The Home Depot, Inc.
Q2 2007 Earnings Call Transcript

Published: 14 Aug 2007

[Operator:]

Good day, everyone and welcome to today's Home Depot second quarter earnings conference call. As a reminder today's call is being recorded. Beginning today's discussion is Ms. Diane Dayhoff, Senior Vice President of Investor Relations. Please go ahead, ma'am.

[Diane Dayhoff:]

Good morning to everyone. Welcome to the Home Depot second quarter earnings conference call. Joining us on our call today are Frank Blake, Chairman and CEO of the Home Depot; Craig Menear, Executive Vice President, Merchandising; and Carol Tome, Chief Financial Officer and Executive Vice President, Corporate Services. Following our prepared remarks the call will be open for analyst questions. Questions will be limited to analysts and investors, and as a reminder, we would appreciate it if the participants would limit themselves to one question with one follow-up please. This conference call is being broadcast real time on the Internet at HomeDepot.com with links on both our homepage and the investor relations section. The replay will also be available on our site. If we are unable to get to your question during the call, please call our Investor Relations department at 770-384 -2387. Before I turn the call over to Frank, let me remind you that today's press release and the presentations made by executives include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties. These risks and uncertainties include, but are not limited to, those factors identified in the release and in our filings with the Securities and Exchange Commission. Now, let me turn the call over to Frank Blake.

[Frank Blake:]

Thank you, Diane and good morning, everyone. Let me start by saying that I realize that many of you want to know where we stand on the sale of our HD Supply business. Unfortunately, I have no new details to add. We remain in discussions with the buyers and I'm not in a position to answer the very reasonable questions you may have about what is the likely outcome. What I can talk about this morning is the performance of our core retail business. Our market continues to be a challenging one. You are familiar with the statistics

[Craig Menear:]

Thank you, Frank and good morning, everyone. While comp sales in the second quarter continued to be negatively impacted by the current housing environment, we have made progress in executing our merchandise strategy resulting in sequential year-over-year improvements in sales growth, gross margin expansion, and inventory velocity. In the second quarter, four departments outperformed the company's comp

[Carol Tome:]

Thank you, Craig and hello, everyone. Before I discuss the results of the quarter, let me remind you that we are now reporting the results of HD Supply as a discontinued operation. Any reference we make to continuing operations is a reference to our retail business only, and as you review our financial statements, please note that the operating results of HD Supply are found in a one line item on the income statement entitled earnings from discontinued operations and HD Supply assets and liabilities are noted on our balance sheet as assets and liabilities of discontinued operations. In the second quarter, sales were $22.2 billion, a 1.8% decrease from last year, reflecting negative same-store sales of 5.2% offset in part by sales from new and non-comp stores. Consolidated store sales were a negative 3.1% in May, negative 5.4% in June, and negative 6.8% in July, as we did not repeat last years highly promotional activity in July. Now, given the state of the home improvement market, we had planned for negative comp sales in the U.S. and our actual results were, for the most part, in line with our expectations. For our stores outside of the U.S., comps were positive. Now, one last comment about comps. For the first two weeks of August, our comps are running in the negative 3% area. In the second quarter, our gross margin was 33.1%, an increase of 9 basis points from the same period last year. Contributing to the year-over-year increase in our gross margin were the following factors

[Operator:]

Your first question comes from Matthew Fassler - Goldman Sachs.

[Matthew Fassler:]

I want to focus on the capital structure if I can. I know that you're not inclined to comment on the specifics about the sale of Supply, but you still have I would think a range of opportunities, perhaps depending on market conditions, perhaps not. Can you talk about your view and the board’s view about the recap in general given the range of outcomes that you might see on Supply?

[Frank Blake:]

What I'd say, Matt, is we remain committed to the recap strategy. Obviously, this is something we're going to do with our eyes open looking at the market conditions that we're facing in terms of timing, size, and the rest.

[Matthew Fassler:]

If the Supply deal were not to get done or not to get done in a timely fashion, would you be willing to do the tender?

[Frank Blake:]

Well, I'm cautious on answering kind of hypothetical questions on this, as just to put the connection, maybe the easiest way is to give one overview comment. To put the connection between the Supply transaction and our recap and tender in perspective, what I'd say -- and this is an obvious comment and of course you all know it -- is that the $22.5 billion included $10.3 billion from Supply in it. So if you take the Supply transaction out, you've got a different recapitalization size and then you have to look at the tender as it relates to a portion of your recap strategy and that's basically what we would be weighing.

