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Home Depot Has the Tools for Better Bond Valuations

Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm pleased to be joined today by Joscelyn MacKay. She is a Securities Analyst. We'll take a closer look at Home Depot and see why the bonds and the stock look attractive for investors today.

Joscelyn, thanks so much for taking the time today.

Joscelyn MacKay: Thanks for having me.

Glaser: Home Depot has obviously been hit pretty hard by the recession. The downturn in housing is particularly hard for a home improvement warehouse. How have they been performing recently, has the recovery in some of the broader consumer spending helped Home Depot?

MacKay: Home Depot has definitely improved. Their same-store sales turned positive in 2010, and they actually outperformed expectations in the fourth quarter, which they reported last week.

Glaser: So, consumers are really coming back in to the Home Depot stores and what kind of items are they purchasing when they are there?

MacKay: We are really seeing home improvement stores really have a broad brush improvement and we are really looking for consumer confidence, improved consumer spending, and the housing turnover to really begin to stabilize a little bit more in 2011 and improve beyond and really think that recovery is going to hit Home Depot.

Glaser: Now Home Depot's arch-rival Lowe's has also been seeing some of these similar trends. How do you see the competitive dynamics between these two giants in this space working out over the next couple of years?

MacKay: In the most recent couple of quarters, Home Depot has actually outperformed Lowe's. The comp in the fourth quarter was much better, but over time we do see a couple quarters where Home Depot is ahead, a couple quarters where Lowe's is ahead, and we really see these two both benefiting from the upturn in consumer spending.

Glaser: So, there's certainly room for both of them in the marketplace?

MacKay: Definitely.

Glaser: Now let's turn to the balance sheet, and look at Home Depot's financial position. Were they significantly weakened at all by the recession?

MacKay: They were, but they really have a solid balance sheet. So, their credit metrics really weren't too impaired. Their lease-adjusted leverage is around 2 times, which is about where we would see appropriate for a cyclical company.

Glaser: Now, Home Depot has announced they are going to return a lot of cash to shareholders through share buybacks. Is that a kind of program that worries you that instead of using that cash to pay down debt, they're putting it into other uses?

MacKay: At this point, it's not. We rate Home Depot A, which is a solid credit rating. If they were to perhaps take on a lot of leverage to be able to give shareholders more money through share buybacks or dividends, then we might be a little concerned. But at this point, they've got a solid balance sheet and we're not concerned.

Glaser: You've mentioned that bonds look attractively priced today, why do you think that is, why do you think the market is discounting these bonds so much from where we think they should be worth?

MacKay: I think, their slightly weak credit quality maybe relative to Lowe's might be what investors are hanging on. Why we do think these bonds should trade a bit wider of Lowe's, we just think they trade much wider than they probably should.

Glaser: What specific issues do you think investors should take a closer look at?

MacKay: Because of Home Depot's solid, stable wide moat, we'd really encourage investors to reach a little bit further down the maturity schedule to pick up a little more yield. So, we like the firm's 2036 and 2040 notes.

Glaser: What kind of spreads to treasuries could investors expect in investing in these bonds?

MacKay: These bonds trade around a 130 basis points over the 30-year treasuries, which is much higher than Lowe's at around 90 or 100 basis points.

Glaser: So, if the bonds look undervalued to us right now, what about the stock?

MacKay: We do think the shares are slightly undervalued at this point, trading around 0.88 times fair value.

Glaser: So, investors might want to wait for a little bit of a pullback there, but certainly it's a name to keep on the radar screen.

MacKay: We do think Home Depot is going to benefit throughout the cyclical recovery.

Glaser: Joscelyn, thanks so much for your thoughts today.

MacKay: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser.