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Home Depot (NYSE: HD) is the largest retailer of home improvement goods in the world. HD sells everything you would need to build a home -- from tools to paint. As of the end of FY2008, the company operated 2,233 stores throughout the U.S., Mexico, Canada, and China, ^[1] offering products and services to end consumers as well as to professional builders, tradesmen, and repairmen. Home Depot's 2008 revenue of $71.3 billion^[2] is nearly one-and-a-half times that of its nearest competitor Lowe's, which had a revenue of $48.2 billion in 2008. ^[3]

Like all home improvement retailers, Home Depot is very vulnerable to interest rates and the continued housing market slowdown. The subprime mortgage crisis in the financial industry has also been a major factor behind Home Depot's struggles. In 2008, Home Depot's net sales decreased 7.8% from 2007 to $71.3 billion as same store sales decreased 8.7% for the year.^[2][4] The sale of HD Supply, which was even more sensitive to the housing market, may be part of a general effort to stabilize Home Depot's fortunes. Growing international operations in Canada, Mexico and China may also buffer Home Depot's exposure to the domestic US market. In 2008, HD opened 62 new stores, 19 of which were in foreign countries. ^[5]

Despite being the world's largest home improvement retailer, Home Depot still faces many risks from competitors and from outside factors. In August 2007, Home Depot sold one of its business segments called HD Supply, a segment that catered to professionals and contributed nearly 80% of all revenue growth for Home Depot from 2005 to 2006 and 13% of net sales in 2006. ^[6][7] With the sale of HD Supply, the Home Depot lost a significant source of sales allowing its main competitor, Lowe's Companies (LOW) to catch up in terms of net sales.

Company Overview

Home Depot started in 1978 and has since grown rapidly into one of the largest retailer in the U.S. with a record $77 billion in 2007 sales ^[8]. The company reached $1 billion in sales by 1986, ^[9] and had expanded internationally into Chile and Argentina. In 2001, it sold out its operations in Chile and Argentina ^[10]; today, Home Depot operates in the US, Canada, Mexico and China.

Stores and Products

Home Depot provides a wide range of home building supplies (35,000 to 40,000 products per store) and services to its target customers. In 2008, the company operated 2,233 stores of which 88% were located in the United States and the other 12% in Canada, Mexico, and China. ^[1]Most retail outlets are big-box stores averaging around 125,000 square feet of retail space (100,000 sq ft enclosed sales floors and 25,000 sq ft of garden areas outside).

Business Segments

Home Depot operates under four different business segments: ^[11]

• Plumbing, Electrical and Kitchen (30.6% of net sales)
• Hardware and Seasonal (28.7% of net sales)
• Building Materials, Lumber and Millwork (22.1% of net sales)
• Paint and Flooring (18.6% of net sales)

Since 2006, the business segments have represented nearly the same proportion of net sales despite a continuing decrease in overall net sales. ^[11]

Customers

Retail

Home Depot's retail operations generated $71 billion in 2008 revenue, a decrease of 7.8% compared to 2007. The company caters to three main types of retail customers:

• Do It Yourself Customers (DIY): Home Depot markets many of its products to home owners who tackle their own home improvement projects as non-professionals. In order to meet these customers' needs, the company employs staff with specific expertise (e.g., former plumbers in the bathroom remodel section, for instance). Home Depot also offers clinics and "how-to" workshops in order to attract DIY customers.

• Do It for Me Customers (DIFM): DIFM customers--often ones in the process of remodeling homes--purchase materials and then hire professionals to install them (e.g., home owner buys a new sink at Home Depot and then hires a professional plumber to install it). Home Depot matches DIFM customers with qualified professionals and arranges installation services for its products. Home Depot introduced its EXPO Design Centers, replete with elaborate showrooms, to cater to the higher-end and -profit DIFM crowd.

• Professional Customers: Home Depot targets professional contractors and repairmen through delivery services and extended credit programs. This category is the largest, with almost double the sales of the DIY customers.

HD Supply Sold

Home Depot's HD Supply business that served professional and industrial customers was sold to private equity investors for $8.5 billion--18% less than the price Home Depot had originally hoped to receive, before the subprime lending crisis damaged the health of the credit markets.

