Key Factors Behind Home Depot’s $59 Valuation

Home Depot is the largest home improvement retailer in the US. The company operates a chain of retail stores that stock items related to home improvement and development such as building materials, electrical appliances and hardware tools. The company’s network consists of around 2,250 stores, out of which nearly 2,000 are spread across the US. The rest of the stores are in neighboring countries such as Canada and Mexico. The company also operates a few stores in China. Apart from physical stores, customers can also make purchases over the Internet through the company’s online store.

Our complete analysis for Home Depot’s stock

The company’s closest competitor is Lowe’s, the second largest home improvement retail chain in the US. Lowe’s operates around 1,700 stores, most of which are also located within the country.

Who are Home Depot’s customers?

Like any standard retailer, Home Depot sources home improvement products from third-party suppliers. The company then sells these goods to both private consumers and professional home developers. Private consumers usually work on their own home improvement projects or pay Home Depot for services such as installation and repair. Professional home developers, on the other hand, simply purchase the goods from Home Depot and work on a contractual basis for private homeowners.

How much does Home Depot earn and what are the major product segments for the company?

Home Depot earned around $70 billion in revenues in 2011. This makes it the largest home improvement retailer in the United States. Its revenues stood at around $77 billion five years ago. This decline is mostly a result of the downturn in the US housing industry, leading to lower sales of home improvement products.

The company earns revenues from four key product segments:

1. Hardware and Seasonal: This segment comprises hardware tools (power tools) and outdoor tools (gardening equipment). It also includes seasonal items such as outdoor play structures, grills and cooking devices, etc. This segment contributed 30% of the company’s total sales in 2011.

2. Plumbing, Kitchen and Electrical: This segment comprises kitchen appliances (such as mixers and dishwashers), plumbing equipment (pipes, fittings, plungers, etc.) and household electrical items (bulbs, plugs, wires). This segment contributed around 30% of the company’s revenues in 2011.

3. Building Materials, Lumber and Millwork: This segment comprises mainly of raw materials for constructing new houses. These include materials such as concrete, cement, plywood, dowels, wall panels, etc. This segment contributed 21% of the company’s revenues in 2011.

4. Paint and Flooring: This segment offers painting equipment (paints, sprayers) and flooring equipment such as rugs and tiles. It contributed around 19% of total revenues in 2012.

A key point worth noting is that while a significant chunk of sales from the first two segments originate from regular household repair and maintenance projects, the last two segments are heavily dependent on new home constructions.

Historically, the company’s operating margins have been around 12-13% with the figure standing at a five-year high of a 13.9% in 2012.

What matters most for the company?

1. The US Housing Market:

The single biggest factor that influences Home Depot’s performance is the overall health of the housing market in the US. Since the company earns around 90% of its revenues within the US, factors such as new home constructions, housing vacancies and new home sales in the country have a direct bearing on the company’s top-line.

Past

With the housing bust in 2008, Home Depot’s top-line fell sharply from around $77 billion in 2007 to around $71 billion in 2008. As the sector continued to perform poorly in the following few years, revenues touched a low of $66 billion in 2009. Since 2010, a gradual recovery in the US economy has helped the company improve revenues at a slow pace, with the top-line touching the $70 billion mark in 2011.

Present

The housing market in the US certainly seems to be recovering, albeit at a slow pace. New home sales have crawled their way up to 368K for 2012, the highest since 2009. Permits for new constructions stood at 624K for 2011, the highest since 2008. Home vacancy rates for both rental and home-owned properties also declined in 2011, compared to the 2009-10 period. This signals a resurgence in demand for home improvement products, both for regular repairs and upgrades as well as materials for new construction. The company’s latest quarter results certainly seem to reflect this with growth of around 4% over the same quarter last year, beating wall street estimates.

Future

Despite the numbers, optimism in the housing market remains quite tempered for the long run. This is primarily because of uncertainty surrounding the fiscal cliff. If the US adopts stringent economic measures to meet the fiscal deficit, increased unemployment and lower consumer spending could potentially weigh down the market for home improvement products yet again. Most of the growth in the near future is likely to come from private consumers who work on a D-I-Y basis as opposed to paying for services and private contractors.

2. Competition:

The second big factor for Home Depot is how its closest competitor Lowe’s is faring in the US market.

