01 January 2009

HD: Look Ahead to January 2009 Quarterly Results

Fiscal 2008 for Home Depot will conclude on 1 February 2009. The company will announce its fourth quarter and fiscal year results on 24 February.

This post explains how we modeled Home Depot's Income Statement for the fourth quarter. When the actual results are published, we will compare them to the model to identify the extent to which sales, expenses and other gains/losses differed from our expectations. GCFR estimates are derived from trends in the historical financial record and guidance provided by company management.

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. The company competes fiercely with Lowe's (NYSE: LOW) and a multitude of smaller hardware and lumber retailers.

Investors with large stakes in Home Depot include RBS Partners, L.P., and Berkshire Hathaway (NYSE: BRK.A). RBS is associated with Edward Lampert, Chairman of Sears Holdings (NASDAQ:SHLD). Berkshire, of course, is run by super-investor Warren Buffett.

Home Depot invested $325 million for a 12.5 percent equity stake in HD Supply. This former Home Depot division, which served professional contractors, was sold to a consortium of private equity firms. The value of this investment has probably declined, given current economic and market conditions, and Home Depot might have to record an asset impairment charge at some point. (Home Depot has also guaranteed $1.0 billion of HD Supply debt.)

Chairman and CEO Frank Blake, when he announced third-quarter earnings, stated that Home Depot was "making the adjustments to respond to a tough [housing and home improvement] market environment." In May 2008, the company announced "it will no longer pursue the opening of approximately 50 U.S. stores that ha[d] been in its new store pipeline." A related decision was made to close 15 existing stores. Home Depot recorded pretax charges of $586 million in conjunction with these two actions.

Home Depot indicated it would cut prices in an attempt to boost slowing sales.

In the third quarter, which ended on 2 November 2008, the GCFR Overall Gauge of Home Depot slipped from 45 to 41 of the 100 possible points. Our initial and updated analysis reports explained the results in some detail. [A recalculation trimmed a point off each score.]

The Cash Management and Value gauges were reasonably strong at 14 and 13 points, respectively, of the 25 possible points. Growth, at zero points, was non-existent. Revenue in the quarter was 6.2 percent less than in the year-earlier period. Same-store sales were down a substantial 8.3 percent, but (only?) by 7 percent if a shift in the fiscal calendar is considered. Trailing four-quarter Revenue fell 3.6 percent.

Net Income from continuing operations was down 29.4 percent.

When Home Depot reported third-quarter results, 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 negative macro economic conditions, the Company now believes that fiscal 2008 sales could be down as much as 8 percent for the year. The Company expects that earnings per share from continuing operations will decline by approximately 24 percent, consistent with 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.

We will first examine the statements in the guidance related to earnings. In fiscal 2007, Home Depot reported earnings from continuing operations of $4.2 billion ($2.37 per share). Decrementing the per-share figure by 24 percent yields a target fiscal 2008 EPS from continuing operations of $1.80. If we assume 1.685 billion diluted shares outstanding, the projected Net Income from continuing operations for the year is $3.03 billion. In the first three quarters, Net Income totaled $2.31 billion. However, we have to add back in $375 million ($586 million less taxes) for the "store rationalization" charges. Therefore, if we have interpreted the guidance correctly, the company expects fourth quarter Net Income to be $3030 - (2310 + 375) million = $345 million ($0.20/share).

Since Revenue in fiscal 2007 was $77.35 billion, the quoted guidance is to expect fiscal 2008 Revenue as low as (1 - 0.08) * $77.35 billion = $71.2 billion. If we subtract the $56.7 billion of Revenue in the first three quarters of the year, this leaves $14.5 billion for the fourth quarter. Since Revenue in last year's final quarter was $17.7 billion, we're looking at a quarter-on-quarter sales drop of 18 percent.

Home Depot's Gross Margin as a percentage of Revenue has been 33.7 percent during the last four quarters. It seems reasonable to expect the slow economy and the price cuts identified above to cut into the margin. Our target for the Gross Margin is 33.2 percent. Given our Revenue estimate, we forecast a Cost of Goods Sold (CGS) of (1-0.332) * $14.5 billion = $9.7 billion.

Depreciation and Amortization expenses per quarter have been about $450 million. We will assume this trend will continue in the fourth quarter.

Sales, General, and Administrative (SG&A) expenses have been 23 to 24 percent of Revenue. With Revenue falling steeply, we assume the ratio will rise to 25 percent in the fourth quarter, or 0.25 * $14.5 billion = $3.6 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 $740 million in the fourth quarter. This figure is 41 percent less than in the January 2008 quarter.

Net interest and other expenses have been between $150 and $165 million per quarter recently. Since these costs are often a little higher in fourth fiscal quarters, we have set our target for the current quarter at $170 million.

An effective income tax rate of 36.2 percent would lead to Net Income of $360 million ($0.21/share) for the quarter. This figure, which is reasonably close to the company's guidance, is 47 percent less than earnings in fiscal 2007's fourth quarter.

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.

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