The HD Supply division provided a wide range of products and services to builders, contractors, government organizations, industrial businesses and maintenance professionals. This business unit accounted for $12.1 billion in 2006 sales, an increase of 162% compared to the previous year. HD Supply accounted for nearly 80% of the total growth of the company from 2005 to 2006. The sale of HD Supply may help to limit the company's total exposure to fluctuations in a dangerously volatile housing market, but it also cuts off a large potential growth opportunity.

Business Growth

FY 2008 (ended February 1, 2009)^[2]

• Home Depot's net income dropped 48.6% in 2008 from $4.4 billion in 2007 to $2.3 billion in 2008. The large decrease can be attributed to the housing crisis and the economic recession.

• Net sales also dropped from $77 billion in 2007 to $71 billion in 2008, or a 7.8% decrease. This is reflected by the comparable store sale decrease of 8.7% for the year as a result of the slowdown in the home improvement market, higher unemployment, and decreased consumer credit availability. In addition, store cannibalization caused a 1% decrease in comparable store sales.

• Operating margin for the year was 6.1% compared to 11.7% in 2007, a 5.8% decrease as a result of higher operating expenses.

• There was an 8.7% decrease in comparable store sales in 2008, compared to a decrease of 6.7% in 2007.

• Home Depot opened 62 stores, closed 15 stores, and discontinued its EXPO and THD Design Center locations.

Q3 2009 (ended November 1, 2009)^[12]

• Home Depot incurred a net gain of $689 million, a decline of 8.9% as compared with the previous-year fiscal quarter's net income of $756 million. The company attributes the decline in net income to the weak housing market. Lower income was offset by reduced SG&A expenses.

• Net sales were $16.3 billion in Q3 2009, down 8.0% from net sales of $17.7 billion in Q3 of last year. The substantial reduction in earnings was primarily due to pressures from the economic downturn and a bleak home market that stifled inventory growth and sales. To add on, same store sales were down 6.9% for the quarter. In addition, currency exchange rates and the strong dollar negatively impacted total sales (in the first nine months of FY2009, exchange rates had a negative impact of $750 million).

• Operating profit for Q3 2009 was $1.26 billion, and operating margin was 7.7% of net sales. This is a 30 bps increase from Q3 2008, during which operating profit was $1.32 billion, or 7.4% of net sales. This was probably partly due to the 8.4% decrease in SG&A expenses.

• Comparable store sales fell 6.9% for the quarter, compared to a 8.3% decrease in Q3 2008, a 140 bps increase. Paint was the company's only merchandise category that had positive comparable store sales growth.

Trends and Forces

Home Depot Sales Face Slow Recovery After Housing Market Reaches Bottom

In June 2009, Home Depot claimed that the worst of the housing market fallout had already passed. ^[13] However, this does not mean that the company will suddenly see higher sales or net income -- Home Depot still expects a 9% decrease in sales. Although the housing market might have bottomed out, the economy is still suffering from the recession. The household savings rate has reached a 15 year high ^[14] and the number of homes on the market due to foreclosures is very high. Homebuilders will have to wait until foreclosed homes, which are selling at rock bottom prices, and for the economy to rebound before they see any increases in housing construction. In May 2009, the Department of Commerce reported that home construction in April reached a 50 year low falling 12.8%. ^[15] However, in June, the department reported that housing consruction increased by the largest amount compared to the prior three months, ^[16] perhaps a sign that the slow recovery is already beginning.

Changes in Housing/Interest Rates Affect Homebuilders which Home Depot Relies On

To read a more detailed discussion of how interest rates affect housing, see also Interest Rates.

In the past, a high correlation has existed between the rate of home purchases and buildings and interest rates. As interest rates fall, prospective home owners and builders can borrow money less expensively and therefore will be more likely to do so. When more homes are built and purchased, Home Depot's sales to homebuilders and re-modelers increase. On the flip side, when interest rates rise, borrowing becomes more expensive and the number of building and home improvement projects decline, resulting in fewer sales for Home Depot. In addition, higher interest rates make home refinancing, a major source of funds for home improvement projects, more expensive.

Since 2006 the housing market has been struggling as a result of the credit crunch that began in 2007 in the financial industries with fallouts on subprime mortage-backed securities. As a result, national home foreclosure rates have gone up dramatically, with the hardest hit places being the Southeast and Southwest. ^[17] The foreclosure rate in February 2009 was 30% higher than the rate in 2008 and in places like Nevada, one in every 70 homes recieved a foreclosure notice ^[18] The more foreclosures there are, the more homes are on the market, which results in a decrease in demand for building new homes. Home Depot has struggled through this period seeing annual decreases in revenue and net income since 2006. In addition, same store sales have been negative in 2006, 2007, and 2008 at 2.8%, 6.7%, and 8.7% respectively. ^[19]

It should be noted that housing booms do not always occur when interest rates are low. This is especially true in the case of a geographic area housing boom. There are many reasons for such booms (e.g., a company may move to an area, providing a boon through new jobs creation). Because Home Depot has widespread locations throughout the U.S., they are in position to take advantage of such booms.

