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Investment Overview for Home Depot (NYSE:HD)
WHAT HAS CHANGED
Home improvement spending is highly correlated with trends in the economy, job markets, and housing markets. Here is what has changed over the past quarter and the full year in terms of macroeconomic fundamentals, and in terms of Home Depot's company specific strategies:
- Changes in the last year - U.S. economy and housing markets
- Over the last year, Home Depot has continued to benefit from strong macroeconomic fundamentals. In 2014, the U.S. economy grew about 2% and unemployment rates reached record lows of about 6%. In spite of an upbeat economy, housing statistics remained slack in the year, with existing home sales declining 2.9% (after growing by over 9% in 2013) and new home sales increasing just 1.6% (after growing by over 16% in 2013).
- However, Home Depot's share price and performance, in general, continued to benefit from the phenomenal growth in housing markets in the previous years. Furthermore, the National Association of Realtors projects existing home sales and new home sales to increase at a whopping 31% and 13%, respectively, going into 2015, which could ensure sales for the retail giant.
- Changes in the last quarter - U.S. economy and housing markets
- In Q1 the U.S. economy failed to grow as expected, which occurred as a consequence of an appreciating dollar choking off exports, labor disputes on the West coast adversely impacting trade, declining oil prices leading to lower investments in the sector, and harsh winter weather choking off consumer spending. However, a rebound was seen in Q2, with the economy growing at 2.3%. Q3 again suffered a slowdown, with GDP growing below expectations at 1.5% as businesses waited to run down inventory rather than restock in the quarter. However, economists suggest that this could be a temporary phenomenon.
- While the slowdown in the U.S. economy at large, exerted a negative impact on the housing markets in the earlier part of Q1, housing statistics have improved since, which could support the home improvement industry. Existing home sales were recorded at 5.59 million units in July and the metric underwent a 8.3% increase in Q3. The NAR anticipates a 7% increase in existing and new home sales over the full year to clock in an estimated total of 5.8 million home sales in 2015. Furthermore, this figure is approximately 25% less than the total observed pre-recession, indicating that there is immense potential in the U.S.
- In short, although the U.S. economic growth has been slower, housing statistics show that there could be more growth in store for Home Depot going into Q3 and Q4.
- Company specific strategies over the last year
- Two spheres that have shown immense potential has been the Pro segment and the online business. Home Depot has done a great deal to leverage the potential in these segments.
- In 2013, the retailer declared the launch of "Home Depot Delivers" in select stores to allow same-day shipping for all online orders. In this respect, they opened two distribution fulfillment centers in 2014, with each center holding more than 100,000 stock keeping units, approximately 70,000 more than the average store. Through a network of over 2,000 stores, Home Depot continued to ship goods straight from their inventory to customers, which drastically improved customers' shopping experience by reducing the time lag between ordering a product and its delivery. With the addition of a third fulfillment center later this year, Home Depot will be able to to deliver approximately 90% of all online orders in less than two days time, which could set them gaining further in this sphere.
- Company specific strategies over the last quarter
- Home Depot has continued to focus on its Pro customer base by expanding its products and services that target this group. Latest in this is the acquisition of Interline Brands, a leading distributor of maintenance, repair, and operations (MRO).
- In Home Depot's Q2 earnings announcement, CEO, Craig Menear said that "Interline's expertise in hospitality, multifamily, and institutional MRO, brings strong fulfillment and sales capability to The Home Depot and the residential MRO product market." This, apart from increasing Home Depot's customer base by adding customers from Interline, is also expected to drive efficiency to grow the retailer's Pro customers.
Home Depot EBITDA Margin: From 2009-2014, Home Depot improved margins to about 16% by streamlining its operations, supply chain, and cutting down heavily on its SG&A expenses. Margins were also aided due to the 5.3% growth in same store sales. Going forward, we expect the margins to continue to slightly increase to cross the 17% mark over the Trefis forecast period, with further operating leverage as comps improve. However, if the comps stay flat, and there is limited or no operating leverage, margins could decline to around 15%, causing a 10% downside to our current price estimate. On the other hand, if the housing market and home improvement industry continue to strengthen, and outpace previously forecast growth estimates, and comps improve better than expected at 4-5% over the next few years, there could be a 15 to 20% upside to our current price estimate.
Home Depot is the world’s largest retailer of home improvement products. Home Depot has grown to 2,269 stores spanning across the U.S., Canada, and Mexico. It offers a wide range of home improvement products and installation services to individual home owners as well as professional builders. In addition to the physical stores, consumers can buy these products through the company’s dedicated website.
Home Depot has deep penetration in the U.S., Canada, and Mexico. Due to its large number of stores, Home Depot's sales are nearly one-and-a-half times those of its closest competitor, Lowe’s.
Home Depot's business is vulnerable to the housing market, and the housing slowdown has widely affected its sales. In fact, Home Depot had to close down its EXPO and HD supply businesses as their sales were badly impacted during the housing market downturn, making these businesses highly unprofitable.
The Plumbing, Electrical and Kitchen division, and the Hardware and Seasonal products division, are more valuable than Home Depot's other divisions for the following reasons:
Plumbing, Electrical and Kitchen has a larger total market than the Hardware and Seasonal, Paint and Flooring markets
The Plumbing, Electrical and Kitchen market size is more than double the Hardware and Seasonal market and Paint and Flooring market combined. Consumers are more likely to buy home plumbing, electrical, and kitchen products owing to the importance in their daily lives. For example, products like electrical lights, kitchen appliances, water pipes, wash basins, toilets, and showers, are basic requirements for every household. These products become necessary for consumers to fix when they break. Home Depot occupies a much higher market share in the Hardware and Seasonal tools category, compared to the Plumbing, Electrical and Kitchen division.
