15 July 2010

HD: Look Ahead to July 2010 Quarterly Results

This post describes our model of Home Depot's (NYSE: HD) Income Statement for fiscal 2010's second quarter, which will end on 1 August.

The purpose of the model is to establish a baseline for identifying surprises, positive or negative, in the quarterly results the company will report.  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.  The company has 2,244 retail stores, of which 88 percent are in U.S. states or territories.

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

As a result of the market swoon this spring, Home Depot's market capitalization is now under $50 billion.

A big drop in sales in 2008 affected most retailers, and stores dependent on the housing market were doubly challenged.  Home Depot chose 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.

U.S. retail sales had been recovering, modestly perhaps, for about a year, but two small steps backward were taken when sales fell in May and June 2010. Persistent high unemployment and the fragile housing market remain concerns.  The willingness of consumers to open their wallets is far from clear:  one recent report showed consumer confidence falling; another suggested rising consumer sentiment.

Home Depot competes with Lowe's (NYSE: LOW), cooperatives such as Ace and True Value, and a multitude of smaller hardware stores.  These rivals took advantage several years ago of lapses in Home Depot's customer service, which had deteriorated.   Frank Blake, who took over as Chairman and CEO in early 2007, has made improved customer service a high priority.  The company's current investments in technology upgrades are evidence that this effort continues.

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.

In early 2007, Home Depot sold HD Supply to a consortium of private equity firms.  Home Depot kept a 12.5 percent stake in HD Supply, which serves professional contractors.  Unfortunately, this investment cost the company $325 million that it subsequently wrote off.  Home Depot also guaranteed $1.0 billion of HD Supply's debt.

In fiscal 2010's first quarter, which ended on 2 May 2010, Home Depot earned $0.43 per diluted share.  This GAAP result was 41 percent more than the $0.30 it made in the same quarter last year.  Earnings increased from $0.35 to $0.45 per share, 29 percent, on a non-GAAP "adjusted" basis, which excludes store closing charges, business termination expenses, restructuring costs, and the results of discontinued operations.

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

When Home Depot reported first quarter results, it updated its following guidance for fiscal 2010.

Updated Fiscal 2010 Guidance

Based on its year-to-date performance, the Company updated its fiscal 2010 guidance and now expects sales to be up approximately 3.5 percent for the year. The Company expects diluted earnings per share from continuing operations as reported to increase by approximately 21 percent to $1.88 for the year.
The previous guidance is listed below:

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 totaled $66.176 billion, the company's updated guidance for fiscal 2010 is (1.035) * $66.176 billion = $68.492 billion.  Revenue in the first quarter was $16.683 billion, which leaves $51.809 billion for the last three quarters.

From results in previous years, we expect that 38 percent of the $51.8 billion will be realized in the second quarter.  This suggests a Revenue estimate for the current quarter of 0.38 * $51.809 billion = $19.7 billion.

We have assumed the second quarter's Gross Margin will be 34.2 percent of Revenue.  The margin was 34.4 percent in both of the last two quarters, but we are being a little conservative for the second quarter.  Given our Revenue estimate, we are forecasting a Cost of Goods Sold of (1-0.342) * $19.7 billion = $13.0 billion.

The estimate for Depreciation and amortization expenses in the current quarter is $420 million.  This item has mostly been between $410 and $430 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 second quarters were between 21 and 22 percent of Revenue.  Using the mid-point, we're targeting the current SG&A expense to equal 0.215 * $19.7 billion = $4.2 billion.

Subtracting these operating expenses from Revenue yields an estimate for Operating Income of $2.08 billion in the second quarter, 13.6 percent more than last year.

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 37 percent (as per the guidance) would lead to Net Income of $1.2 billion ($0.71/share) for the quarter.  In the second quarter of 2009, Net income was $1.12 billion ($0.66 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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