Why Home Depot Needs a Bigger Footprint

GuruFocus.com

Sun, Jul 10, 2016, 1:11 AM

- By Shudeep Chandrasekhar

With a 24% market share, Home Depot (HD) is the clear leader in the home improvement space in the U.S. So, why have they only added a grand net of one store in the past five years? How did they grow revenues by nearly $10 billion between 2012 and 2014?

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We know that their China foray ended in complete failure, and Mexico has been doing fairly well, but the bulk of their revenue still comes from their home market. What we need to find out is how the company is able to keep growing the top line in a mature market without the additional store count that you'd expect to accompany that growth. Is that kind of growth really sustainable?

Healthy numbers for early 2016

Home Depot reported $22.8 billion in revenues for the first quarter of 2016, up 9% from the same quarter a year before. In fact, it expects to do so well this fiscal year that it raised the guidance to 6.3% revenue growth.

Obviously, that top line is constantly moving up. More pertinent to this analysis, however, is the expansion in average ticket size and overall transactions. On the ticket front, the company reported a 2.4% increase to $60.03; transactions have grown from 360.2 million to 374.8 million, a year over year increase of 4.1%.

But the question is: How long can the company sustain such growth before it is forced to look at new opportunities?

On the e-commerce front it faces competition from Amazon (AMZN) and other e-tailers, but the company's own online format is growing at an impressive 20% year over year. There's no real external threat to its e-commerce business as of now, and with plans to roll out the order management system by the end of this year, things are looking up there as well, with 2015 bringing in $4.7 billion from web sales - a billion dollars more than the year before.

Unfortunately, none of that can explain what the company said in its Letter to Shareholders for the fiscal 2015:

"Fiscal 2015 was another record setting year for The Home Depot. Our sales, net earnings and customer satisfaction scores were the highest in Company history. Sales grew $5.3 billion to $88.5 billion, an increase of 6.4 percent from fiscal 2014, with comparable store sales up 5.6 percent for the Company and 7.1 percent in the U.S."

What's really driving its growth? The market itself. The industry segment is largely dependent on existing and new home sales. As long as those metrics keep growing, HD will grow on their backs.

The U.S. housing market

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As you can see, from a year ago until early this year, the median price of existing homes has been going down. This year, it's showing a sharp increase. When prices are low, demand is high; that, in turn, pushes up prices in a cyclic manner.

But how is that impacting the actual sales?

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If you look only at the past few months, you'll see that existing home sales are actually on an uptrend while prices keep going up. But it's not only existing homes. New home sales have stayed above the 500,000 per month level since late last year.

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The combination of credit availability and low interest rates could be one explanation for what's happening. If you look at the 30-year mortgage rates for the past few months and compare them with previous years, you'll see what I'm talking about.

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Source: Freddie Mac

Interest rates are the lowest they've ever been since 2013, and the Fed is wary of pushing them in the wrong direction.

And that's essentially the wave that Home Depot, Lowe's and other home improvement operators are riding at the moment.

What happens at the trough?

The long-term worry here is Home Depot's dependence on the market. The comps are great, more people are coming into its stores and more people are buying online. But what happens when that market begins to recede, as it most definitely will?

The only way for HD to stay ahead of the game is to widen or deepen its footprint. The wider it spreads its nets, the lower the risk of being affected by a downturn in the housing market. Mexico is a great start, but the company needs to go above and beyond that. A planned expansion strategy over the next five to 10 years is what the company sorely needs at this point.

Some investors will ask: Why rock the boat when it's smooth sailing? But that's exactly when you make your plans - not when you're in the middle of a storm. The U.S. economy is currently stable and growing, albeit as a slow pace. This is the time when Home Depot needs to use its brand and financial muscle to safeguard itself.

I see international expansion as the only realistic way to make the company future-ready. Growing sales, improving margins and an expanding online revenue channel should be the foundation that it builds on, not laurels to sit on.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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This article first appeared on GuruFocus.