20 October 2010

HD: Look Ahead to October 2010 Quarterly Results

This post describes our model of Home Depot's (NYSE: HD) Income Statement for fiscal 2010's third quarter, which will end on 31 October.

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 also operates in Canada, China, and Mexico.

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.)

The market value of the company is currently near $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.

The U.S. Census Bureau's Monthly Retail Trade Report indicates that sales have been recovering, modestly and somewhat erratically.  The Bureau estimated U.S. retail and food services sales in September were a seasonally adjusted $367.7 billion, up 0.6 percent (±0.5 percent) from August and up 7.3 percent (±0.7 percent) from September 2009.

Persistent high unemployment and the still-fragile housing market in the U.S. remain concerns.  Consumer sentiment was down in one recent report.

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.

Home Depot earned $0.72 per diluted share on a GAAP basis in fiscal 2010's second quarter, which ended on 1 August 2010.  Earnings per share were 8.6 percent more than the $0.66 Home Depot made in the same quarter of 2009.

On a non-GAAP "adjusted" basis, earnings increased from $0.67 to $0.72 per share.  The non-GAAP numbers exclude unusual items, but the most recent quarter had no such gains or losses.

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

When Home Depot reported second-quarter results, it updated its guidance for fiscal 2010.

Updated Fiscal 2010 Guidance

Based on its year-to-date performance and expectations for the remainder of the fiscal year, the Company updated its fiscal 2010 guidance and now expects sales to be up approximately 2.6 percent for the year. The Company expects diluted earnings per share from continuing operations as reported to increase by approximately 22.6 percent to $1.90 for the year. This earnings per share guidance includes the benefit of the Company’s year-to-date share repurchases, but excludes the impact of future share repurchases.

During the conference call (transcript available from Seeking Alpha) that followed the earnings announcement, Home Depot made some additional comments about its expectations

we now believe that our expenses for the year will grow at a factor of less than 50% of sales growth.

For the year, we expect our effective tax rate to be approximately 36.5%.

We believe the back half of the year will resemble the first half of the year, which, when backing out the commodity price inflation we experienced in the first half, suggests back-half sales growth in the 2% area.

Within this guidance, we now expect our operating margin to be approximately 8.3% for the year.

Because Net Sales in fiscal 2009 totaled $66.176 billion, the company's updated guidance for fiscal 2010 is (1.026 * $66.176) billion = $67.9 billion.  Revenue in the half of the year was $36.3 billion, which leaves $31.6 billion for the last two quarters.

From results in previous years, we expect that 52.5 percent of the $31.6 billion will be realized in the third quarter.  This suggests a Revenue estimate for the current quarter of 0.525 * $31.6 billion = $16.6 billion.  The estimate is 1.5 percent more than Revenue of $16.36 billion in the October 2009 quarter.

Given the company's results to date this year, we have assumed the third quarter's Gross Margin will be 34.3 percent of Revenue.  Our estimates for Revenue and Gross Margin translate into a forecast for the Cost of Goods Sold of (1-0.343) * $16.6 billion = $10.9 billion.

The estimate for Depreciation and amortization expenses in the current quarter is $410 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 October quarters were 23.7 percent and 23.8 percent of Revenue.  Since the company has become a little more efficient, we are using 23.5 percent for the current period.  Using the Revenue estimate, we're targeting the SG&A expense to equal 0.235 * $16.6 billion = $3.9 billion.

Subtracting these operating expenses from Revenue yields an estimate for Operating Income of $1.38 billion in the third quarter, 9.5 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 36.5 percent (as per the guidance) would lead to Net Income of $776 million ($0.47/share) for the quarter.  In the third quarter of 2009, Net income was $689 million ($0.41 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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