12 October 2008

HD: Look Ahead to October 2008 Quarterly Results

When we analyzed Home Depot's 10-Q quarterly report for the second quarter of the 2008 fiscal year, the GCFR Overall gauge of the company's performance and value increased from 46 to 50 of the 100 possible points. 

The Overall score edged up despite downward pressure from lower Cash Flow from Operations and Net Income.  The countervailing force was the weight given by the contrary-minded Value gauge to the historically low Price/Earnings, Price/Revenue, and Enterprise Value/Cash Flow (EV/CFO) as determined on 31 July 2008.  The P/E value was also at a significant discount to the S&P 500's multiple.

Given the current market conditions, it's not surprising that Home Depot shares are trading at an even lower price now.

The Home Depot, Inc. (NYSE: HD) is the largest retailer of do-it-yourself merchandise, which includes building materials, home improvement supplies, and lawn and garden products.  It competes fiercely with Lowe's (NYSE: LOW) and various other, generally smaller, hardware and lumber retailers. 

New management sold the Home Depot Supply division, which served professional contractors, to a consortium of private equity firms on 31 August 2007.  The price was $8.5 billion, or $1.8 billion less than the figure originally negotiated.  Management then executed a $10.7 billion Dutch Auction tender offer for Home Depot shares.

On 18 November 2008, Home Depot is scheduled to report its third-quarter results.  This period consists of the 13 weeks ending 2 November.  In anticipation of this report, we've modeled the company's Income Statement for the quarter.  The intent of this exercise was to produce a baseline for identifying any deviations, positive or negative, in the actual data.  GCFR estimates are derived from trends in the historical financial results and guidance provided by company management.

When Home Depot reported its second-quarter results in August 2008, it provided the following guidance for the remainder of the fiscal year:
Given the continued softness in the housing and home improvement markets as well as the commitment to invest in its key retail priorities, the Company believes fiscal 2008 sales will decline by approximately five percent and diluted earnings per share from continuing operations will decline by approximately 24 percent. This is consistent with its previous guidance. The Company’s 2008 earnings per share guidance does not include its store rationalization charge from the closing of 15 stores and removal of 50 stores from its future growth pipeline.

The last two sentences in this guidance refer to Home Depot's announcement on 1 May 2008 "it will no longer pursue the opening of approximately 50 U.S. stores that have been in its new store pipeline, in some cases for more than 10 years."  The write-down of previously capitalized development costs led to a $400 million charge.  Similarly, a related decision to shutter 15 existing stores resulted in an additional expense of $186 million.  The bulk of these charges were recognized in the first quarter.

More recently, the Associated Press reported Home Depot will cut prices in an attempt to boost slowing sales.

Since Revenue in the four quarters of fiscal 2007 was $77.35 billion, the quoted management guidance is to expect fiscal 2008 Revenue to be 0.95 * $77.35 billion = $73.5 billion.  In the first two quarters of fiscal 2008, Revenue was $38.9 billion.  This leaves $34.6 billion for the third and fourth quarters. 

To split this figure over the two periods, we determined third-quarter Revenue has averaged 52 percent of second-half Revenue in the last five years.  Therefore, management's guidance leads us to expect third-quarter Revenue of 0.52 * $34.6 billion = $18.0 billion.  This is 5.3 percent less than the $19.0 billion of Revenue in last year's third quarter, excluding the sales of the former Home Depot Supply business.

While the price cuts identified above are likely to increase the amount of merchandise sold, it's not at all clear whether the effect of the price cuts will be to increase Revenue (i.e., transactions will surge enough to compensate for lower prices) or decrease it (i.e., transactions increase, but fewer dollars pass through the till).  We will, therefore, adopt a wait-and-see approach.

Home Depot's Gross Margin as a percentage of Revenue has averaged 33.7 percent over the last four quarters.  The price cuts identified above, implemented half way through the quarter, will cut into the margin.  However, the magnitude of the contraction is uncertain.  Our guess is that the Gross Margin won't be any lower than 33.0 percent.  Given our Revenue estimate, we forecast a Cost of Goods Sold (CGS) of (1-0.33) * $18.0 billion = $12.1 billion.

Management indicated, when reporting fiscal 2007's fourth-quarter and full-year results last February, that Depreciation and Amortization expenses in fiscal 2008 will be about $1.9 billion.  However, we expect the actual figure will be a little less because some depreciable assets have already been written off entirely.  Depreciation charges per quarter have been about $450 million instead of the $475 million implied by the guidance.  We will assume another $450 million (2.5 percent of Revenue) depreciation expense for the third quarter.

Sales, General, and Administrative (SG&A) expenses as a percentage of Revenue have averaged about 23 percent over the last four quarters.  Applying this ratio to the third quarter results in our expectation of SG&A expenses in the third quarter to be 0.23 * $18.0 billion = $4.1 billion.

In the Other Operating Expense category, there might be some residual charges due to the reduction in new and existing stores.  However, we will assume that the first quarter took care of these charges.

Given the estimates above for Revenue and Operating Expenses, we're projecting that Home Depot's Operating Income, as we define it, will be $1.35 billion in the third quarter.  This figure is 23.5 percent less than in the October 2007 quarter.

Net interest and other expenses has averaged about $160 million per quarter in the last year.  This value would decrease pre-tax income to $1.19 billion.

Management guided analysts to expect an income tax rate of 37.2 percent.  The trend to date would suggest a slightly lower rate, but we will stick with the guidance value for the time being.  It would lead to a $443 million provision for income taxes if our other estimates prove true.  And, it would result in Net Income of $747 million for the quarter.  This is 30 percent less than earnings of $1.1 billion in fiscal 2007's third quarter.  We expect Earnings per share to drop to $0.44 from $0.59, if the number of shares outstanding hasn't changed much from July.

Please note that the tabular format below, which we use for all analyses, can and often does differ in material respects from company-used formats.  A common difference is the classification of income and expenses as Operating and Non-Operating.  The standardization is simply for convenience and to facilitate cross-company comparisons.

($ M)
2 November 2008
28 October 2007
18,000 18,961
Operating expenses

CGS  (12,060) (12,622)


SG&A  (4,140) (4,144)

Other (0)
Operating Income
1,350 1,764
Other income

Investments 0 0

Interest, etc. (160) (125)
Pretax income
1,190 1,639
Income tax
Net Income from
continuing operations

Discontinued operations
0 20
Net Income
Shares outstanding
1,687 1,815

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