Home Depot Earnings Review: Rough Weather In Q1 Gives Way To Higher Comparable Sales In Q2

Home Depot (NYSE:HD) reported strong sales and operating performance in the second quarter ended July, which saw its stock jump roughly 5% just after the announcement on August 19. Net sales of $23.8 billion in Q2, up 5.7% year-over-year, beat consensus estimates of $23.61 billion. ^[1] As expected, the rebounding U.S. housing industry laid out a strong sales ground for home improvement retailers, after a slight slump in the early part of the year. Unfavorable weather conditions had dragged down Home Depot’s sales in the first quarter as consumers looked to wait out the extreme winter weather to make home improvement purchases. However, pent-up demand and repair and retrofitting activities in spring and summer fueled growth for the retailer this quarter, with comparable sales rising 5.8%, up from only 2.6% in Q1. ^[2] Home Depot depends on both new and existing house sales, as following the purchase, consumers look to buy home improvement goods and services to furbish their homes. House sales in turn depend on mortgage rates, home prices and unemployment rates. With economic environment in the domestic market looking up for the rest of the year, consumer spending on durable goods is likely to further improve and boost Home Depot’s financial results in the following quarters.

We have a Trefis price estimate of $81.48 for Home Depot’s stock, which is roughly 8% below the current market price. However, we are currently in the process of incorporating the latest quarterly results into our forecasts.

Our complete analysis for Home Depot’s stock

Housing Industry Regains Momentum To Spur Sales

Macroeconomic factors are starting to favor growth in the U.S. home improvement market, bolstered by the increases in home sales in the second quarter. Hurt by the overall slowdown in economic activity, along with high lending rates, sales of existing homes declined from a seasonally adjusted annual rate (SAAR) of 4.87 million in December to 4.62 million in January, 4.6 million in February and 4.59 million in March. ^[3] In fact, sales in March represented a year-over-year decline of 7.5%. New home sales also remained low, and fell to a SAAR of 384,000 in March from 449,000 in February. However, following the first quarter, house sales have picked up in the U.S. Existing homes sales improved in April, May and June to reach a SAAR of 5.04 million, which is the highest sales figure since seen in October last year, although 2% lower than June 2013 levels.

Following tepid growth in the first quarter of the year, the domestic housing market seems to be regaining momentum, supported by declining lending rates and unemployment rate, and improving consumer affordability. Although house sales are still lower than previously estimated by retailers, home sales might grow later in the year in anticipation of the Federal Reserve’s move to increase short-term interest rates in early 2015.

• Following a negative 2.1% contraction in the U.S. GDP in Q1, the country’s GDP returned to positive growth in the second quarter, increasing by 4%. ^[4] In particular, personal consumption expenses rose 2.5%, with spending on durable goods increasing 14% percent, compared with only a 3.2% growth in Q1. Consumer spending could continue to increase in the following quarters, and translate into higher sales for Home Depot.

• According to Freddie Mac, the average rate for a 30-year fixed-rate mortgage declined to 4.13% in July from 4.43% in January and 4.37% in July last year. ^[5] Potential home buyers have looked to take advantage of the lowered borrowing costs, boosting home sales. Lending rates had previously been on a rise since the first half of last year, fueled by the Federal Reserve’s announcement of reduction in bond purchases, which had kept the long-term interest rates low. ^[6]

• Home sales are also impacted by the general business environment that affects job creation and incomes. The U.S. unemployment rate fell to 6.1% in June, the lowest rate since recession started in September 2008. ^[7] Although the unemployment rate rose slightly to 6.2% in July, the figure is still much lower than the 7.6% rate in July last year. This bodes well for the housing industry as job creation would facilitate income growth and consequently also support home sales. In addition, with job stability, consumers might also look to increase spending on home improvement products.

• Rising house prices are closely associated with consumer affordability. After decreasing by more than 30% during the recession, home prices picked up momentum in 2012-2013, rising to within 20% of the peak 2006 levels. ^[8] Home Depot expects home prices to grow by 6% in 2014, which although lower than the rise in 2013, reflects steadily growing incomes, affordability and consumer demand. While during their peak in 2006, home prices were almost 40% overvalued, as compared to metrics such as cost-to-rent and incomes, the domestic housing industry remained 4% undervalued based on the same fundamentals at the end of last year. According to Home Depot, home prices have appreciated by around 5-6% so far this year.

