November 21, 2002
Who Do You Believe: Home Depot or the Fed?
Since 1980 Home Depot has reported consistent revenue and earnings gains in every year but one (1985). Is another down year on the horizon?
Home Depot (HD) sells products primarily to consumers, or the credit hungry mob that accounts for two-thirds of economic activity. When consumer’s change their spending habits Home Depot’s financial results, like Wal-Mart and other retailers, is immediately impacted. As such, HD’s quarterly results and outlook are an important element to consider when forecasting an outlook for the U.S. economy.
By contrast, what Fed members do and say can, at times, be very important when speculating on how the economy may perform, while at other times the Fed’s actions are irrelevant. With this in mind, a Fed member, and despite what you have heard, is nothing more than a dolled up Wall Street analyst that attends luncheons and speaking engagements rather than shareholder meetings and analyst conferences. Everyone from Fed Meyer to Fed Greenspan now believes there is enough monetary stimulus in the system to rejuvenate economic activity. Yes, this is exactly what the Fed thought heading into 2002.
Suffice it to say, when Home Depot reports bad numbers and trims its outlook, and Fed Chairman Greenspan yelps ‘we have provided enough stimulus’, it is up to the investor to determine who is telling the truth. And while it is true that both parties are guessing about the future, it should be remembered that any company would guess for great results if they could…
Dire Times for Depot?
Earlier this week Home Depot reported record 3Q02 net earnings of $940 million (40 cents a share) on revenues of $14.5 billion. These impressive earnings and revenue totals, up 21% and 9% respectively over 3Q01 results, were roughly inline with First Call estimates. However, HD shares crashed by 12% on Wednesday and fell by an additional 0.84% yesterday because HD also reported weak same store sales, and downgraded forward earnings estimates.
Even though HD shares are down more than 50% from their 52-week high HD remains upbeat. To be sure, the company reiterated, quite cheerfully I might add, that it is ‘staying on strategy’ during its recent conference call. HD blamed its comparable store sales decline on a slight increase in cannibalization rates, customer disruptions due to resets (remodeling), and the weak U.S. economy.
Home Depot’s Dilemma: How to Grow?
In recent years the home improvement giants, Home Depot and Lowe’s, have stolen marketshare away from smaller competitors.
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Despite these remarkable growth trends, there remains the threat that HD and LOW will have a difficulty achieving growth in the future because of their size. Moreover, with the U.S. consumer more apt to pinch their pennies these days as opposed to the 1990s the realization that growth in margins may slow also lingers.
Incidentally, beware of the analysts who focus on Home Depot’s history to promote a bullish bias. For certain, HD’s previous results are history, and may not reflect the growth potential for the company going forward. Furthermore, even HD’s stellar history has begun to show some cracks.
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The 2% decline in HD’s 3Q02 same store sales suggests 1 of 3 things:
1) Home Depot has reached a saturation point in some areas.
2) Home Depot is no longer able to crush the competition.
3) The home improvement industry is weakening.
The argument could be made that HD is, or may soon suffer, from a combination of all the above threats. Nevertheless, one thing is for certain: weak same store sales, which have matched the choppiness in the U.S. economy since late 2000, ensure that the company will not being able to attain high rates of revenue growth from existing stores.
The delightful contradiction is that Fed members have come together with the statement that ‘growth will rebound in 2003’ at the same time Home Depot has come to a different conclusion altogether. HD is planning to expand at a slower pace (12 percent to 15 percent growth in square footage over the next three years versus previous estimates as high as 25%), and is expecting same store sales to slump by 3-5% in 4Q02. Clearly the Fed’s outlook is not the ‘same’ as HD’s outlook*
* HD has not published any estimates for 2003 yet.
Wal-Mart versus Home Depot
Wal-Mart began their move into Canada by purchasing beleaguered retailer Woolco. By doing so, Wal-Mart immediately got rid of some of the competition, and at the same time emerged into Canada with a bang: Woolco had hundreds of stores embedded in key locations. Wal-Mart has duplicated this strategy across the world, with the only notable failure being in Germany (debatably because of a culture clash). Point being, Wal-Mart expands by crushing competitors via takeovers and/or by using its pricing power. Canada’s Woolco found this out the easy way (they got taken over) while Kmart found this out the hard way (they went bankrupt trying to compete).
Home Depot cannot follow in Wal-Mart’s footsteps for three interrelated reasons:
1) The gigantic home improvement stores the company focuses on are a relatively new concept -- there isn’t any key global competitors to takeover; no valuable lessons to be learned by tactfully inching into foreign markets.
2) Home Depot’s pricing advantage, while unmatched for its niche, is not as dominate as Wal-Marts. Rather, Home Depot has a real competitive threat in Lowe’s, and faces a commodities risk (potential competitive threat) with lumber.
3) HD actually competes with the likes of Wal-Mart in some areas, and will likely compete in more areas in the future. You don’t bet against Wal-Mart.
In sum, Home Depot is the Wal-Mart of home improvement, but they are not Wal-Mart. When Wal-Mart focused on selling groceries they quickly gained dominance – WMT knew they could undercut the competition and they did. By contrast, Home Depot is focusing on appliances (3rd largest) and wood flooring (service), neither of which they can dominate purely on price. Further, HD is taking this direction when comparable store sales are declining and expected to continue to decline. Is this a positive signal or a sign of desperation?
Conclusion
The Fed’s job following the questionable 50 basis point rate cut is to assure everyone that things are going to be alright. Fed member after Fed member has attempted to accomplish this goal, in part, by endless stating the Fed’s well crafted mantra during speeches and interviews:
“We believe that the monetary policy we have put in place will support aggregate demand.” Fed Moskow – Nov 20. (Similar sentiments were previously echoed by Greenspan, Meyer, Ferguson, etc.)
Home Depot’s job is to give an honest interpretation of future business conditions based upon what information they have. If Home Depot lies shareholders will punish them. Therefore, it serves no purpose for HD to offer a gloomy outlook unless it is the truth.
To note: you could argue that some companies give conservative estimates in order to ensure that their targets can be met or beat. Nevertheless, even if HD’s outlook is conservative the company will have to see a fantastic turnaround in the fourth quarter to beat their estimates by a significant margin since 4Q01 was positively influenced by a ‘yellow tag’ sale (large dumping of old inventory).
In sum, and despite what Fed members have been telling us, Home Depot does not see any consumer spending benefit from the Fed cut materializing. The Fed may ultimately be right, and the U.S. may eek out a few more quarters or even years of choppy growth. However, the investor should understand that as of right now, the Fed is guessing while HD’s quarterly numbers do not lie. The U.S. economy will not be on the cusp of the ‘real recovery’, which is supposedly going to follow the 2002 ‘jobless recovery’, until mammoth retailers like Home Depot begin reporting good news.
Disclosure: No one at FallStreet has an investment position in any of the companies mentioned.
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