From Joshua Kennon,
Your Guide to Investing for Beginners.
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On Thursday, May 25th, 2006, a firestorm of controversy was ignited in the media when the Board of Directors for Home Depot, the second largest retailer on the planet and one of the thirty stocks included in the vaunted Dow Jones Industrial Index, failed to show up to the shareholder meeting. The theory: Directors wanted to avoid shareholders irate over the pay package of CEO Richard Nardelli, estimated to be around $250 million over the past five years, in light of the stock’s fall from $70 per share in 2000 to $37.92 today.

Nardelli Deserves Every Dime

First, I concede that annual meeting is the one opportunity the true owners of the business – the shareholders – are allowed to ask questions and get an idea of management’s outlook for the enterprise. Some companies, such as Berkshire Hathaway, have turned these meetings into an opportunity to make stockholders truly feel as if they own a business, not just a piece of paper. The reward is an almost unwavering and faithful cult-like shareholder base that aids the long-term stability of the corporation and permits management far more latitude than it would otherwise be given. For Nardelli, who reportedly cut off shareholders after one minute and refused to answer many questions, this was a public relations nightmare. It shows an extraordinary lack of judgment on his part (and, given his intelligence, one I expected will never be repeated). More inexcusable, however, was the absence of the Board of Directors.

That said, the real story was the irrationality of the shareholders following the meeting. The fundamental problem is that many, many commentators, reporters, and journalists focused on the stock’s movement – falling nearly 46% over six years – and totally ignored the operating performance of the business. To pour salt on the wound, many are livid over the 300% increase of rival Lowe’s common stock during the same period.

An executive has little to no control over the price of his or her company’s stock. That is determined solely and completely by Wall Street based upon the financial community’s expectations for the business, the economy, interest rates, and other factors that may affect a firm’s cash flows. What is under management’s control, however, is the performance of the fundamental business operations. That, and only that, is what he or she should be gauged on when shareholders discuss “pay for performance”. On this front, Nardelli has hit the ball out of the park.

Home Depot - Then and Now

Consider that when Home Depot traded around $70 per share at the height of the stock market bubble, the retailer was earning around $2.6 billion and had approximately 2.3 billion shares outstanding. For fiscal year ended 2006, the company is expected to report net profit in excess of $6.5 billion and have only 2.1 billion shares outstanding. In essence, as an owner of Home Depot, not only has your company increased earnings 250% during Nardelli’s tenure, but 10% of the outstanding stock has been repurchased and retired, increasing your equity in the business proportionately.

In addition, in the past six years sales have grown from $45.7 billion to $92.5 billion, the number of stores has increased from 1,134 to 2,160, the net profit margin has gone from 5.6 percent to 7.0 percent, return on shareholder equity from 17.2 percent to 21.5 percent, the dividend has increased over 275 percent, and it has acquired a number of general supply businesses such as National Water Works, the company that provides fire hydrants and water pipes to municipalities throughout the United States, thus diversifying the company’s operations.

A cursory glance at the numbers should reveal that the problem isn’t operating performance, but rather the multiple Wall Street is willing to pay for the earnings stream generated by HD. Despite these excellent returns, the price to earnings ratio has fallen from 47 in 2000 to 14 today. In other words, Home Depot was grossly overvalued six years ago. Today, the company is far more attractive on both a valuation and operational basis than it was at the turn of the century. Management is making all of the right moves and, even more impressive, doing so while returning billions of dollars in capital to shareholders. You really couldn’t ask for more.