Buy Home Depot - Barron's Cover Story

Coming Up Roses -- Barron's
Apr 19 at 00:07
Profile hits: NONE

By Avi Salzman

      (FROM BARRON'S 4/21/14)
      For much of America, spring means a trip to Home Depot to load up on
garden supplies, deck furniture, or perhaps a gleaming new grill. After an
unusually harsh winter, the nation's largest home-improvement chain is bracing
for an onslaught, and the folks in the orange aprons are ready. Indeed, Home
Depot is hiring 80,000 additional workers to man its miles of aisles of
warm-weather supplies. The sense of renewal is hard to miss, and it extends well
beyond the blooming begonias and jam-packed parking lot.
      Much like the stores, Home Depot's shares (ticker: HD) could come to life
in the months ahead, especially if the housing market, a crucial driver of
revenue and profit, shows sustained signs of improvement. An uptick in housing,
market- share gains at the expense of an ailing Sears Holdings (SHLD), and
substantial supply-chain improvements could help lift the stock to $95 in the
next 12 months from a recent $77. Add a dividend yield of 2.4%, and investors
could see a total return exceeding 25%.



      Home Depot's shares are up just 6% in the past year, and off 6% in 2014,
underperforming the Standard & Poor's 500 in both periods. The shares sell for
17.4 times this year's expected earnings, slightly less than rival Lowe's (LOW),
whose results have been less impressive. Lowe's has rallied 25% in the past year
as investors have bet its performance will improve.
      Home Depot guided Wall Street earlier this year to expect a 16.5% increase
in earnings in fiscal 2014, which ends the following January, versus 21% growth
in the prior fiscal year. Then again, the Atlanta-based company has a history of
projecting caution but beating estimates, as it has done for the past 24
quarters. Despite a sluggish housing market, profits have risen at an average
annual rate of 21% in the past five years.
      Entrepreneurs Bernie Marcus and Arthur Blank opened the first two Home
Depot stores in 1979 in Atlanta, handing out dollar bills as customers walked
in. Their warehouse-style stores stood out because they were larger than most
big- box outlets, and their employees were trained to guide customers through
do-it- yourself home-improvement projects. Today, the company operates 2,263
stores, with units in all 50 states, as well as Canada and Mexico. According to
IBISWorld, it controls 54.5% of the U.S. home-improvement market, versus 35.8%
for Lowe's.
      Blank succeeded Marcus as CEO in 1997, and stepped down from active
management in 2000. The next CEO, Robert Nardelli, a veteran of General Electric
(GE), brought a hard-charging leadership style to a company that had been
low-key and decentralized.
      Earnings doubled under Nardelli's watch, but customers and investors
complained about changes, including the replacement of experienced employees
with part-timers, and the shifting of resources to Home Depot's lower-margin
wholesale business, HD Supply. The stock price fell 6%, even as Lowe's share
price nearly tripled. Nardelli departed in January 2007 under pressure from
Relational Investors, an activist investment fund that owned Home Depot shares.
      His replacement, Frank Blake, also spent time at GE, and served as a
deputy energy secretary under President George W. Bush before joining Home Depot
in 2002 as executive vice president for business development and corporate
operations. The selection of Blake as CEO was surprising, and expectations were
muted -- but not for long. Blake had little operating experience, "but the thing
he did well was listen to investors and customers and run the business
accordingly," says Brian Nagel, an analyst at Oppenheimer.
      Gary Balter, of Credit Suisse, says Home Depot has the best management
team he has covered in 29 years as a retail analyst, and investors echo the
positive sentiment. Blake, 64, returned Home Depot to its roots, emphasizing
customer service and rewarding managers with a bonus program. He also embraced
the founders' entrepreneurial spirit, even reading portions of their book out
loud to the troops.
      Instead of adding new business lines and expanding overseas --
questionable strategies employed by some slow-growing U.S. retailers -- he
worked to improve the traditional big-box stores and shuttered underperforming
units. In addition, he sold HD Supply, and closed the company's 12 big-box
stores in China.
      The U.S. housing market crumbled early in Blake's tenure, after a
multiyear credit binge. Same-store sales, or year-over-year sales at units open
at least a year, turned negative during the ensuing recession at both Home Depot
and Lowe's. But the companies adopted differing strategies to get things back on
track.
      Lowe's relied on promotional sales and kept adding stores, which produced
diminishing returns. Home Depot chose to cut costs and worked to improve
