26 April 2010

HD: Look Ahead to April 2010 Quarterly Results

This post describes our model of Home Depot's (NYSE: HD) Income Statement for fiscal 2010's first quarter, which will end on 2 May.

The purpose of the model is to establish a baseline for identifying surprises, positive or negative, in the quarterly results the company will report in mid May.  Estimates for each line of the Income Statement are derived from management's guidance, the company's historical financial results, and other publicly available data.

We begin by reviewing 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.  It has a market capitalization of about $60 billion.  The company operated 2,244 retail stores at last count, of which 1,976 (88 percent) were in U.S. states or territories.

Home Depot earned nearly $2.7 billion in fiscal 2009, which ended on 31 January 2010, nearly 18 percent more than in 2008.  Revenue slipped 7 percent to $66.2 billion.

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

Slumping retail sales during the current recession have affected most store operators, and chains closely tied to the housing market have been doubly challenged.  Home Depot has responded by consolidating operations and reducing 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.

Home Depot is also working to reduce inventory costs by streamlining product distribution.  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.

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.  As part of the sale, Home Depot invested $325 million for a 12.5 percent equity stake in HD Supply.  Home Depot has also guaranteed $1.0 billion of HD Supply's debt.  In recognition of later market conditions, Home Depot wrote off half the HD Supply investment in fiscal 2008 and the other half in fiscal 2009.

We are now ready to look specifically at Home Depot's first quarter of fiscal 2010.

When Home Depot reported results for the fourth quarter of fiscal 2009, it provided the following guidance for fiscal 2010.

2010 Financial Outlook (based on GAAP)
  • Sales growth: approximately 2.5 percent
  • Comparable store sales growth: approximately 2.5 percent
  • New stores: 6 net new
  • Gross margin expansion: modest
  • Expense leverage: modest
  • Operating margin: approximately 8 percent
  • Tax rate: approximately 37 percent
  • EPS from continuing operations growth: approximately 15.5 percent to $1.79
    • Does not include the impact of share repurchases
  • Capital expenditures: approximately $1.25 billion
  • Depreciation and amortization expense: approximately $1.75 billion
  • Cash flow from the business: approximately $5.4 billion
  • Share repurchases: intend to use excess cash to repurchase shares

Because Net Sales in fiscal 2009 were $66.176 billion, the company's guidance for fiscal 2010 is (1.025) * $66.176 billion = $67.83 billion.  Data from the last decade indicate that about 24 percent of annual revenue, give or take a percentage point, is realized in the first quarter.  We have combined the guidance and the seasonal pattern to come up with our Revenue estimate for the current quarter of 0.24 * $67.83 billion = $16.28 billion.

This estimate might be on the conservative side because it is not much more than Revenue of $16.18 billion in 2009's first quarter, even though the economy seems to be somewhat stronger now.

We have assumed the first quarter's Gross Margin will be 34 percent of Revenue.  This figure was chosen because the margin has been near 34 percent in the last few sequential quarters and in the first quarter of recent fiscal years.  Given our Revenue estimate, we are forecasting a Cost of Goods Sold (CGS) of (1-0.34) * $16.28 billion = $10.75 billion.

The estimate for Depreciation and amortization expenses in the current quarter is $430 million.  This item has mostly been between $420 and $450 million per quarter recently.  The trend appears to be downward, so the next reported value could be a little lower.

Sales, General, and Administrative expenses in the two previous first quarters were around 24 percent of Revenue.  Given this, we're targeting the current SG&A expense to equal 0.24 * $16.28 billion = $3.9 billion.

Subtracting these operating expenses from Revenue yields an estimate for Operating Income of $1.2 billion in the first quarter, 22 percent more than last year.

Our target for interest and other non-operating items is a net expense of $160 million, roughly the same as in recent quarters.

An effective income tax rate of 37 percent (as per the guidance) would lead to Net Income of $654 million ($0.39/share) for the quarter.  In the first quarter of 2009, Net income was $514 million ($0.30 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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