Private and Proprietary Brands

Each Home Depot store stocks proprietary brands exclusively sold by Home Depot and national brand name items sold by other retailers and suppliers. Some notable brands unique to Home Depot include: Charmglow (gas grills), Husky (hand tools), and Ryobi (power tools). The contracts that give Home Depot exclusive rights to sell certain brands generate dual value, especially in regards to the professional customer base.

• When craftsmen become accustomed to one type/style of tool they will most likely replace that tool with one of the same style/type because of the utility gained from saving money, time or just from personal preferences. This is an example of customer lock-in, a theory that says a customer has to rely on a particular vendor for his needs in order to avoid a high increase in costs.
• Private label brands have a higher profit contribution for Home Depot.

Older Poplulation Increase in Number of "Do-It-for-Me" (DIFM) Customers

As the demographics of the U.S. change, specifically baby boomers getting older, there will be an increased amount of demand for DIFM services. The 77 million baby boomers provide a growing market for Home Depot's DIFM business line -- in 2005, the DIFM business increased by 20.5%.^[20] This is good for Home Depot because they reap additional revenue in this segment from installation charges that they do not accrue from DIY (do-it-yourself) customers.

Store Expansion

Home Depot operated 2,233 stores in the U.S., Canada, Mexico and China at the end of the of the 2008 fiscal year. ^[1]

• U.S.: 1,971 The Home Depot stores; 41 were opened in 2008
• Canada: 176 The Home Depot stores; 12 were opened in 2008
• Mexico: 74 The Home Depot stores; 9 were opened in 2008
• China: 12 The Home Way stores
• Other: 34 EXPO Design Center stores, 5 Yardbird stores, 2 THD Design Center stores were sold in 2008.

Home Depot holds a head start in global expansion compared to its main competitor, Lowe's, whose international operations amount only to 6 stores in Canada which were opened in 2007. In 2006, China's rapid economic growth prompted Home Depot to purchase The Home Way, a Chinese home improvement retailer. This acquisition, with its 12 store locations, has allowed Home Depot to enter an international market that many consider to be booming. The international market not only gives Home Depot access to growing markets but also reduces the effect of the economic downturn on US sales, the country that has been hit the hardest.

Economies of Scale

In 2008, Home Depot announced that it would be constructing new 'rapid deployment centers' (RDCs) to serve as supply centers for hundreds of stores across the country. The method of having central distribution centers is in contrast to the old method of maintaining large inventories of items through a store/warehouse system in which larger stores served as distribution points. One of the advantages of this system was that it decreased the wait time for customers and allowed them to select from more products. However, as Home Depot grew in size, this process became more and more inefficient as inventories would pile up in some stores and would be needed in others. The new RDCs will put inventories in the right places, save money, and allow the company to cut prices which they hope will lead to larger profits. ^[21]

Competition

Home Depot vs. Lowe's

Home Depot's only significant competition in the home improvement retail industry is Lowe's Companies (LOW). In 2008, Home Depot dominated in terms of sales revenue ($71B vs $48B)^[2][3]. Lowe's and Home Depot are by far the leaders of the home improvement retail industry, but together they comprise only 18% of the estimated $725 billion home improvement market (this includes pure product demand as well as installation labor demand). The rest is distributed between other "big-box" retailers such as Wal-Mart Stores (WMT), smaller hardware store chains, construction firms, and other small businesses.

Sales do not tell the whole Lowe's and Home Depot story. Lowe's has outpaced the market leader along key metrics of same stores sales growth and operating margin growth.

