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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 2015, the real GDP of the U.S. grew about 2.4% and unemployment rates reached record lows of about 5%. Housing continues to be a bright spot in the economic growth story for the country. Home prices are expected to increase 5-6% in 2016, a sign of growth in the housing industry. This could also boost home improvement sales.
- Home Depot's share price and performance, in general, has continued to benefit from the phenomenal growth in housing markets in the previous few years, and steady growth in recent times.
- Lowe's beat Home Depot in terms of domestic comp sales growth in Q1 2016
- Around 90% and 98% of Home Depot and Lowe's' sales, respectively, come from the U.S. While Home Depot's domestic comps grew by 7.4% in Q1 2016, Lowe's managed a 7.5% growth. Facing up to Home Depot, which has more stores in the U.S. (1,977 stores compared to Lowe's 1,805 stores), and is typically more well-known, Lowe's is focusing on making itself more customer-centric for the non-expert — a potentially weak spot for Home Depot. This could help Lowe's gain more Do-It-Yourself customers and help it differentiate itself from Home Depot. This strategy can be seen playing out in the Q1 results where Lowe's comps beat that of Home Depot's, on the back of higher customer transactions.
- However, Home Depot still scored better in terms of overall sales growth, and is operating on a higher margin as compared to Lowe's. Moreover, Lowe's gross margin declined by 50 basis points in Q1, as sales of lower margin products grew by a high proportion. Lowe's plans to open 45 home improvement and hardware stores this year, including stores in the U.S. and international markets. Increasing presence could help Lowe's further narrow its gap with Home Depot.
Home Depot EBITDA Margin: From 2009-2014, Home Depot improved margins to over 17% by streamlining its operations, supply chain, and cutting down heavily on its SG&A expenses. Margins were also aided due to the 5.6% growth in same store sales in 2015. Going forward, we expect the margins to continue to slightly increase to cross the 19.5% mark over the Trefis forecast period, with further operating leverage as comps improve. However, if the comps grow only modestly, and there is limited or no operating leverage, margins could decline to around 18%, 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 2,275 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 1.3x 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 0.7% in 2014, and by 1.3% in 2015, and could further grow while Sears continues to struggle. Around 78% of Home Depot's stores are within 10 miles of a Sears location. Sears will close another 78 stores (68 Kmart units, and 10 Sears stores) in 2016, as it looks to restore profitability. That accounts for ~5% of its store base, which is nearly 1,700 stores.
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 ($286 Billion v. $146 Billion), it is a very fragmented market and Home Depot currently captures only around 5.6% of it. In comparison, Home Depot's share in Plumbing, Electrical and Kitchen goods is about 18% and in Hardware and Seasonal Tools it is close to 52% -- although the Plumbing market is three times larger ($146 Billion for Plumbing v. $46 Billion for Hardware).
Consistently outpacing Lowe's in terms of comps
In 2013, Home Depot outpaced Lowe's in terms of same store sales growth with better pricing. In 2014, sales growth was recorded at 4.3% for Lowe's and 5.3% for Home Depot. In 2015, while Home Depot's comps grew 5.6%, that of Lowe's grew only 4.8%. We expect the trend to continue.
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, and have been growing by high-single-digit/double-digit percentages in the last few quarters.
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-2010, Home Depot's quarterly comparable-sales-growth rates have consistently outpaced Lowe's. Comparable store sales for Home Depot grew by 5.6% in 2015, and are expected to grow by approximately 4.5% in 2016.
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 5.6% in 2015, and is expected to increase by 4.5% in 2016. This helped Home Depot improve its margins through operating expense leverage during 2010-2015. 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., and two in Canada.
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.
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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