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Home Depot, Inc. (NYSE:HD)

F1Q06 Earnings Conference Call

May 16, 2006 9:00 a.m. EST

Executives

Diane Dayhoff - VP IR

Bob Nardelli - Chairman, President, CEO

Tom Taylor - EVP Merchandising & Marketing

Carol Tome - EVP & CFO

Joe DeAngelo - EVP Home Depot Supply

Analysts

Deborah Weinswig - Citigroup

Armando Lopez - Morgan Stanley

Gregory Melich - Morgan Stanley

Daniel Binder - Buckingham Research

Gary Balter - CSFB

Colin McGranahan - Bernstein

Joe Feldman - Telsey Advisory Group

Operator

Good day, everyone, and welcome to today's Home Depot first quarter 2006 earnings conference call. As a reminder, today's call is being recorded. Beginning today's discussion is Ms. Diane Dayhoff, Vice President of Investor Relations. Please go ahead.

Diane Dayhoff

Thank you, Gwen, and good morning to everyone. Welcome to The Home Depot's first quarter earnings conference call. Joining us on our call today are Bob Nardelli, Chairman, President and CEO of The Home Depot; Carol Tome, Executive Vice President and Chief Financial Officer; Tom Taylor, Executive Vice President of merchandising and marketing; and Joe DeAngelo, Executive Vice President and President of Home Depot Supply.

Today's discussion will begin with a review of our business by Bob. Tom will provide insight into our merchandising efforts, and Joe will update you on The Home Depot Supply. Carol will complete our prepared statement with a discussion of our financial results. Following our prepared remarks we will open the line for 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.

This conference call is being broadcast real time on the Internet at HomeDepot.com with links on both our home page and the Investor Relations section. A replay will also be available on our site.

Before I turn the call over to Bob, let me remind you that today's press release and the presentations made by our 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 Bob Nardelli.

Bob Nardelli

Thanks, Diane. Our first quarter financial performance reinforced our three-prong strategy to grow the top line, expand our product and service offerings, while continuing to deliver record EPS. In the first quarter we delivered record sales of over $21 billion. Net earnings were $1.5 billion and diluted EPS were $0.70, an increase of almost 23%.

Given the growth in Home Depot Supply, we will for the first time be reporting two segments: Home Depot Retail and Home Depot Supply. Carol Tome will take you through the details of our financial results in a minute, but now I would like to share with you some highlights of both of these segments.

In the first quarter the retail business drove solid gross margin expansion. We again demonstrated our ability to leverage expenses and reported a record operating margin. We also achieved a record average ticket of over $60, and while we continue to gain momentum with average ticket, we were disappointed with the overall retail sales.

We did see strong sales in areas like building materials, electrical, hardware, kitchen and bath, but weakness in two key areas, seasonal and flooring. Now we are well-prepared for spring and summer, and Tom Taylor will expand upon this in his remarks.

Our service business grew by 8.5% during the first quarter. We saw solid growth in installation categories such as countertops, windows, solar and exterior patio and doors, but experienced softness in flooring, which historically has been a strong installation category for us.

As we discussed in the past, we are committed to improving the shopping experience and driving growth in transactions. Tom will talk about our merchandising initiatives, including an accelerated reinvestment program for the stores later on in the call.

During the quarter we expanded our product offerings through Home Depot Direct. Our website continues to grow as an e-commerce site and with over 4 million visits per week. Our assortment is also expanded through our various catalogs.

On May 1st we acquired Home Decorators Collection. Home Decorators Collection is an ideal and strategic fit for Home Depot Direct, doubling its size and significantly increasing its presence in the affordable home decor category. This acquisition gives us immediate scale in the direct-to-customer market with its 3.3 million customer file, providing us with a new customer base in industry-leading skills to expand our direct-to-consumer platform. With the acquisition of Home Decorators Collection, Home Depot Direct will be a $1 billion business by the end of fiscal 2006. We are pleased to welcome the associates of Home Decorators Collection to the Home Depot family.

As in the United States, in Canada and Mexico we maintained our leadership position and currently we have 141 stores in Canada, and expect to open an additional 14 stores this year. In Mexico we have 56 stores and expect to open an additional four stores this year. By the end of this year Mexico will be a $1 billion business. Today approximately 10% of our store base is located in Canada and Mexico, and both businesses reported solid financial results in the quarter.

Now I would like to turn to Home Depot Supply. This business is an important growth driver for us, and we use a disciplined approach to develop or to acquire businesses that build off our strength, scale and core competencies, as well as leverage common customers and suppliers.