• Same Store Sales Growth: Lowe's has consistently been ahead of Home Depot in same store sales growth since 2004. Same store sales growth lends the best comparison of sales growth between the two companies by looking at the same stores year over year for both companies. By doing this it does not allow new store openings to affect the comparison. In 2008, same store sales of HD decreased by 8.7% ^[2] whereas same stores sales of LOW decreased only by 7.2%. ^[24]

• Operating Margin: Lowe's had been behind Home Depot in terms of operating margins for several years until 2006 when Lowe's won a slight advantage over Home Depot. However, Home Depot surpassed Lowe's again in 2007. Home Depot's operating margin fell to 6.1% compared to Lowe's 7.3% mark in 2008. ^[23]

• International Markets: Home Depot has 262 stores ^[1]outside of the US (mostly in Canada and Mexico) which is 19 more stores than it had in 2008. On the other hand, Lowe's expanded internationally with just 11 new stores in Canada in 2008. ^[25] Lowe's hopes to continue this expansion to catch up to Home Depot's global sales.

One key driver of the difference in operating performance is Lowe's store environment, which is often noted to be more more customer friendly than Home Depot's. Consumers wanting less of a "warehouse style" home improvement retailer often choose Lowe's over Home Depot. This is especially true for the lucrative, growing DIFM customer base. Home Depot is taking steps to incrementally improve the customer experience by:

• Modernizing many of its stores to improve customer perception of Home Depot's physical locations.
• Introducing a 24-hour help hotline to improve customer service.
• Developing a new employee incentive program to improve customer service at Home Depot stores.

Home Depot has long been known for appealing to the professional contractor and the weekend warrior alike. But does the "warehouse" feel of its retail stores put it at a disadvantage to rival Lowe's?

Smaller Competitors

Home Depot also faces competition from smaller independent mom & pop stores. Although these stores usually cannot match the prices of the industry giants Home Depot or Lowe's, they make up for higher prices with customer care, tradition, and perhaps convenience. ^[26] In addition, the presence of Home Depot in some areas has even caused customers to boycott the giant firm and to shop at local businesses. ^[27] The advantage that Home Depot has against these smaller competitors is that they stand a better chance at outlasting the economic downturn and in the mean time attracting old customers of fallen businesses.

One example of a small competitor is Builders FirstSource (BLDR), a company that makes and sells structural and related building products for residential new construction. The company is based in the United States and operates in the United States.^[28]

References

1. ↑ ^{1.0 1.1 1.2 1.3} HD 2008 10-K, pg. 8-9
2. ↑ ^{2.0 2.1 2.2 2.3 2.4 2.5} HD 2008 10-K, pg. 28
3. ↑ ^{3.0 3.1} LOW 2008 10-K, Exhibit 13, pg. 21
4. ↑ HD 2008 10-K, pg. 15
5. ↑ HD 2008 10-K, pg. 16
6. ↑ HD 2006 10-K, pg. 20
7. ↑ New York Times "Home Depot Sells Unit, With Price Cut" 29 August 2007
8. ↑ HD 2007 10-K, pg. 34
9. ↑ Funding Universe "Home Depot, Inc."
10. ↑ All Business "Home Depot Bowing Out of South America" 26 Oct 2001
11. ↑ ^{11.0 11.1} HD 2008 10-K, pg. 2
12. ↑ ^{12.0 12.1} HD Q3 2009 Report
13. ↑ Motley Fool "Home Depot Calls a Bottom" 11 June 2009
14. ↑ MSNBC "Americans saving more, spending modestly" 26 June 2009
15. ↑ Times Online "New US housing starts fall to a 50-year low" 19 May 2009
16. ↑ Fox News "Housing Construction Jumps by Largest Amount in 3 Months" 16 June 2009
17. ↑ Housing Zone "Rising Foreclosure Rate Restrains Housing Starts" 5 June 2009
18. ↑ CBS "Foreclosure Rate Up 30% From Last February" 12 March 2009
19. ↑ HD 2008 10-K, pg. F-1
20. ↑ CNN Money "Baby Boomers: Do-It-For-Me generation" 11 May 2005
21. ↑ AJC "Home Depot’s supply chain overhaul to free up cash, improve inventory" 28 Sept 2008
22. ↑ ^{22.0 22.1} Google Finance: HD Overview
23. ↑ ^{23.0 23.1} Google Finance: LOW Overview
24. ↑ LOW 2008 10-K, Exhibit 13, pg. 2
25. ↑ LOW 2008 10-K, Part 1, pg. 5
26. ↑ Juneau Empire "Surviving Home Depot" 17 Feb 2008
27. ↑ Costal Point "Home Depot plan stirs talks of boycott" 11 Aug 2006
28. ↑ ^{28.0 28.1} Google Finance: BLDR Overview