Editor's note: "Bricks and Mortar" is a mock portfolio created by reporter Nicholas Yulico that is meant to help generate real estate and gaming-related stock ideas. In keeping with TSC's editorial policy, Yulico doesn't own or short individual stocks.
The housing market, no doubt about it, stinks. Government data on Monday showed that new-home sales in 2007 were the lowest on record.
Nonetheless, homebuilders stocks have been surging in recent weeks as investors bet that further interest rate cuts by the Federal Reserve this week will save builders and the housing market.
But I wouldn't jump into buying the homebuilders just yet, since their fundamentals are
still deteriorating. Even though the stock is near five-month highs, I continue to flag
as overvalued in the "Bricks and Mortar" mock portfolio.
For those who want to snap up a beaten-down stock and bet on a housing market recovery,
represents much better risk/reward potential than homebuilder stocks.
Today, I'm adding Home Depot to the "Bricks and Mortar" portfolio as a stock to own. While there's no doubt the housing market will remain severely depressed in 2008, this stock price already reflects a significant cut to earnings this year and next.
In a slowing economy, cash flow is king. Home Depot, the world's largest home-improvement retailer, will generate $2.5 billion of free cash flow this year, by my estimates. This forecast is based on the 2% revenue drop that analysts are projecting for 2008, along with the flat to slightly down margins estimated for 2007.
Going out to 2010 -- once a full recovery begins at the retailer -- free cash flow will be closer to $4 billion.
The housing slowdown has already eaten into Home Depot, resulting in ongoing declines in same-store sales, or sales at stores open at least a year. In the third quarter, same-store sales tumbled 6%.
Historically, same-store sales growth at Home Depot and its main competitor,
, tend to highly correlate with sales of new and existing homes, according to recent research notes from Jefferies & Co. analyst Daniel Binder.
The simple message here is that once home sales begin to grow again, so should same-store sales at Home Depot.
Looking out to next year, there are several catalysts to boost shares, including a large stock buyback, easing comparisons for same-store sales, and an expanding price-to-earnings ratio as long-term growth once again becomes more visible for investors.
Analysts also expect Home Depot to slow down store expansions and reinvest in the current stores to compete better with Lowe's, which has made inroads in many of Home Depot's markets.
Even assuming a drop in earnings in 2008 and flat growth in 2009, I estimate Home Depot is worth around $34 per share -- about 15% upside from the current $29.50 price.
To get this valuation, I've used a discounted cash flow model, since Home Depot generates so much cash.
My upcoming earnings scenario at the retailer is slightly more bearish than the consensus analyst estimates. I project revenue will fall 7% in 2008, remain flat in 2009, and eventually recover to a long-term trend of 5% annual growth in 2010 and beyond.
I estimate gross margins this year will be slightly down from the depressed levels of 2007, and should eventually recover in 2010, once sales growth returns.
When looking across sectors and individual companies, the enterprise value-to-EBITDA metric is important because it compares cash flow-generating abilities independent of a firm's debt levels.
Home Depot has an enterprise value-to-EBITDA ratio of 7.2 (based on 2008 estimates). Wal-Mart, in comparison, has an 8 multiple. That's because Wal-Mart is expected to grow EBITDA from 2007 to 2009, compared with a slight decline at Home Depot in the same time frame.
But further into the future, Home Depot should have similar -- if not better -- growth when compared with Wal-Mart.
Thus, I'm assuming in my discounted cash flow valuation that Home Depot eventually gets an 8x EV/EBITDA ratio.
Add all these factors up, and my valuation estimates that Home Depot shares are worth $34.
If earnings come in better than expected in 2009, then the stock has additional upside.
If earnings estimates come down further, then the stock probably falls to a range of $25 to $27, which is not much downside.
In the meantime, investors are compensated with a 3.2% dividend yield. Home Depot also enjoys downside protection from its large real estate portfolio (it owns about 85% of its retail stores).
Management's long-term goal is 5% annual revenue growth and 5% net income growth. But the company believes it can achieve 10% long-term EPS growth because of ongoing share buybacks.
At $29.50, the stock trades at a forward P/E multiple of about 12.5, based on the most recent Thomson Financial estimate for the coming fiscal year.
If you believe in management's long-term growth estimate of 10% annually, then the stock also looks cheap on a P/E basis.
Ryland Due for Hits
In other "Bricks" holdings, homebuilder Ryland last week reported a loss of $202 million for the fourth quarter, and new orders were down 7%. The company now has a book value of $26 per share.
As the builder aggressively cuts prices to move product, I project more land writedowns are looming, resulting in further hits to book value. At around $32, the stock is trading at 1.2 times book value.
In 2006 and 2007, Ryland and other homebuilders rallied prior to the Super Bowl under the belief that the spring selling season would be a good one, a notion that eventually fizzled out.
I believe Ryland's stock price will retreat back to book value or lower in coming months, as investors realize that homebuilders are in for another brutal spring selling season.
Melco PBL Gains Steam
, a Macau casino developer, has seen its stock price enjoy a nice pop lately because of news that the company's Crown Macau property is starting to take over significant market share in the VIP segment. I continue to rate the stock "own" in the mock portfolio.
On Monday, UBS analysts said Melco PBL has been the biggest relative gainer in Macau market share during the past month.
Crown has gone from 7% market share in the fourth quarter of 2007 to greater than 15% in the first three weeks of January, UBS said.
Melco needs to grab increased market share in the VIP segment in order for the stock to keep moving higher, as I wrote
last month .