FOOL's take on HD:
Home Depot Keeps Building
fnews.yahoo.com
Last September, The Home Depot (NYSE: HD), the nation's largest home improvement retailer, ended some embarrassing gender discrimination lawsuits by writing fat settlement checks. The problem cost $104 million in pre-tax income and cut reported earnings from $1.64 per share to $1.55 for FY97. Clearly, no shareowner likes to pay for management's poor judgment. Still, this regrettable episode has at least directed management's attention to a problem that, once resolved, will make the company stronger. It also highlights the fact that this category killer still has room to improve its business. Based on recent results, it's easy to forget that.
In a world of hot growth stories, Home Depot has managed to be boringly terrific. First quarter results announced yesterday offer a snapshot. Sales rose 26% to $7.12 billion while net income jumped 30% to $337 million. Earnings per share increased 29% to $0.45 from $0.35, easily beating the First Call consensus estimate of $0.42.
The revenue gains followed the steady store rollout. With 32 new stores opened during the quarter, Home Depot now has 656 stores overall, including six Expo Design Centers. The results also reflect the strong economy, which has boosted do-it-yourself (DIY) home improvement sales. In addition, warm April weather helped lawn and garden sales. Same-store sales vaulted 7% overall, or 11% if you back out those stores that saw revenues cannibalized by the opening of new stores nearby.
Net profit margins expanded to 4.73% from 4.58% a year ago thanks to an across-the-board improvement in operations. The company enjoyed higher gross margins (27.6% vs. 27.4%) due to product line reviews and improved merchandising. It experienced lower selling and store operating expenses (17.8% of sales vs. 17.97%) thanks partly to lower average advertising spending due to concentrating more stores in each market. Lower general and administrative expenses (1.7% of sales vs. 1.73%) also helped margins. Meanwhile, inventories rose more slowly than sales at just 23.4%.
And the outlook remains rosy. In yesterday's conference call, CEO Arthur Blank reiterated the company's long-term goal of increasing its number of stores by 21% to 22% a year. That would give the retailer 761 stores by year-end and over 1300 stores by the end of 2001. EPS should grow faster at 23% to 25% a year. After nearly doubling in the last year, Home Depot's stock trades at around 2.2 times the company's enterprise value and 36 times the current consensus EPS estimate of $2.03 for FY98 and 29 times FY99 estimates. However, there's reason to believe this price premium is justified and that long-term Home Depot investors -- who have enjoyed a fifteen-bagger during the '90s -- will continue to smile.
The key is that Home Depot is operated on the principle of aggressive but controlled growth. Through the late '80s and early '90s, the retailer was delivering revenue growth in the high 30% range, with earnings appreciating around 46% a year. As the firm gobbled up market share in the vast home improvement sector, such gangbuster gains weren't sustainable. The stock took a breather for several years beginning in late '92 as the market adjusted to that fact. But the stock has renewed its upward trajectory lately as investors have come to believe that annual EPS gains in the 24% range are sustainable. Two points stand out in an overview of Home Depot's outlook: huge untapped markets and the firm's absolute patience in finding a profitable means of tapping them.
CEO Blank puts the entire domestic building-related market at $365 billion. Of that, about $100 billion is DIY whereas the rest involves sales to professionals. Of the $265 billion professional market, about $50 billion involves heavy industry, leaving around $215 billion of home-related sales. Of that, Home Depot is targeting the $71 billion in sales to smaller professional customers who buy less than $200,000 of product annually. So Home Depot is addressing or looking to address a $171 billion U.S. market in which it's already the undisputed leader with around a 14% share. (Indeed, even in Atlanta and Dallas where its smaller rival Lowes (NYSE: LOW) has come on strong, Home Depot sales remain ahead of plan.)
But that's just in the U.S. The company now owns all of its Canadian operations after recently acquiring the remaining 25% from Molson. Home Depot Canada has expanded from 7 stores in 1994 to 34 stores today, with another 8 to be opened by year end. This year, the company also plans to open its first store in Chile and another in San Juan, Puerto Rico. Yet that's the extent of its international biz. In other words, Home Depot today has the global presence of Coca-Cola (NYSE: KO) -- before World War II.
What's most intriguing and impressive is Home Depot's patience in addressing new markets. Rather than growth at any cost, the company simply won't roll out a new concept until management is sure the return on investment is in line with its current operations. Management will test a new platform literally for years until it's just right. Consider the Expo concept. These stores, designed around specific home improvement projects such as bathroom renovations, are smaller and more upscale than traditional Home Depots. Yet the first store, opened in San Diego in 1991, proved too cluttered. Six years later, the company finally opened its definitive Expo in Miami, only its fifth Expo store overall. About half of its merchandise sales come from special orders, a major departure from the firm's conventional cash-and-carry approach. Now that the financial model is in place, management plans to open 200 Expo stores over the next seven years.
Home Depot is also working on two promising new pilot programs. In Austin, it has been testing an initiative to cultivate more business from professionals. The next test site in Las Vegas should further refine the model, which depends mainly on enhancing customer service to foster and expedite transactions. This is a natural step since at least 75% of its potential professional customers already shop at Home Depot but buy just 10% to 15% of the products they use from the retailer.
The company is also developing a new convenience store about one-third the size of typical Home Depots. This concept is designed to target urban markets and compete in the $50 billion U.S. segment that includes traditional hardware stores. About a quarter of sales are expected to come from general merchandise items not currently sold in Home Depot stores. The concept is being led by senior VP Bob Wittman, formerly COO of Orchard Supply Hardware, a 69-store California chain acquired by Sears in 1996. Four test stores will open in the Northeast by the first quarter of 1999. A decision on rolling out the concept isn't expected until at least 2000. Therefore, the company's forward-looking sales and earnings targets don't include contributions from these convenience stores.
What does this all mean for investors? Making the optimistic but hardly outrageous assumption that Home Depot continues to deliver 24% earnings growth, an investor would be looking at estimates of $4.80 per share for fiscal year 2002. Valued at 30 times forward estimates, or a reasonable premium to its growth rate, the stock could trade up to $144 just four years from now. That's compound annual growth of 18.5% from here, no doubt a market-beating performance.
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