The first quarter represented a significant milestone for us. We closed on the Hughes Supply acquisition on March 30th. This is our largest acquisition, which more than doubled Home Depot Supply. Hughes strengthens our market position, gives us new platforms and brings a wealth of talent into our company. With this acquisition we are better positioned to serve the professional customer. Hughes is a great company with strong leaders, and we welcome the associates into the Home Depot family. Joe DeAngelo will provide more detail on Home Depot Supply later.

During the quarter we continue to focus on returning value to our shareholders. We recently increased our dividends by 50% and over the past five years we have more than doubled our dividends paid. In February, our Board approved an additional $1 billion for share repurchases, bringing our total share repurchase authorization to $12 billion. Since the inception of our buyback program we have repurchased $10.3 billion or approximately 13% of our outstanding shares.

Our commitment to dividends and share repurchase is part of our balanced approach to capital allocation, of reinvesting back into our business for growth and returning cash to our shareholders. Over the past five years we have returned nearly 60% of our cumulative earnings to our shareholders.

So now I would like to turn the call over to Tom.

Tom Taylor

Thanks, Bob, and good morning everybody. From a merchandising perspective we were better prepared for spring than I have seen in a long time, and we saw great average ticket growth across the store. While I don't want to sound like a weather report, unusually wet weather in the west -- where we have high concentration of stores -- impacted transactions.

Although we continue to gain momentum with average ticket, we were disappointed with transactions, and it is not just weather. As Bob mentioned, the weakness in the quarter was due to seasonal and flooring. Today we are pleased with our performance in seasonal, as weather across the country has improved, and we are addressing the softness in flooring through several initiatives, including reset. We see increased customer satisfaction and great sales lift when we reset a category.

For example, our recent faucet reset drove a 5.3% increase in units and our recent decking reset drove an 8.3% increase in units. So beginning in this quarter we are accelerating additional reset activity in 500 of our highest volume stores, and we will reset over 100 days in each of those stores by year end. We are also moving forward with some additional major category expansion in areas like appliances and ceramic tile.

Another way to drive traffic in conversion in our stores is to continue our focus on introducing distinctive and innovative products. I will talk more about the merchandise you will see in our stores in a minute, but first let's discuss some of highlights in the first quarter.

We posted strong double-digit sales growth in our professional categories, due to benefits from initiatives we implemented in early 2005 and our continued focus on providing the Pro's with superior service. Additionally, we experienced some commodity price inflation during the quarter. We experienced strength in Pro Classes including gypsum, insulation, concrete, wire, conduit, wire devices, fasteners and pipes and fittings to mention a few.

Kitchen and bath showed strong performance driven by both in-store and online appliance sales, as well as sales of countertop and bath installations. In appliances, our momentum continued as we grew market share and hit our highest close rate ever. According to an independent third party, on a rolling twelve-month basis our core market share increased 140 basis points to 9.9%. Our results were driven by our merchandising assortment and knowledgeable associates.

For over a year now we have had dedicated associates in our consulting and selling areas focused exclusively on their respective product and services. Our customers continue to be enthusiastic about our full set of LG appliances. They also responded well to the introduction of new innovative products particularly our GE Smart Dispense dishwasher, Maytag Ice2O refrigerator, Maytag blue metallic laundry set and GE Adora front loaders.

As Bob mentioned, and as a result of our relentless focus on innovation our average ticket for the quarter was $60.75, representing a 4.3% increase over the previous year.

While spring was late, when it arrived we were pleased with our outdoor living category. We saw strength in everything from grills to exterior paint. During the quarter we broadened our assortment of patio furniture, adding wrought iron patio sets, tables and fire pits and ceramic tile tops. Our customers are responding to these additions as well as our commanding assortment in garden where we've introduced many exciting new and exclusive products.

Our outdoor power equipment line-up is unparalleled in the industry. We carry seven of the top 10 rated lawn mowers and three of the top 10 rated tractors in our stores and on our website. This, together with our in-store certified power equipment specialists, makes us the clear destination for outdoor power equipment.

We're selling lawn tractors online for the first time in 2006 and are extremely pleased with the results. We've seen enthusiasm over our Cub Cadet and Toro zero turn mowers which allow for closer cuts, greater maneuverability and reduces your cutting time. Sales of both have significantly exceeded our expectations.

It is these types of experiences that we want to repeat across the entire store. To create this we must continuously introduce new, distinctive and innovative products. That is why as I look forward, I am particularly excited by the merchandise we will be offering in our stores in this quarter.

