12 January 2010

HD: Look Ahead to January 2010 Quarterly Results

The Home Depot, Inc. (NYSE: HD) earned $0.41 per share in the third quarter of fiscal 2009, which ended 1 November 2009, down from $0.45 in the same quarter of last year. 

In November, we examined Home Depot's Income Statement for the third quarter and compared the entries on each line to our "look-ahead" estimates.  We later performed a financial gauge analysis of Home Depot, which determined that the GCFR Overall gauge edged up from 27 to 29 of the 100 possible points.

We have now modeled Home Depot's Income Statement for the fourth quarter of fiscal 2009, which will end on 31 January 2010.  The intent of this exercise was to produce a baseline for identifying deviations, positive or negative, in the actual data the company will announce on 22 February.  GCFR estimates are derived from trends in the historical financial results and guidance provided by company management.

First, we set the stage with some background information about Home Depot and the business environment in which it is currently operating. 

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 with Lowe's (NYSE: LOW), cooperatives such as Ace and True Value, and a multitude of smaller hardware stores

Weaker consumer sentiment -- a result of rising unemployment and lower home values -- caused most retailers to suffer in 2008 and 2009.  Economic conditions have been especially crippling to firms tied to the ailing housing market.  A list of retailers that have filed for Chapter 11 protection in the last couple of years contains many familiar names.

Home Depot's response has been to consolidate operations and reduce capital outlays.  The first step, announced in May 2008, was to relinquish 50 planned stores in the U.S. and to close 15 existing stores.  The second step, taken in January 2009, was to exit the EXPO Design Center and a few other peripheral businesses.  These actions led to asset impairment, severance, and other charges over $1.1 billion.

The company is also working to reduce inventory costs by streamlining distribution of products to stores.  New Rapid Deployment Centers are key elements of this effort.  These regional warehouses receive mass deliveries from manufacturers and dole out the products to 100 or so area stores.  This distribution model is similar in form to Wal-Mart's (NYSE: WMT) exemplar of efficiency.

Several famous investors have trimmed or liquidated their bets on Home Depot.  RBS Partners, associated with Edward Lampert, reported owning no shares of Home Depot on 30 September 2009.  This Limited Partnership owned 9.9 million shares on 30 June 2009 and 17.8 million shares three months earlier.  Mr. Lampert is Chairman of Sears Holdings (NASDAQ: SHLD). 

Berkshire Hathaway (NYSE: BRK.A), run by investing legend Warren Buffett, owned 2.76 million shares on 30 September 2009 (down from 3.7 million shares on 31 March 2009).  Soros Fund Management, on the other hand, hiked its interest from 190,000 shares in June to 942,000 shares in September.

After Frank Blake replaced Robert Nardelli (who subsequently served an ill-fated term at Chrysler) as Chairman and CEO in early 2007, Home Depot sold HD Supply, which serves professional contractors, to a consortium of private equity firms.  Home Depot repurchased $10.7 billion of its own shares after the sale of HD Supply.

As part of the sale, Home Depot invested $325 million for a 12.5 percent equity stake in HD Supply.  In fiscal 2008,  Home Depot recorded a $163 million pre-tax charge to reflect the reduced market value of its HD Supply investment.  Home Depot has guaranteed $1.0 billion of HD Supply's debt.

We are now ready to look specifically at the current quarter.

When Home Depot reported its third quarter results, on 17 November 2009, it updated its guidance for the year and, thus, the fourth quarter.

Based on its year-to-date performance, the Company continues to expect sales to be down approximately 9 percent for the year. The Company updated its fiscal 2009 EPS guidance and now expects diluted earnings per share from continuing operations of approximately $1.50, up 9.5 percent from fiscal 2008. On an adjusted basis, the Company now expects diluted earnings per share from continuing operations of approximately $1.55 for the year, a decline from fiscal 2008 of approximately 13 percent. [emphasis added]

The salient change was the hike in the estimated EPS annual growth rate from "flat to up 7 percent" to "up 9.5 percent."

Because Revenue in fiscal 2008 was $71.3 billion, the company's guidance for fiscal 2009 is (1 - 0.09) * $71.3 billion = $64.9 billion.  Revenue in the first three quarters of the year was $51.6 billion, which would leave $13.3 billion for the fourth quarter.

However, this figure seems too low.  Home Depot's normal quarter-to-quarter Revenue patterns would suggest a range between $14.5 billion and $15.5 billion.  We're not willing to go that high for our Revenue estimate, but adding $500 million to the $13.3 billion calculated value is a reasonable, if not conservative, adjustment.  The resulting amount, $13.8 billion, would translate into a Revenue decline for the year of -8.25 percent instead of the company's guidance of minus 9 percent.

Home Depot's Gross Margin as a percentage of Revenue has been 34 percent or greater in each of the last three fourth quarters.   We are assuming a similar margin in the fourth quarter of fiscal 2009.  Given our Revenue estimate, we are forecasting a Cost of Goods Sold (CGS) of (1-0.34) * $13.8 billion = $9.1 billion.

Depreciation and amortization expenses have been about $430 million per quarter recently.  We are looking for a similar figure in the fourth quarter.

Sales, General, and Administrative (SG&A) expenses in the first three quarters of the year have been 23 percent of Revenue.  However, the fourth-quarter rate has been about 3.3 percent higher than the nine-month value in recent years.  Given this, we're assuming 26.3 percent, or 0.263 * $13.8 billion = $3.6 billion.

The estimates above lead to a projection of $633 million for Home Depot's Operating Income in the fourth quarter.

Our target for interest and other non-operating items is a net expense of $170 million, roughly the same as in recent quarters.

An effective income tax rate of 36.5 percent would lead to Net Income of $294 million ($0.17/share) for the quarter.  For the fiscal year, Net Income would be $2.6 billion ($1.54 per share, $0.04 more than the guidance value).

In the fourth quarter of fiscal 2008, Net income was minus $54 million (-$0.03 per share).

Please click here to see a full-sized, normalized depiction of the projected results next to Home Depot's quarterly Income Statements for the last couple of years.  Please note that our organization of revenues, expenses, gains, and losses, which we use for all analyses, can and often does differ in material respects from company-used formats.  The standardization facilitates cross-company comparisons.

Full disclosure: Long HD and WMT at time of writing. 
No position in any other company mentioned.

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