[Carol Tome:]

From a liquidity perspective, as you know we ended the quarter with $3 billion in cash, we have access to the A2 P2 commercial paper market and we do have a $10 billion bridge financing facility.

[Matthew Fassler:]

You talked about August comps to date, just looking at your last year’s third quarter performance, August was actually your toughest compare. How should we think about the fact that business is tracking somewhat better in August? Any color you could give us there?

[Carol Tome:]

Actually, Matt, let me just call out the comps last year by month. August was a negative 1.1, September was a negative 4.3, and October was a negative 8.7.

[Matthew Fassler:]

So to the extent that August is your toughest compare and you're doing somewhat better in the first couple weeks, it would sound like a pretty impressive performance.

[Frank Blake:]

Matt, I just would add a caution that you have to look at last year’s comp numbers because they were compared to the prior year’s numbers which were so influenced by the hurricane impacts. So I'd like to reach exactly the same conclusion you're reaching but we're cautious on that as we see this unfold.

[Carol Tome:]

Yes, let's look at the third quarter comps, negative 5.1 last year, positive 3.6 the prior year, a positive 4.5 the year before that.

[Operator:]

Your next question comes from Budd Bugatch - Raymond James.

[Budd Bugatch:]

Good morning as well. I'd like to just ask a question about gross margin. Carol, in your remarks you had talked about the July comparison being down 6.8 because you did not repeat the last year’s promotional activity and yet when you went through the gross margin activity, gross margin results you were down 16 basis points for a combination of mix and markdowns and I would have thought if you had less promotional activity you might have actually seen a lift from that. Can you maybe parse out mix and markdowns and give us a feel of how that works out?

[Craig Menear:]

There's two things. As Carol mentioned number one, we were less aggressive in July from a promotional standpoint. We shared with you that in first quarter we were too aggressive and that we would relook at that in second quarter which we did. Secondly, as we continued to work our assortment strategies and continue to focus on our line structure, we are aggressively moving product out that isn't performing to the standard that we would like to see. Like we shared with you on the cabinet program, we made a decision to move quickly on that and accelerate the pace of the introduction of new product.

[Budd Bugatch:]

In cabinets you had made a comment, Craig, between assembled and RGA, and that the overall cabinet business looked like it was down and under performing. How did assembled do versus RGA?

[Craig Menear:]

The assembled cabinets are performing very well as we get that into our stores.

[Budd Bugatch:]

Frank, for you, my last question is talk about if -- and this is a hypothetical and I know you're going to love it -- if HD Supply is not sold for whatever reason, you had previously said that you wanted to integrate that into the stores as opposed to the silo type of strategy that was being employed before. Is that still your view or would you relook at that original thought process?

[Frank Blake:]

The strategy, what I'd say, Budd is it is very important to me strategically that we think of ourselves as a retail business because the value in this business is the retail company. So assuming a world with Supply, we'll adjust but it will still be within the framework of the dominant focus of our company is going to be retail.

[Operator:]

Your next question comes from Seth Basham - Credit Suisse.

[Seth Basham:]

On the gross margin front again, is your guidance for the year still intact?

[Carol Tome:]

Our guidance for slight margin expansion is still intact.

[Seth Basham:]

The reset cadence going forward, are you expecting less of a negative hit from markdowns related to resets?

[Carol Tome:]

I think that as we look at our reset program going forward, we plan as part of that process for the change over and liquidation of inventory in that process and we expect that to be as we had planned it going forward.

[Seth Basham:]

Finally just related to the expenses in the quarter, can you give us some more color as to what beat your plan this quarter? I think you mentioned $140 million in difference?

[Carol Tome:]

Yes, I can give you some color. We were laser focused on how we spend our advertising dollars and our advertising dollars came in under plan and our -- I'll call it our operations expense category -- lots of categories from the cost of the bags that you use when you check out at the register, and if you go line by line by line we were just really, really controlled. When you added it all up, it was about $140 million. I should point out in that $140 million that it was about $20 million less in depreciation and amortization than we had planned.

[Operator:]

Your next question comes from Steve Chick – JP Morgan.

[Steve Chick:]

Good quarter under the circumstances. If I could ask some follow-up questions on Supply. Based upon the data you gave, which was a little limited, I think EBIT for that business looks like it was about down year-over-year say $60 million and I was wondering if you could speak to what the sales trends were there and if it was margin versus sales? Secondly, as it relates to your willingness to restructure the terms potentially, is it the performance of the business or is it the credit market that are factors there?

[Frank Blake:]

Well, let me ask Carol to address the first and not surprisingly I'll pass on the second.