Past

Lowe’s, which pretty much offers the same product segments as Home Depot, has been losing out to the company in terms of market share over the past few years. This has been primarily because of Lowe’s attempts to reinvent itself with a new ‘Everyday Low Pricing’ strategy, which hasn’t gone down well with consumers. Moreover, Home Depot has a more extensive store network in the US, with around 200 more stores than Lowe’s. This has allowed the company to better leverage the recent upturn in the housing market more effectively.

Present

Q3 2012 marked the eight straight quarter in which Lowe’s trailed Home Depot in rise in same-store sales. This shows that Home Depot continues to fare better than its rival in total sales.

Future

Although Home Depot has fared better than Lowe’s in the recent past, we think there are reasons to believe that the competition might get stiffer in the coming months. Lowe’s launched a new online shopping platform in 2011, which is witnessing good traction. Lowe’s has also been focusing on improving its in-store experience through staff training, better aisle placement, improved labeling, etc. This places Lowe’s in a good position to leverage growth in demand, especially in the DIY segment.

3. International Sales

In order to reduce its dependence on the US market, Home Depot has been trying to increase its international footprint, with special emphasis on Canada and Mexico. The company earned around 10% of its total revenues from outside the US in 2011. How the company performs in these geographies in the future will again depend on the performance of the housing market in these economies. The company is investing a lot in Mexico in particular. Home Depot opened its 100th store in the country in 2012, up from around 66 in 2007. The company is fending off local players in these regions. Lowe’s is also planning to invest in the country in a big way, but its Mexican footprint is quite small presently.

Where does Home Depot go from here?

The company’s response to the challenging macroeconomic conditions in recent years has been to strongly focus on managing internal costs and improving its supply chain. These include setting up rapid deployment centers for faster sourcing of products, reducing inventory pressure. Another example is the company’s deployment of smartphones and walkie-talkies to store staff so that they can perform quicker inventory look-ups. Moreover, the company put a halt to expanding its store network in the US in 2009. In fact, over the period 2009-11, its total store count in the country went down by 2 stores. This helped the company cut down on capital expenditure. Initiatives such as these allowed the company to improve margins from around 11% in 2008 to around 14% in 2011.

The strong bottom-line performance means the company is quite well-positioned to leverage top-line growth which it hopes will come along in the near future from the three major factors outlined above. Considering this, here’s a brief look at three different scenarios that show where the company might be in a couple of years.

1. Optimistic Scenario – This scenario takes the three things that matter most to the company and takes an optimistic outlook:

a) The US housing market remains largely on track in the near future and is unaffected by the fiscal cliff policies as a whole. Unemployment continues to decline and consumer spending goes up. The total market for home improvement products grows at a steady pace of around 2-3% annually.

b) Home Depot is able to gain a large chunk of this growth by continuing to gain over Lowe’s in terms of market share.

c) The company continues to gain traction in countries such as Mexico, displacing local vendors and keeping Lowe’s at bay in these geographies.

2. Even Scenario – This scenario takes a less optimistic approach, especially with regard to the US housing market:

a) The recovery in the US housing market slows down driven primarily by macroeconomic and fiscal pressures. Increased unemployment and lower consumer spending weigh down demand for home improvement products.

b) Lowe’s poses a greater challenge to Home Depot than in recent years as its pricing policies and internal restructuring and reinvention continue to pay dividends. Home Depot maintains a slight edge over its competitor, primarily because of a larger store network.

c) The company sees good to medium traction in its international forays with Mexico driving sales outside the US. There is stiff competition with local players, but Lowe’s isn’t able to gain a significant foothold in key international markets.

3. Pessimistic Scenario – Here’s a picture of what could go wrong with the company in the next few years:

a. The US housing market nosedives with new fiscal policies increasing unemployment, lowering new home sales and lowering consumer spending, which severely affects demand for home improvement products.

b. Lowe’s succeeds in its recent attempts to bolster top-line growth through initiatives such as its new online platform and improved in-store experience. The company’s pricing policy also succeeds in wooing consumers away from other stores, leading to lower market share for Home Depot.

c. Home Depot’s international expansion plans hit a brick wall as the housing markets in key areas such as Canada and Mexico stagnate. Competition heats up with local players and Lowe’s is also able to slice out its share of international markets.

We have a Trefis price estimate of $59 for Home Depot’s stock, which is marginally below the market price.

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