In appliances we will continue our momentum through the addition of several new refrigerators, freezers and ranges. For example, we will add refrigerators from LG, General Electric, Maytag, Jenn Air and Americana. Some of these products will have the latest features including smart water filtration, upfront electronic controls and spill-proof glass shelves.

In paint, we have a new exclusive sports-themed paint line called team colors. Through this program customers can purchase paint in the exact colors of their favorite professional and college sports teams. Timing is great because it coincides with the beginning of the major league baseball season and the NBA and NHL playoffs. We will offer more than 400 paint colors representing more than 125 different teams.

In flooring we are enhancing our offering by updating our laminate assortment, adding more natural stone tile products and a new line of odor resistant carpet called [Purell].

In our power tool area we will introduce the DeWalt 36 volt lithium ion cordless combo kit representing the next generation of cordless power tools, with even more torque and a longer run-time. We will also continue expanding the Ryobi One Plus system, adding more products like the Ryobi One Plus Fan and the Ryobi One Plus Hand [planer].

We plan to roll out a new bathroom vanity top program with products that will feature styles and finishes not previously available in the market such as a matte finished onyx top.

In lighting we will bring in new interior lighting families, new lamps and upgraded commercial electric recess cans.

In millwork we will carry Anderson low E-4 high-performance glass for windows and patio doors. This is an innovative, low maintenance product which is energy efficient, reduces sound penetration and features a unique exterior coating making cleaning easier.

These products, together with our focus on store modernization should create excitement in our store. What excites me the most are the opportunities within the store. I believe we have endless opportunities to continue adding innovation and distinctive merchandise to our core categories. This will help us create excitement, drive traffic and make our stores more productive. Now I would like to turn the call over to Joe DeAngelo.

Joe DeAngelo

Thanks, Tom. The Home Depot Supply team delivered an exceptional first-quarter executing year-over-year sales growth of 225% and operating earnings growth of 432%. With total sales of $2.1 billion, Home Depot Supply represents almost 10% of Home Depot's first quarter sales.

Excluding 2006 acquired sales, total revenues of Home Depot Supply grew by 151% in the first quarter and for the businesses we owned as of the end of the first quarter last year the year-over-year sales growth was approximately 18%.

Powerful organic growth is a hallmark of our Home Depot Supply business model and our strong first-quarter performance is the direct result of our team's exhaustive focus on delivering increased customer success. Home Depot Supply's first quarter 2006 operating profit was $149 million, representing 6% of Home Depot's consolidated operating profit, with an operating margin of 7%, a triple-digit increase from the first quarter of 2005.

We closed the Hughes Supply acquisition on March 30th and I'm extremely proud of the joint team that delivered an exceptionally smooth close and integration kick-off. The senior leadership teams at each business have been named and are focused on executing their integration and growth plans. All integration areas are ahead of plan, and we are particularly pleased with the stellar integration and implementation in our four overlapping businesses of maintenance repair and operations, waterworks, construction supply and plumbing and HVAC.

Our Home Depot Supply leadership teams have visited with over 2,000 customers of these overlapping businesses and alignment of all sales teams is complete. Because of the teams' efforts we are continuing our strong sales momentum in all business units.

During the first two weeks after closing the Hughes transaction our new combined Home Depot Supply leadership team executed 13 road shows, visiting the leadership of each Home Depot Supply business unit and discussing our Home Depot Supply vision and mission with approximately 3,000 field and headquarter associates.

As part of the road show, each business President solidified their businesses 2006 execution imperatives and worked with their teams to define how they will continue to accelerate transformation in the industries in which they participate. Our momentum is tremendous and it continues to build as we operate as one team driving customer success and shareholder value.

We are well on our way to achieving our committed Hughes deal synergies. As we continue to execute processes to harmonize Home Depot enterprise-wide supplier programs, allowing us to buy better. We will also sell more by aligning our sales teams to support each other as they sell around our customer's circle of business platforms from infrastructure through construction to lifetime maintenance and improvement.

Today less than 20% of Home Depot Supply sales are to new home builders. We have a diversified business platform with concentration in infrastructure and maintenance.

In addition, on May 1st we closed the acquisition of Cox Lumber, a family run lumber and building materials business which has been added to our Williams Brothers Lumber platform, expanding our presence into the robust Florida market. Together Williams Brothers and Cox Lumber are $1 billion business. We could not be happier to welcome Hughes Supply and Cox Lumber associates to our Home Depot Supply team and we look afford to working with them to drive exceptional growth and customer success.

