak before their microphone was shut off.

The only shareholder proposal adopted after the votes were cast was a measure that will require a majority vote from shareholders for the election of board members rather than the plurality that was required this year.

"That's not much, but it's a step in the right direction for a company that really needs to step back and re-evaluate how it treats its shareholders," says Craig Johnson, president of Customer Growth Partners, who owns shares of Home Depot. "They've got a public relations problem on their hands right now."

That problem manifested itself in a series of criticisms launched at Home Depot's conduct on the airwaves of news networks and the editorial pages of major newspapers like

The Wall Street Journal

and

The New York Times

.

"Consistent with the way we run our company -- in which we listen, learn and lead -- we will return to our traditional format for next year's annual shareholders meeting, which will include a business overview, the presentation of proposals, an opportunity for shareholder questions and with the board of directors in attendance," Home Depot announced Thursday, in an acknowledgment of the controversy. Previously, the company said the recent meeting shouldn't be interpreted as a "lack of respect for our shareholders or a lessening of our commitment to high standards of corporate governance and transparency."

Still, the drumbeat of criticism continues. If Home Depot is eventually forced to make more changes as a result, its corporate governance may be improved. Even better, the increased attention may get investors to realize the company's true value.