Home Depot’s 2015 Margin Target of 12% Achievable If Sales Trends Continue

Home Depot (NYSE:HD), the largest home-improvement retailer, expects to achieve its operating margin target of 10% this year which is a year ahead of schedule. The company has now raised its operating margin target to 12% by 2015. It also expects to increase its return on invested capital to 24% from 15% currently. The new target should be achievable if Home Depot continues to see sustained trends in same store sales and productivity. Additionally, these targets don’t account for the possibility of a drastic improvement in the housing market. Any upside in industry trends over the next few quarters would provide further upside for Home Depot.

Our complete analysis for Home Depot’s stock

Home Depot’s operating margin declined from 9% in 2007 to 7% in 2009 as sales declined by 15% during the period. In 2009, Home Depot set an operating margin target of 10% that it hoped to reach by 2012-13. The company then began streamlining its operations by heavily cutting down on its expenses, particularly SG&A costs. It achieved 9.5% operating margin in 2011 driven by supply chain improvements and expense leverage as same store sales increased by 3% in 2010 and 3.5% in 2011. This year, the company is likely to exceed its 10% operating margin target.

Improving same store sales and supply chain initiatives expected to be primary drivers of margins

Despite the slow economic recovery, Home Depot’s same store sales growth has gradually improved from 2.9% in 2010 to 3.4% in 2011. Home Depot’s margins have improved during this time due to operating leverage. Going forward, we expect same store sales growth to continue to increase at 3-4% as the housing market slowly recovers over the 2012-13 period, driving further margin expansion. In Q1 2012, Home Depot generated 109 bps of expense leverage as SG&A expenses grew much slower than sales growth.

Home Depot has been focusing on its supply chain by adding rapid deployment centers (RDC) that improve inventory management and reduce costs. In 2011, margins improved as the company redirected more than 70% of its inventory through the new RDCs. We expect overall margins to further improve as the company continues improving its supply chain. The company has also been rolling out a new initiative called ‘First Phone Junior’ across its stores to allow store staff to increase the number of hours dedicated to customer-facing activities vs. tasking activities, thereby improving overall store service levels. Through this initiative, the company plans to achieve a target of 60:40 (customer-facing to tasking) by 2013.

Our models indicate that Home Depot’s EBITDA margin improved from 10% in 2008 to 13% in 2011. We expect margins to continue to improve going forward as the company benefits from operating leverage and other initiatives. However, if same store sales growth stays flat and there is limited or no operating leverage, margin growth would fall below expectations leading to a 15% downside to our current price estimate of $56. On the other hand, if the housing market and thereby home improvement demand recovers sooner than expected, same store sales growth would be ~4-5% over the next few years, leading to a 10% upside to our current price estimate.

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