[Carol Tome:]

Regarding HD Supply as you know, their business is heavily focused on residential construction and you know what's going on in the residential construction market. For the quarter, sales for HD Supply were down almost 7%, organic growth was down about 10%. Their gross margin did suffer some contraction in the quarter. They did a great job of controlling expenses in this environment but when you add it all up there was operating margin contraction. I should point out, as we look at it from a market share perspective, we see that they continue to do a very good job in share gains. It's just a tough market out there.

[Steve Chick:]

Can you speak to maybe, Frank, what the timing would be in terms of when we might hear what the resolution is on that process?

[Frank Blake:]

Everything is better off with a fuller, freer discussion than we can have, but just genuinely these are issues in negotiation and I just wouldn't be comfortable talking about it.

[Steve Chick:]

A second question if I could. CapEx guidance, it looks like you're back half weighted again this year for your cap spending. Is that still on track? I think your target is -- refresh my memory -- $4.5 billion and do you still planned on hitting that in the second half?

[Carol Tome:]

Thank you for asking the question. This is the perfect opportunity to give clarity and update that guidance. We were looking at $4.5 billion at the beginning of the year, we're now looking at $4 billion. The delta is in two big buckets. The first bucket is HD Supply. We spent some capital for HD Supply for the first half but we're not planning to spend any capital for HD Supply in the back half so that's about $100 million. The rest all is related to the timing of new store capital. As we've looked at when we were going to pay for the purchase price of land, et cetera, some of that has gotten pushed off into 2008. So as it relates to the capital for our five key initiatives, we are spending and in the stores taking care of those five key priorities as we speak.

[Operator:]

Your next question comes from Colin McGranahan - Bernstein.

[Colin McGranahan:]

I was going to ask you what your reserve price on Supply was but I'm afraid I wouldn't get an answer to that. Seriously, I would like to focus on maybe the core retail implementation, and if I understand you're probably fairly close to the Canadian implementation. Could you give us a quick update on where you are in Canada, any changes versus the timeline you've laid out and just a general update on core retail?

[Frank Blake:]

Absolutely, Colin, and actually Mark Holifield is in the room here so I will turn this over to Mark.

[Mark Holifield:]

Thanks, Frank. I'd say core retail is going very well with Score being our Canadian implementation there. In Canada we're in the very heavy lifting phase of this right now where we're really deep into the implementation process. We do still expect to pilot some stores in Canada this year and then rollout throughout 2008. We've accelerated since our business plan in 2007 originally did not include U.S. core retail. We've actually accelerated our efforts there and we're in the process of planning our U.S. core retail implementation with the folks that Frank talked about earlier. Our EVP from Stores and Merchandise Vice President and Logistics Vice President all working together to make the plan for U.S. Core retail which will launch shortly after the heavy lifting efforts there.

[Colin McGranahan:]

So Mark in Canada you're piloting a few stores this year. When would you expect to have Canada completely switched over to SAP?

[Mark Holifield:]

In 2008.

[Colin McGranahan:]

Just some time in 2008?

[Mark Holifield:]

Yes.

[Colin McGranahan:]

So if we can't find any hammers in Toronto at some point, we know it's switched?

[Frank Blake:]

You'll find exactly the hammer you're looking for.

[Colin McGranahan:]

Okay, good luck with that. Actually, Mark since I've got you on the line, can you talk at all about the logistics plan and any change there on how your strategy there is evolving as well?

[Mark Holifield:]

We're working against the plan that we've laid out previously and we're pleased with progress there. We've successfully hit some key milestones there on new systems and processes around Warehouse Management Systems and new distribution techniques, so we've hit key milestones also on our network planning effort and we've got the plans for the new DC facility openings through 2008 consistent with that plan.

[Operator:]

Your next question comes from Mike Baker - Deutsche Bank.

[Mike Baker:]

Your SG&A sounds like you're in line with your plan but your SG&A was better than planned, so was there areas where you were disappointed, was it just the comps? Although it sounded like that was about what you expected.

[Carol Tome:]

The comment about our performance in line with the most of our expectations starts with the sales. Our sales were very close to our plan. We continue to see weakness in areas like South Florida and in California. That's weaker than what we planned. You back those areas out and we would have been right on our plan, so that's really where my comments rested, I think as you go down the rest of the income statement we did a pretty good job as well.

[Mike Baker:]

Is there more SG&A opportunity for some of the belt tightening that you talked about or is that something we should continue to expect?

[Frank Blake:]

Look, we're always looking for opportunities to do things more effectively and more productively and we have those opportunities, so we'll continue to work on that.

