Wednesday, February 14, 2007

Who Is To Blame?

You are thinking about buying shares in the following company in January 2001. Sept. 11th is 9 months away, the recession that followed is almost a year away and the current events in Iraq and Afghanistan are not on anyone radar screens. Looking at the financial picture of this company, you decide to pick up some shares. Now fast forward 5 years and this is what has transpired:

Revenues have grown 80%
Earnings grew 147%
The dividend has grown 150%
Cash flow from operations grew 137%
Shares outstanding decreased 8%
Assets increased 109%

You are probably thinking you are sitting on the porch of your new ocean front house reading this. How could the stock of this company not have doubled or even tripled? Life must be good.

Reality check. Not only has your stock not double or tripled but you have actually lost money! How much? As of today you are down about 20% but, don't feel bad as this is far better than the almost 60% you were down in 2003. "Who is to blame?" you shriek. "Heads must roll!! Fire the CEO, hang the Board of Directors and bring me the head of Alfredo Garcia!!" Do you want to know who is to blame? I will tell you. Please get up from your computer screen, go over to a mirror and stare in it. Who do you see? That's right..You!! You are to blame. "Why me," you ask?

Because, for some inexplicable reason you paid over 50 times earnings for a company that sells screwdrivers and lawn mowers and was growing at a rate of less than half that. The company? Home Depot (HD). I have said it before and it bears repeating, timing in life is everything. Now former CEO Bob Nardeli took the job when the stock was at an irrational all time high and because he was not able to re-write the number one law of investing, overpriced stocks always fall, (see SBUX & Google) he is out of a job. Here is the timing part, had he taken the over in Jan. 2003 when HD stock was at its lows, and delivered the same financial performance, his reign would be marked by a stock price increase of 95% and we would writing articles about how he "Rescued Home Depot". Irony...

The HD Board of Directors caved to pressure from delusional investors who thought there was a "new paradigm" and plowed money into shares of HD at the turn of the century only to be shocked when there wasn't, and ousted Nardeli. I know "technically" he left over a pay dispute but if I am in charge and want you to leave, I will refuse to give you what you want hoping you get mad and do just that. That is what happened here. It is clear the Board of Directors no longer wanted him around. Now, Nardeli did not help his cause with his management style and made himself an easy target. A GE product from the Jack Welch days, he attempted to bring that same hard charging persona to the HD ranks. He failed to realize that an up and coming manager at GE who has aspirations of greatness will accept that pressure and try to perform. But, the retired plumber or electrician who works nights and weekends at HD for a little extra cash will tell him to stick it (and they did in droves). He then decided to stop giving "analyst" earnings and sales guidance and Wall St. freaked (he later changed his mind). Continuing to dig the grave, he was less than graceful (to be polite about it) to shareholders at the annual meeting. In short, he did put the bull's eye on his back.

Shrill investors were not satisfied just with his ouster though. They demanded board representation and new CEO Frank Blake did hid best impersonation of a French soldier and instantly surrendered before the battle began. His reasoning must have been "hey, these guys were shrewd enough to pay 80% too much for the stock when they bought it, surely they are qualified to make decisions for the future of the company" Okayyyy.

He then sent two key executives close to Nardeli packing probably thinking, "24% earnings growth per year? These clowns got to go". I can only assume he was listening the same investor group he gave the keys to the boardroom to.

Now, "Bend Over Blake" has decided that the Hughes Supply Division that Nardeli purchased for $3.8 billion dollars (including assumed debt) less than a year ago might need to be sold (again listening to these same investors). The claim is that Nardeli overpaid for Hughes and it is a drag on the company. Opponents of the acquisition claim in has distracted HD from its core business of retail sales. This is ridiculous, they are still selling the same items, just to different people, it isn't like they decided to go into the shoe business. I mean if Church & Dwight can make selling baking soda and condoms work (who doesn't think of those two in the same sentence?) why can't HD make selling screwdrivers and uh screwdrivers work?!? Estimates today have the division going for $8 to $13 billion. Let's do the math, Nardeli paid $3.8 billion and less than a year later estimates are that HD could realize a return of 110% to 240% on that investment. He overpaid? This too is foolish. If you look at HD retail operations, is there a town in the US that does not have one? Where is the future growth for HD? The answer? Currently it is in the very supply business they are considering selling!

This summer I picked up some HD when it was trading at $34 a share. I sold it in December at $39 (it currently sits at $41) when the Nardeli ouster hysteria was hitting a crescendo. My thinking was "the devil I know is better than the devil I don't". I decided to get out and wait to see how things shook out. I also would not be a buyer of it at this time.

Why? Hall of Fame football coach Marv Levy, the only coach to ever lead a team to four consecutive Super Bowl's once said "If you listen too much to the fans, you'll soon find yourself sitting with them." This is exactly what "Bend Over Blake" is doing. Yes I want management to listen to shareholders concerns and behave in a way that adds value for us, but management cannot let them run the company. Especially when it was not running poorly to begin with. Think about it, in the past 6 years HD went through 9/11, a recession and now a housing downturn. HD's business is very sensitive to these events and through it all it has performed well. The phrase "if it ain't broke, don't fix it" has meaning for a reason. HD was not broken, it just needed tweaking. Maybe a little "warm and fuzzy" from management to employees and shareholders would have turned attitudes around. Had HD been losing money or had rapidly falling profits then shareholders and Bend Over would be justified in taking these drastic actions. But, giving the reigns to people who, let's be honest, made a terribly indefensible buying decision themselves is insanity. I'll get your seat ready Mr. Blake.

I would like to buy HD again but with what is happening, who knows what they are going to do. So I wait. I will not add it to the watch list because the conditions that would have me considering a buy at this point have nothing to do with price and everything to do with the direction. I cannot figure out a price to buy when I do not know what the company will look like. I am just wondering what will be left after these guys are done.

Don't think I have forgotten about you either. Yes Nardeli made mistakes, and Blake appears to be making bigger ones but if you are holding this stock and are under water, the biggest mistake was made by you. "Wait a minute!" you scream. The stock of Lowes, HD's only competitor is up 200% in the same time. "What do you think about that!" you ask indignantly. This one is real easy. Those Lowes investors in 2001? They only paid 20 times earnings for their shares for a company growing at 20%, therefore they received the full benefits of Lowes earnings growth. It should be noted here that all the stocks in the Value Plays Portfolio trade at about equal to or less than their earnings growth rates. When you pay a price commensurate to or less than a companies earning growth, you reap the rewards of that growth. You on the other hand paid over 2.5 times earnings growth for HD shares and are suffering despite the 147% earnings growth over that time. Lesson learned? The next time you want to pay 50 times earnings or over twice a companies growth rate for anything, email me and I will try to talk you off the ledge before you and your money fall. If you do not want to email me, take a hammer and smash your thumb with it rather than buy the stock. At least that pain will go away soon, the pain of the stock buy will linger for as long as you own it.

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