Sears is the leading U.S. appliance retailer, but has been losing market share to Home Depot in the last few years. Home Depot's market share in appliances improved by 0.6% in 2014, and could further grow while Sears continues to struggle. Around 78% of Home Depot's stores are within 10 miles of a Sears location.
Smaller market size but greater market share than the Building Materials, Lumber and Millwork segment
Though the Building Materials, Lumber and Millwork market is almost twice the size of the Plumbing, Electrical and Kitchen market ($278 Billion v. $144 Billion), it is a very fragmented market and Home Depot currently captures only around 5.4% of it. In comparison, Home Depot's share in Plumbing, Electrical and Kitchen goods is about 16% and in Hardware and Seasonal Tools it is close to 50% -- although the Plumbing market is three times larger ($144 Billion for Plumbing v. $44 Billion for Hardware).
Consistently outpacing Lowe's in terms of comps
In 2013 and 2014, Home Depot outpaced Lowe's in terms of same store sales growth with better pricing.
Home Depot has been stealing valuable market share from arch-rival Lowe's due to better pricing models. In late 2011, Lowe's had decided to move away from promotions to everyday low prices to establish itself as the retailer offering the most competitive prices. However, Lowe's sales continue to struggle more than they already would have in a depressed housing market as customers continued to seek discounts, particularly for discretionary and big-ticket purchases. Home Depot has been grabbing market share from Lowe's due to better pricing models. Transactions over $900 contribute around 20% of all U.S. sales for Home Depot, growing 10.3% in Q4 2014.
Following the recession, Home Depot focused on cost-cutting and improving customer service, whereas Lowe's opted for promotional sales and kept opening new stores, which produced diminishing returns. Since mid-2009, Home Depot's quarterly comparable-sales-growth rates have consistently outpaced Lowe's. The trend continued into 2014, although the gap narrowed possibly on account of the data breach at Home Depot. Comparable store sales for Home Depot grew by 5.3% in 2014, and are expected to grow by approximately 4.5% in 2015 against continued recovery in the U.S. economy and housing markets.
Emerging competition from online retailers
Online retail has been an emerging threat to the market share of brick and mortar home improvement retailers like Home Depot and Lowe's. For this reason both companies have made significant investments in online strategies, including small acquisitions and improvements in the web experience for their customers.
Improving same store sales could provide operating leverage
As a result of the gradual market recovery, Home Depot's same store sales growth (comps) has gradually improved from 2.9% in 2010 to 5.3% in 2014, and is expected to increase by 4.5% in 2015. This helped Home Depot improve its margins through operating expense leverage during 2010-2014. Going forward, we expect comps to continue to improve at 3.5-4.5%, as sales rise. This should bring in further operating expense leverage, thereby pushing up margins.
Home Depot's supply chain improvements
Home Depot has been focusing on supply-chain improvements through its central distribution system. We expect overall margins to further improve as the company continues its supply-chain improvements. Rapid Deployment Centers (RDC) aim to aggregate product needs for multiple stores to a single purchase order, and then rapidly allocate and deploy inventory to individual stores upon arrival at the RDC. This move aims to simplify the ordering process and improve inventory management. Home Depot has 18 fully mechanized RDCs in the U.S.
Do it Yourself (DIY) activity will drive home improvement industry growth in the near future
Until the housing market situation in the U.S. improves even further, more buying action is anticipated from DIY customers. Repair & maintenance of small house projects will dominate DIY activity. The North American Retail Hardware Association (NRHA) forecasts that plumbing and electrical products will be a major part of consumer spending in the near future. The spending will come mainly from DIY consumers who will demand more selection, information, and service from the retailers.
Shift in consumer preferences will impact traditional range of home improvement products
A survey from NRHA suggests a change in the buying patterns among U.S. home improvement consumers. People are no longer only loyal to products made in the U.S. Consumer demand is driven more by price and quality. Consumers may find foreign products, which may be better suited to their needs, and more appealing than products made in the U.S. Another observable trend is the shift in consumers toward buying green or eco-friendly products, such as water-saving flushes and electricity-saving appliances.
Aging baby boomers will increase Do it For Me (DIFM) customers in the U.S.
With the change in U.S. demographics due to the aging of the 77 million baby boomers (representing 28% of the U.S. population, and accounting for 77% of all financial assets), we expect an increase in Do it For Me (DIFM) customers. This is good for retailers, such as Home Depot, as they can reap additional revenue by providing installation services, unlike in the case of Do it Yourself (DIY) customers.
How Does Trefis Modelling Work?
How do we get the historical numbers for this chart?
Trefis has a team of in-house Analysts who gather historical data from company filings and other verifiable sources. When historicals are available, we explain how we got them at the bottom of the Trefis analysis section below.
Who came up with the Trefis forecast for future years?
The Trefis team of in-house Analysts considers a variety of factors when projecting any forecast. The rationale for our projections is explained in the Trefis analysis section below.
How does my dragging the trendline on the chart impact the stock price?
- We use forecasts for business drivers to calculate forecasted Revenues and Profits for each division of the company.
- We then use forecasted Profits in a Discounted Cash Flow (DCF) model to obtain the Price Estimate for the company.
See more on: DCF Methodology
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