[Mike Baker:]

I'll take my shot at Home Depot Supply question. So in my mind, a tender in the Home Depot Supply were linked to the extent now that you can do the tender, you can buy the same number of shares for less amount of money. Does that make it easier for you to be able to accept less for the Home Depot Supply because again, in my mind, it was essentially trading Home Depot Supply for 250 million shares; or is that just too simple?

[Frank Blake:]

It's not exactly how I'd say certainly I look at it. I look at Supply, as we've said right from the start, we're taking a look at creating shareholder value with our Supply transaction and what's the best way to do that. The linkage to how does that tie into the share price on the tender offer, I mean it's there but that is not what's in our line of sight.

[Carol Tome:]

Supply was linked to the size of the recapitalization plan.

[Operator:]

Next we'll move to Parham Behrooz - Evergreen Investments.

[Parham Behrooz:]

I have a question on your debt funding. You seemed very confident you were going to be able to place a lot of debt after you placed a lot of debt last year, and then hit everybody with a four notch downgrade. Can you expand on how you're planning on placing debt, when you're planning on placing it, and any changes to the terms of existing debtholders?

[Carol Tome:]

Well, it sounds like you may be a fixed income investor or an analyst and you know the debt capital markets better than we. They're extraordinary turbulent today. We're watching them very carefully. Our approach to raising capital is to be prudent and to be practical with everybody's interests at heart, so we have not clearly determined nor articulated when we will go to market, how we will go to market. We're looking at all of our opportunities.

[Parham Behrooz:]

So you don't want to expand on any of that today?

[Carol Tome:]

I do not. As Frank said, there are some things we'll talk about today and some things we aren't.

[Parham Behrooz:]

When can we look for you to put a plan together? Because it seems like you have a plan together for the stockholders but you really don't for the debtholders.

[Carol Tome:]

We are thinking about our debtholders as stakeholders, very important to our company and our overall capital structure and as we continue to refine our plans we will certainly be articulating those plans.

[Operator:]

Your next question comes from David Schick - Stifel Nicolaus.

[David Schick:]

As we think about the existing home sales and obviously the pressure on the business and the way the consumer thinks about things differently and in the meantime, you've affected gross margin with some of the resets, et cetera. Forget this year, even maybe forget '08. Is the consumer, do you think, coming out or is this business coming out with anything different on what it should support from a gross margin perspective as you think about the elasticity that you see as you work some of these things through?

[Frank Blake:]

Well, if I understand the question, let me take a general comment to that and then turn it to Craig. I think if you look at how our stores reflect some of the trends in the market and how people think about their homes, you can see it in things like the outdoor living that Craig was referencing, so now when you go into our stores you see an assortment around outdoor living for the home that frankly has opportunities for us on the gross margin side and I think is addressing what customers are interested in doing with their homes. I think you'll see that in other areas of the store as we build out our product mix.

[Craig Menear:]

Two other things that I would add-on and number one is as we continue to drive innovation, that certainly should help us drive not only top line sales but then the resulting gross margin dollars and then the second key thing that we have to stay focused on to continue to drive the gross margin dollars for the business is project selling, and as we stay focused on the overall line structure and selling projects, we can have a positive impact to the gross margin dollar generation.

[David Schick:]

With the pressure you're seeing, there's nothing with the pressure we're seeing in the consumer to make you think five years from now gross margin should be lower in this industry than it is today, in fact perhaps higher based on things you can do?

[Carol Tome:]

Oh, goodness if I could just jump in, if you think about what we're doing with core retail and logistics, our margins should grow through a cost out perspective.

[David Schick:]

I'm just trying to clarify sensitivity and elasticity. Great. Thank you.

[Operator:]

Your next question comes from Eric Bosshard - Cleveland Research.

[Eric Bosshard:]

The retail profit looked like it was down around 18% and your guidance for the full year suggests that you don't expect much of a change in the profit degradation in retail in the second half on a year-over-year basis, in other words down 18% first half, down 15% or 18% second half. The comparisons are a lot easier in the second half. Can you talk a little bit about why the rate of decline in retail is expected to continue to be at that level in the second half?

[Frank Blake:]

Well, I think as I said, we continue to see some pressure ahead for us. If you were to ask in kind of a general perspective, the year-to-date in terms of the market I'd say has played out pretty close to our expectation. The first quarter we had some weather impacts but it was pretty close to what we expected. The second quarter has been pretty close to what we expected. In terms of how we had developed our plans, we've had to adjust the third and fourth quarter are going to be more difficult, and frankly we're reflecting that additional difficulty that we see in the back half of the year, particularly as compared to last year.

