2/23/2010
By Brian Sozzi, Research Analyst

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This morning, Home Depot Inc. (HD) released its 4Q09 earnings results and its preliminary outlook for FY10.  On both accounts, it's our view that Home Depot delivered.

We foresee the following as catalysts to sales and earnings in 2010, all of which suggest Home Depot's FY10 outlook may end up conservative by February 2011.

External Catalysts
* Absent the arrival of a "black swan" to the economic pond this year, we wouldn't be surprised to see a mini boom in remodeling demand later this year and into 1H11.  We think what you are seeing in the numbers from Home Depot and Lowe's (LOW) is spend by those people in their homes feeling more confident from when median home values troughed in January 2009.  Later this year, we think you will see entrants to the remodeling market in the form of those who utilized the $8,000 tax credit or home flippers seeking to boost the value of their recently purchased foreclosed property. 

Firm-Specific Catalysts
* Continued development of RDC strategy (these small distribution centers served about 65% of the store base in 4Q09, up from 50% in 3Q09 and 25% coming into 2009)
* Continued share gains from fresher appearing stores, improved merchandise selection, and enhanced customer service
* Growth opportunities in China, Mexico, and Canada

Overview

For 4Q09, Home Depot reported a revenue result that at $14.6 billion surpassed consensus by $532.0 million, the exact opposite of what transpired at Lowe's yesterday (marginal revenue beat).  We attribute the significant upside to a better than expected U.S. comp of -1.1% (beat Lowe's from what we can decipher), fueled by strengthening demand in hard hit housing markets and continued success in plumbing, paint, and flooring.  Home Depot's exposure to Mexico, China, and Canada where dollar translation was beneficial and local market demand solid helped.  Lowe's, for example, had a high double-digit percentage Canadian comp in 4Q09.  Overall, Home Depot reported a +1.2% comp for 4Q09.

Within in Home Depot's total comp the decline in average ticket was pared for the second consecutive quarter, while customer traffic slipped sequentially (-8.2%).  However, we note that 4Q09 is Home Depot's smallest revenue quarter and storm activity was prevalent across the U.S., hindering traffic somewhat.  Importantly, customer traffic increased 2.1% y/y.  Home Depot's discipline on the operating expense side of equitation was also obvious, and a major factor in EPS outpacing consensus on an adjusted basis by $0.06 (and every single estimate in Thomson Reuters consensus).  SG&A expenses and Depreciation expense fell 9.0% and 5.9%, respectively.

Touching upon the FY10 outlook, the ranges provided were stronger than those issued by Lowe's yesterday.  Home Depot, through improved end market demand in residential remodeling and benefits from structural cost removal in 2008 and 2009, looks well positioned to expand operating margin in FY10.  For perceptive, on a 7.5% sales drop in FY09, Home Depot eked out 8 bps of y/y operating margin expansion.  We view favorably Home Depot's decision to limit new store openings in FY10, instead focusing on driving sales and earnings from an ever efficient existing store base.

Two signals that Home Depot is confident in its outlook for the year include a 5% increase in its quarterly dividend and a 30% increase in annual capex to $1.25 billion.  Home Depot has not increased capex since 2007, so this is perhaps a stronger indicator of the outlook than the dividend raise.  Given Home Depot's net new store plans for FY10 (six), which is minimal, the increase in capex is likely split between continuing the RDC rollout and further technology upgrades, both positioning the company to outperform Lowe's in terms of returns as we move beyond the housing downturn.

Valuing Home Depot shares on a PE multiple of 16.0x our FY11 EPS est. of $2.05 derives a price target of $35.00, implying at least 13.0% appreciation from the stock's present residence extending the next 12-months.  Our multiple assumption is at the high-end of an eight-year range of 15.0x to 18.0x on expectations for an acceleration in sales and earnings growth in FY11.  Key inputs include a mid-single digit percentage positive comp, modest new unit growth, and operating margin progress that takes Home Depot one step closer to a return of the 10% plus rate of yesteryear (maybe by 2012).  Unlike Home Depot's guidance for FY10, we have assumed a reasonable amount of share repurchases.  Note that even though Home Depot shares have risen appreciably since March 2009, the stock is some 30% off the prior cycle peak touched in 2006.

Brian Sozzi
Wall Street Strategies