customer service. Since the middle of 2009, its quarterly same-store sales gains
consistently have outpaced Lowe's. Home Depot posted 6.8% growth in comparable-
store sales in 2013, its highest level since 1999.
      Home Depot emerged from the housing bust leaner and smarter. Sales have
risen 10.6% since 2009, but profits have jumped 133% as a result of cost cuts,
share buybacks, and tighter inventory management. "They have such great earnings
leverage," says David Batchelder, a principal at Relational. "As comp-store
sales improve, they get more and more to the bottom line."
      Home Depot earned $5.4 billion, or $3.76 a share, in fiscal 2013, on
$78.8 billion in revenue. It is expected to earn $6 billion, or $4.43 a
share, in the current fiscal year, on $82.7 billion. Analysts are forecasting
earnings of $ 5.12 a share the following year.
      Wall Street expects Home Depot to achieve long-term earnings growth of
16.4%, far ahead of the average Dow stock, at 9.2%. Visa (V) is the only
component of the Dow Jones Industrial Average with better perceived earnings
prospects, and it trades for 21 times forward estimates. While other blue chips,
including Coca-Cola (KO), Procter & Gamble (PG), Wal-Mart Stores (WMT), and
ExxonMobil (XOM), face considerable head winds -- among them, declining demand
in core markets, weakening production, and changing consumer appetites -- Home
Depot has the wind firmly at its back.
      There is no "easy" button for success in retailing; Eddie Lampert found
that out the hard way at Sears, as did Bill Ackman, at J.C. Penney (JCP). Home
Depot simply worked to become a more efficient operator than competitors, with
an 11.6% operating-profit margin, versus 7.9% at Lowe's. The company's success
hasn't come from raising prices, but rather from selling through inventory at a
rapid clip. Its inventory turned over at a rate of 4.7 times in 2013, compared
with 3.9 times for Lowe's and 3.8 for Sears.
      To achieve such numbers, Home Depot has spent the past few years
reorganizing how it gets goods to customers. Before the changes, each store
ordered merchandise directly from manufacturers, and often had to overorder due
to shipping minimums. Beginning in 2007, the company created 18 "rapid
deployment" warehouses around the U.S. to centralize distribution and speed the
delivery of high-demand goods.
      Additionally, Home Depot gave sales associates hand-held devices loaded
with data about products and their availability, which led to big improvements
in customer service. The company also put more focus on merchandising, with an
eye to local tastes.
      Return on equity has shot up to 35.5% since these changes were
implemented, compared with 22.2% when Blake became chief executive. In fact, ROE
is roughly twice that of competing retailers. And the cash generated from
operations -- $ 7.6 billion last year -- allows Home Depot to annually buy
back $5 billion of stock, and to pay a fast-growing dividend, currently
$1.88 a share.
      As strong as results have been, investors haven't yet seen what an
improved Home Depot can do in a more normal housing market. But that could
change in the year ahead. Even without expanding its current store base or
adding many new products, the home-improvement giant is likely to see a big pop
in revenue as the housing rebound accelerates.
      So far, there is little to cheer on the housing front. New-home
construction stalled during the crash and recession, and has barely gotten up
off the mat since. Housing starts totaled an annualized 946,000 in March,
compared with two million in 2005.
      Prices and sales rose in 2013 at the fastest rate since the recession, but
here the news is mixed. Growth has been driven to an unusual degree by investors
looking to rent properties and speculate on real estate. First-time buyers --
the sort who invest in cabinets, tile, carpets, and mulch at Home Depot --
accounted for only 28% of existing-home sales in February, versus a more normal
40%, according to the National Association of Realtors. In part, that's because
many would-be buyers in the 25-to-34-year-old age bracket still are living with
mom and dad. The recession also has curbed the other main drivers of household
formation -- immigration and divorce.
      Yet, economists are encouraged that the household-formation rate finally
popped up to 1.375 million last year, spurred by job growth and pent-up demand.
That exceeds the average annual rate of 1.2 million in the 20 years preceding
the recession. They estimate that the industry will have to build 1.5 million
homes a year just to keep up with U.S. population growth. Indeed, housing starts
are expected to rebound to 1.1 million in 2014 from last year's 925,000.
      The shares of home-improvement retailers are "the safest way to play this
trend," says Chuck Lieberman, chief investment officer at Advisors Capital
Management in Hasbrouck Heights, N.J. Home builders also will benefit from the
rebound, but their stocks tend to be more volatile.