[Eric Bosshard:]

Is that reflective of concern with sales or with spending or with gross margin?

[Frank Blake:]

Sales. I think the key point there would be sales.

[Eric Bosshard:]

Secondly, you talk about this is the year where you are spending more money to drive share progress which you've done successfully. Can you talk about how you're thinking about balancing controlling expenses to generate earnings and with that investment, how are you thinking about that?

[Frank Blake:]

First the general point of view is we're investing in our stores. We want to see share gain because we think as the number one home improvement retailer we should be performing at our market and from where we are now, that implies improved share performance. But we're investing in our stores because our stores really require the investment to meet the customer expectation, and we start from that before we go to the is it a share gain play? Is it an expense improvement play? We've done a lot of work around what our customer expectations are and we know we just have to improve the shopability of our store and we know we have to invest to achieve that.

[Eric Bosshard:]

As you look at the second half plans at $140 million reduction in expenses in Q2, are we likely to see that follow through in the second half? Have you lowered the planned spending in the second half already at this point?

[Carol Tome:]

We're looking at every expense item that we can control, but not diluting our focus on our five key priorities. I think what I'd ask you to do is just look at the guidance that we've given and expect us to deliver along that guidance.

[Eric Bosshard:]

Last question, Carol, on Supply. You've talked about your performance versus plan on a lot of categories. Can you talk about the Supply profit performance in the second quarter and how that related to the plan you had for the second quarter?

[Carol Tome:]

I could, but given where we are, it's a discontinued operation and I think we've given enough color on the business.

[Operator:]

We'll go next to Susan Hutman - Alliance Bernstein.

[Susan Hutman:]

My question is really for Carol. I just want to clarify an answer you gave to an earlier question. It was about whether the full tender would be completed even if Supply weren't sold and you made a strong point to note that you have CP access and bank availability. By my calculation, if you actually did completely debt finance the full $22.5 billion, your lease adjusted leverage would be four times which is way above your 2.5 times target. At the recent Analyst meeting you stated your commitment to strong investment grade ratings and I would doubt at four times that you could hold your current high BBB which is already four notches below. Would you say that your view on ratings has changed relative to your strong view relating to the recap?

[Carol Tome:]

No. Our view of ratings has not changed. We have a targeted adjusted debt to EBITDA ratio of 2.5 times. It's our intent to stay true to that ratio. Now it will go up and down each time you measure it every quarter but nothing is changed on the rating. My comment on the size of the recap at HD Supply is simply that we sized our recap based on $10.3 billion of anticipated proceeds from Supply and $12 billion of debt finance to be raised as soon as practical. If HD Supply, if we have no proceeds from HD Supply and I'm not saying that's the case but if that were to happen our recap would be reduced to $12 billion.

[Operator:]

Your final question comes from Danielle Fox - Merrill Lynch.

[Danielle Fox:]

Thanks, good morning. Could you talk a little bit more about what drove the sequential improvement in transactions and should we be reading transaction as the equivalent to traffic? It was a little bit surprising given that Carol, you mentioned one of the things, one of the areas where you found some savings was in advertising, so I'm wondering what you think drove the sequential improvement in the transaction count?

[Frank Blake:]

Danielle, first as an overall comment for the company and then turn to Craig and Carol, we had very strong performance in our garden and live goods, so when you think about transaction count and if you saw some of our stores, I think if you had the chance to walk them, I think you'd be very, very impressed this year with what we did in our D28 and I think that accounted for a lot of the transaction growth, just the performance of garden and live goods.

[Craig Menear:]

As we shared with you early on in the year, we were really focused on our focused bay approach and we had a roll on ten categories and we've been working hard to implement that and part of that as we shared with you there were traffic driving categories and certainly in our lawn and garden area that was one of them. I think the other piece of it is as we continue to work the merchandising strategy from our end, we're working very closely with Paul Reines and the operations team to make sure that we're doing everything we can to communicate to our store associates the advantages that we have in the marketplace and try to communicate that to our customers both through our marketing and through our associates on the floor, and I certainly think that's having a benefit as well.

[Danielle Fox:]

I know you mentioned where you were tracking in August. Carol, did you give us the monthly comps for this quarter? If I missed it I'll just go back through the transcript but I don't have that in my notes.

[Carol Tome:]

For this quarter I did. I think I kind of stumbled through that description. Let me go through it one more time. May was negative 3.1%, June was a negative 5.4% and July was a negative 6.8%.

[Diane Dayhoff:]

Thank you to everyone who has joined us today and we look forward to talking to you next quarter.