According to the Home Improvement Research Institute, home improvement product sales in the U.S. are expected to rise to $309 billion this year, up 6.5% year-over-year, after rising 4.2% in 2013. ^[9] Home Depot leads this market with around 27.2% market share, followed by Lowe’s, which has a 18.4% value share. With economic activity and consumer spending picking up, and given Home Depot’s strong positioning and vast reach, the company’s sales could continue to rise in line with the target of 4.8% top line growth this year. With 2,264 store locations, Home Depot beats its closest competitor Lowe’s by a big margin of more than 400 stores (total 24% more stores than Lowe’s) spread across the U.S., Canada and Mexico.

Online Platform And Pros To Provide Growth Going Forward

In addition to in-store sales, Home Depot has also been expanding its online sales platform, in order to compete with companies such as Amazon, which also offers home improvement goods online. Amazon boasts of a superior online market expertise and could eat into the sales of traditional home improvement retail stores. Home Depot’s online sales grew 38% in Q2, and now form around 4.5% of the overall sales, up from less than 1% during 2010-2011. ^[10] The retailer launched its “Buy Online Pickup In-Store” service, in effect substituting in-store sales with online sales. About one-third of the online sales this quarter culminated in-store. In addition, in order to enhance delivery systems, Home Depot also started the development of three new direct fulfillment centers, the first of which opened in February 2014. Each facility will be able to hold approximately 100,000 product offerings available to be shipped directly to customers, along with the capability to ship most orders the same day they are received. With further expansion of the dot-com business and strengthening of delivery channels, Home Depot could not only attract consumers due to improved efficiency and convenience, the retailer could also add incremental sales from customers who prefer shopping online, going forward.

Rebounding economic conditions in the domestic market this quarter also fueled growth in large ticket purchases, mainly from professional (pro) customers. Sales to high-spend pro customers, who spend more than $10,000 annually, rose more than the company’s average for the tenth consecutive quarter. This boosted Home Depot’s average ticket size, which however, got dragged down due to commodity price deflation. Pro customer base is crucial for Home Depot as it forms around 35% of the company’s net sales, and is growing faster than the retail consumer market at present. The company’s Pro Xtra loyalty program has signed up over 1.7 million pro consumers, with over 200,000 members joining in the last quarter. Growing pro consumer base and higher average transaction sizes, as the housing market grows, should boost Home Depot’s top line going forward.

Operating Margins Expand On Lower Workers’ Compensation

While Home Depot’s gross margins remained flat in Q2, as lower-margin outdoor product categories returned to positive growth in spring and summer, the company’s operating margins expanded 100 basis points year-over-year to nearly 14.5%. This growth came on the back of lower workers’ compensation due to increased operational efficiencies and lower casualty reserves. In addition, fueled by a 6.4% comparable sales growth in the U.S., Home Depot leveraged higher profits on incremental sales. Due to lower workers’ compensations and ongoing productivity initiatives, the company’s operating expenses are now expected to grow at 23% of the sales growth rate this year, down from the previously estimated figure of 33% of the net sales growth rate. We presently estimate company-wide EBITDA margins to remain relatively flat in the near term. However, if margins rise by 50 basis points in 2015 and then remain somewhat stable, there could be a 4% upside to our current estimate.

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1. Home Depot earnings preview, seekingalpha.com [↩]
2. Home Depot 8-k [↩]
3. “New and existing home sales, U.S.“, National Association of Home Builders [↩]
4. U.S. GDP growth rate [↩]
5. 30-year fixed-rate mortgages since 1971 [↩]
6. historical 30-year fixed-rate [↩]
7. U.S. unemployment data [↩]
8. What’s ahead for 2014 housing market [↩]
9. Home improvement research institute forecasts [↩]
10. Home Depot earnings transcript [↩]