23 February 2011

HD: Income Statement Analysis for the January 2011 Quarter

Home Depot (NYSE: HD) earned $0.36 per diluted share on a GAAP basis in the January-ending fourth quarter of fiscal 2010, up 78.5 percent from $0.20 in the same three months of the previous year. 

The earnings growth rate was unusually strong because the year-earlier results were depressed by a $163 million charge.  Excluding special items, earnings increased from $0.26 per share to $0.36.

This post examines Home Depot's Income Statement for the quarter and compares the entries on each line to our "look-ahead" estimates.  Reported earnings were $0.06 better than the $0.30 per share we had forecast.

The principal sources for this income statement analysis were the earnings announcement and the ensuing conference call (transcript available from Seeking Alpha).

In a second article, we will report Home Depot's scores as measured by the GCFR financial gauges.  The follow-up post will also provide the latest figures for the various financial metrics we use to analyze Cash Management, Growth, Profitability and Value.

Before getting into the details, we will take a step back to introduce the subject of today's analysis.

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 at last count has 2,244 retail stores, 88 percent in U.S. states or territories.  Home Depot also operates in Canada, China, and Mexico.

Home Depot earned $3.3 billion in fiscal 2010, which was 25 percent more than in 2009.  Revenue increased a more modest 3 percent to $68 billion.  (Fiscal 2010 ended on 31 January 2011.)

The company announced in February that it had decided to increase its dividend 6 percent, to $0.25 per quarter.

In the last couple of months, Home Depot's market value has increased from $50 billion to over $60 billion, on a fully diluted basis.  The market value is much less that it had been a decade ago, partially as result of share repurchases.

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.

Retail sales have, more recently, been rising in the U.S., but results for many store operators continue to be pressured by high unemployment

The still-fragile housing market and weak consumer sentiment in the U.S. remain very significant concerns for retailers, especially those with ties to housing.  At Home Depot, economic uncertainty has recently been reflected in parameters such as the average "ticket," and the number of tickets valued at $900 or more.

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 (the 19th was recently opened) 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.

Please click here to see a normalized depiction of the actual and projected results for the just-concluded quarter, as well as the 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.

Revenue in the January quarter increased 3.8 percent, from $14.6 billion last year to $15.1 billion in the most recent three months.  Revenue beat our $14.85 billion estimate for the quarter by 2 percent.  Our estimate was derived from the company's sales guidance.

Comparable (akin to same-store) sales in the fourth quarter grew 3.9 percent.  This was the fifth consecutive quarter of positive comparable-store sales.

The average sale per transaction ("ticket") was up 2.6 percent, and the number of tickets over $900 was up 9.6 percent, a nice turnaround after recent declines. These figures suggests that improved sales to contractors and other tradespeople.

The Cost of Goods Sold increased to $9.9 billion (65.3 percent of Revenue) from $9.6 billion in the year-earlier quarter.  The latest amount translates into a Gross Margin of 34.7 percent, about 25 basis points more profitable than the 34.4-percent margin achieved in last year's fourth quarter.  Home Depot attributed the margin expansion to lower levels of "clearance inventory" at U.S. stores.

The Gross Margin was only 10 basis points below our target of 34.8 percent of Revenue.

Depreciation and Amortization charges of $399 million were 4.3 percent lower than last year because the company has a smaller base of fixed assets.  The Depreciation expense was essentially identical to our $400 million target for the quarter.

At $3.81 billion, Sales, General, and Administrative expenses in the latest quarter were slightly less than last year's $3.87 billion.  As a percentage of Revenue, SG&A expenses were cut from 26.6 percent to 25.2 percent.

SG&A expenses were 1.4 percent less than our $3.86 billion estimate. 

Subtracting the various operating expenses discussed above from Revenue yields Operating Income of $1.04 billion, up 43 percent from $727 million in the year-earlier quarter.  The increase can be credited to Revenue growth, the better Gross Margin, and lower Depreciation charges.

Operating Income was 14 percent better than our $907 million estimate.  This surprise was mostly due to better-than-expected Revenue and lower-than-expected SG&A expenses.

Turning to the non-operating portion of the Income Statement, lower indebtedness and some one-time tax-related matters cut Home Depot's net interest expense from $158 million in the prior-year quarter to $87 million in the latest period.  The expense was much less than the $140 million we anticipated.  We had no visibility into the non-recurring tax matters that led to lower interest expenses.

There was no repeat in the January 2011 quarter of the $163 million investment write-down that negatively affected year-earlier earnings.

Pretax income of $950 million surpassed our $767 million target by a substantial 24 percent.  The lower-than-expected interest expense helped.

The effective Income Tax Rate was 38.2 percent, a rate somewhat more burdensome than the 36.5-percent rate we had assumed.  This brought after-tax Net Income to $587 million, which is 72 percent better than the $342 million earned in last year's fourth quarter.  Our estimate was $487 million.

Taxes brought after-tax Net Income to $587 million, which is 72 percent better than the $342 million earned in last year's fourth quarter.  Our estimate was $487 million.  On a per-share basis, earnings increased from $0.20 to $0.36.

The latest number beat our estimate of $0.30 by a $0.06.  Higher-than-expected Operating Income, combined with lower-than-expected interest expenses, slightly offset by higher income taxes, propelled earnings above our target. 

Home Depot management reported that the company achieved positive comparable-store sales in 49 of the 50 U.S. states, signaling broad demand for the company's products and services.  One wonders how much higher sales might have been if winter weather hadn't been severe in parts of the country late in the quarter.

Full disclosure: Long HD at time of writing.

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