Coming Up Roses -- Barron's -2-
Apr 19 at 00:08
Profile hits: NONE

      Even if housing takes longer to come around, Home Depot has other growth
levers. Sears, still the leading U.S. appliance retailer, has been losing money
and market share for several years. Home Depot gained 1.7 percentage points of
share in appliances in 2013, and could grab more while Sears continues to
struggle.
      Seventy-eight percent of Home Depot's stores were within 10 miles of a
Sears location, according to a report released in September by Morgan Stanley.
The bank's analysts estimate that Sears sells about $9 billion a year in
appliances and home-improvement goods. If its sales decline by 5% in the next
three years, Home Depot could add at least $100 million in yearly sales.
      "That's a major driver for Home Depot and Lowe's for the next three
years," says Balter, of Credit Suisse.
      A robust assortment of big-ticket items has helped Home Depot attract
higher- income buyers. Transactions for more than $900 now contribute about
20% of annual U.S. sales, and grew more than twice as fast in the fourth quarter
as tickets under $50.
      Online sales also are climbing at a rapid pace; they rose 50% last year,
to 3.5% of total revenue. Home Depot has warded off online competitors by
negotiating with some suppliers to carry items exclusively. It also is
attempting to integrate online and in-store shopping by offering extensive
product information and reviews online, and letting customers pick up or return
items in the stores that were bought online. At the same time, more than 10% of
online orders are placed at the stores, often after shoppers have worked with
Home Depot specialists to customize merchandise, such as patio furniture.
      Home Depot customers still want a curated experience, unlike shoppers at
Amazon.com (AMZN), says Craig Menear, president of Home Depot's U.S. retail
operations. He defines his goal as ensuring that the company creates "a more
seamless connected experience for our customers, no matter how they choose to
shop with us."
      Home Depot also has opportunities to expand its best-in-class margins.
Supply- chain improvements remain a work in progress, and the company expects
additional initiatives to lift operating margins to 13% by 2015, from 11.6% now.
That alone could boost operating earnings by more than 10%.
      Home Depot's progress, and that of its shares, could stall if the housing
market flat-lines or heads south again. Credit requirements remain exceptionally
high, with an average credit-score requirement of 750 for mortgages sold to
Fannie Mae, up from the usual 700, says Mark Zandi, the chief economist at
Moody's Analytics. "The difference between 700 and 750 is about 12.5 million
potential homeowners," Zandi says. "That credit box has to open. It's starting
to happen."
      That's all the more reason Home Depot's shares look cheap. Given the
company's continued operating improvements and growth potential, investors can
buy the house now for the price of the two-by-fours.
      ---
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Company Symbols: HD US4370761029
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  04-19-14 0007ET
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Company Symbols: HD US4370761029
Subject Codes: I/HIM I/RTS I/XDJGI I/XDJI I/XDJLC I/XFFX I/XGDW I/XISL I/XNYA
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