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The management team of Home Depot, led by Robert Nardelli, the former General Electric star, employs a “balanced” approach to capital management. This includes a mix of dividend payouts, acquisitions, capital expenditures and share buy-backs. I believe Home Depot should temporarily alter this approach to take advantage of an opportunity to create huge shareholder value with little effort. This opportunity won’t last forever.
Specifically, I believe Home Depot should offer to repurchase 25 per cent of its outstanding stock in a tender offer, using debt to finance the transaction. (This is in addition to the 17 per cent of shares the company has purchased over the past five years.)
My reasoning is as follows. Retail investors have been net sellers of mega cap stocks such as Home Depot for each of the past three years, causing prices of the largest US companies to stagnate or decline even as earnings have increased.
The influx of capital to hedge funds further exacerbates this problem. Nearly all long-short equity hedge funds focus on small caps. Hedge funds are not buying Home Depot stock. Much of the new money going into hedge funds is probably coming out of large cap mutual funds.
Some investors believe that Home Depot’s earnings will decline because of a slowdown in the housing market. In fact, the company’s earnings have increased each year since its initial public offering in 1984 – through two declines in the housing market and two recessions.
Today, Home Depot’s stock is at 11 times trailing 12-month earnings, cheaper than it has been since it went public.
The economics of stock buy-backs are simple yet few corporations seem to understand them. When you buy back stock at a price above the intrinsic value of the company, you destroy value. When you buy back stock at, or close to, the intrinsic value, you create no value and the buy-back is a waste of time and effort.
But when you have the rare opportunity to buy back shares at a bargain price, you create value for shareholders with each share you repurchase and retire. The key is the intrinsic value of the underlying company.
Based on a discounted cash flow model, I believe Home Depot’s intrinsic value is at least $50. At $34, the stock is 30 per cent below its intrinsic value. A 500m share repurchase (25 per cent of the outstanding shares) would, therefore, create more than $8bn value for shareholders.
Many buy-backs are only neutral to shareholder value or even destructive. Companies that engage in “serial” buy-backs year in and year out, regardless of the share price, are essentially destroying value over the long term.
Their managements are abusing shareholder capital in order to prop up the share price so they can exercise and sell their options at a profit. I have witnessed this value destruction too many times.
There are companies that opportunistically increase their repurchases only when the shares are undervalued.
International Game Technology, the leading slot machine manufacturer, has a history of increasing repurchases when stock is at a multi-year low and decreasing buy-backs when stock is at a multi-year high.
There’s another reason Home Depot ought to increase its share repurchases – its private market valuation is probably greater than its public valuation. There has been a number of leveraged buy-outs in the retail sector over the past few years. Nearly all of these have been done at higher multiples than Home Depot’s current one.
Home Depot owns 58 per cent of the land under its retail stores and 87 per cent of its buildings (the rest are leased). I estimate the value of the land and buildings to be close to $20bn.
What I’m proposing is essentially a mini-leveraged buy-out using the borrowing capacity of Home Depot’s real estate. It would need to borrow about $17bn to repurchase 25 per cent of its outstanding shares.
This amount of debt is about 1.3 times trailing 12-month earnings before interest, tax, depreciation and amortisation, an amount that would allow it to maintain its investment-grade credit rating and lower its cost of capital.
If the markets won’t give Home Depot the valuation it deserves, management owes it to the shareholders to do something.
Mark Sellers is a hedge fund manager with Sellers Capital in Chicago.
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