Home Depot (HD)

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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:

  1. 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 2016, the real GDP of the U.S. grew about 1.6% and is estimated to grow around 2.1% in 2017. The unemployment rate has remained below 5% since September 2015. Housing continues to be a bright spot in the economic growth story for the country. Home prices are expected to increase 5-6% in 2017, 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.
  2. Home Depot's online sales continue to propel overall growth
    • Online sales formed 6.4% of Home Depot's top line in fiscal 2016 (up from 1% in 2011), growing 19% year-over-year. In Q2 FY17, online sales grew 23% y-o-y, and was a key driver in the impressive growth of the company.
    • A significant portion of the online growth leverages the physical store assets. ~43% of Home Depot's online orders are picked up in stores. This reflects a strong and successful interconnected strategy.
  3. Latest earnings
    • Home Depot delivered yet another beat, posting strong sales growth of 6.2%, easily surpassing revenue expectations by $300 million. It was also noted to be the highest ever quarterly sales reported by the company in its history. Comparable sales also rose by 6.3%, exceeding consensus estimates which called for a 4.9% gain, with those of the US stores coming in at 6.6%. These factors, together with fiscal discipline, resulted in better earnings, which were up by 14.2% to $2.25 per share.
    • However, the company's stock fell over 3% despite the robust earnings announcement. This likely stems from the poor showing of other retail companies, such as Coach and Dicks Sporting Goods. Furthermore, the company's guidance of 5.5% comparable sales growth for the full year implies a deceleration in the second half of the year. However, this figure exceeds that of a majority of retail companies, with HD continuing to be a standout in this sector, and it has been calculated based on the planned foreign exchange rates for the second half of the year. Given the performance of the US dollar recently, there is a possibility of an upside to the guidance. Below we'll highlight the key takeaways from the earnings.

POTENTIAL UPSIDE & DOWNSIDE TO TREFIS PRICE

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 both in 2015 and in 2016. Going forward, we expect the margins to continue to slightly increase to reach 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.

BUSINESS SUMMARY

Home Depot is the world’s largest retailer of home improvement products. Home Depot has grown to 2,281 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.

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.

SOURCES OF VALUE

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.

Ongoing structural and strategic challenges have resulted in the loss of market share for Sears, once the leading U.S. appliance retailer. Sears is now the third-ranked appliance retailer behind Lowe's and Home Depot, reducing its Top 50 market share to 19.5%, from 23.5% in 2014. As Sears continues to struggle, Home Depot can steal some share. Around ~80% of Home Depot's stores are within 10 miles of a Sears location. Sears closed another 78 stores (68 Kmart units, and 10 Sears stores) in 2016, and after announcing at the start of 2017 that it would shutter 150 underperforming stores, it has recently added at least 30 more locations to the list, as it looks to restore profitability.

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 ($302 Billion vs. $144 Billion), it is a very fragmented market and Home Depot currently captures only around 5.7% of it. In comparison, Home Depot's share in Plumbing, Electrical and Kitchen goods is about 19.4% and in Hardware and Seasonal Tools it is close to 56% -- although the Plumbing market is three times larger ($144 Billion for Plumbing vs. $46 Billion for Hardware).

KEY TRENDS

Consistently outpacing Lowe's in terms of comps

Home Depot and Lowe's are the number one and two home improvement retailers in the U.S., holding 24% and 17% market shares, respectively. 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%. Home Depot bucked the trend of declining sales for retailers in early 2016 on higher consumer spending on home improvement. The company beat Lowe's comps in Q4, Q3 and Q2, after falling short in Q1. 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.

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 2016, and are expected to grow by approximately 4.6% in 2017.

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 2016, and is expected to increase by 4.6% in 2017. This helped Home Depot improve its margins through operating expense leverage during 2010-2016. 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.

Pro customer activity will drive home improvement industry growth in the near future

The pro segment is estimated at $120 billion a year, nearly as large as the do-it-yourself segment. A breakdown of Home Depot's comparable sales growth in the last few quarters shows a broader increase in the average ticket size as compared to a customer traffic increase. Transactions of $900 or more have grown by high single-digit or double-digit percentages in the last few quarters. Pro sales continue to grow disproportionately faster than Home Depot's average, boosting its top line and leading to a market-beating growth in categories such as plywood, fencing, and industrial lighting.

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.

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