Home Depot Supply now operates over 900 locations in 44 U.S. states and in Canada and we look forward to continuing to enhance our geographic reach as, together with our core Home Depot retail business, we offer professional customers exceptional convenience, choice and value. Thanks to our great team effort we are off to a terrific start for 2006. Now I would like to turn the call over to Carol Tome.

Carol Tome

Thank you, Joe, and hello everyone. Before I get into the details of our first quarter financial results there are a few things I would like to highlight from a reporting perspective.

First as Bob mentioned, we are now operating and reporting our business in two segments, Home Depot Retail and Home Depot Supply. The retail segment includes our retail stores, as well as our retail installation business we call Services and Home Depot Direct, our catalog and online sales business. The supply segment is our trade distribution segment and consists of businesses like Hughes Supply.

For comparability purposes we have moved away from comp sales reporting and now will provide sales growth for both segments as a percentage change over the prior period. We will continue to provide you with retail operating metrics, including sales per square foot and weighted average weekly store sales.

Finally, in the past Services revenue included new homebuilder installation revenues that are now reported as part of Home Depot Supply. Going forward any discussion about Services revenue will pertain to installation services in our retail stores and our services franchise known as Chem-Dry.

So with that as a background: as Bob mentioned in the first quarter, our total company sales grew by 13.1% or $2.5 billion to $21.5 billion. Of the $2.5 billion in sales growth, $1 billion came from our retail segment, and $1.5 billion came from our supply segment. In the first quarter, sales in the retail segment were $19.4 billion, a 5.7% increase over the same period in 2005. This sales increase was primarily driven by the addition of new stores.

We saw strong growth within our supply segment. As Joe mentioned, sales in the supply segment were $2.1 billion, up 225% over the same period in 2005. We look at sales growth in this segment from an organic and an acquired perspective. For us, acquired sales means sales dollars acquired during the fiscal year.

In the first quarter of 2006 we completed the acquisition of Hughes Supply and the total sales acquired in the first quarter were $483 million. Excluding 2006 acquired sales, total revenues at Home Depot Supply grew by 151% in the first quarter. For the businesses we owned as of the end of the first quarter last year, the year-over-year growth rate was approximately 18%. We were pleased with the first quarter operating income results of both segments. Compared to last year, both segments reflected operating margin expansion.

Operating margin in the retail segment grew by 98 basis to 11.8% in the quarter and in the supply segment grew by 273 basis points to 7%. We will review the key drivers of this performance in a minute.

Consolidated net earnings totaled $1.5 billion for the quarter, an increase of 19% over the first quarter of 2005. Reflecting the impact of our share repurchase program, earnings per share increased by 22.8% to $0.70 per share. In the first quarter, consolidated gross margin was 33.68%, an increase of 19 basis points from the same period last year.

As we have told you, today's supply has a lower gross margin rate than our retail business. In the first quarter the gross margin rate for supply dropped 400 basis points from last year to approximately 28%. This was entirely due to a change in the mix of businesses acquired during the year. The businesses we owned at the end of the first quarter last year reported gross margin expansion of approximately 140 basis points.

In the first quarter, Home Depot Supply had a negative impact of 36 basis points on our consolidated gross margin rate. We more than made up for that in the retail segment due to:

  1. A higher penetration of higher margin products sold in the first quarter this year.
  2. Some commodity price retail changes.
  3. A number of merchandising driven cost-out programs.
  4. We anniversaried markdowns taken last year in connection with last year's decision to close 20 Expo stores.

In the first quarter we continued to drive expense productivity as our total operating expenses decreased 56 basis points from the same period last year to 22.39% of sales. For both retail and supply we drove expense leverage in most of our major expense categories. Part of our expense leverage was due to certain process improvements that reduced claim frequency and severity. During the quarter we experienced a significant reduction in workers compensation and general liability expense.

On the retail front, given that about 65% of our expenses are variable, we have a tremendous amount of flexibility in managing expenses. On the supply front, we have a relentless focus on integration and driving efficiencies. Consolidated operating margin for the first quarter was 11.29%, up 75 basis points from the same period last year.

Net interest expense was $52 million in the first quarter, up $39 million from the first quarter last year, reflecting interest associated with $1 billion of term debt issued in August 2005 and $4 billion of term debt issued earlier this year in connection with our acquisition of Hughes.

In the first quarter our income tax provision rate increased to 37.4% from 37.2% last year, reflecting the reversal of deferred tax assets for which the future tax benefit no longer exists. For the year we expect our income tax provision rate to be approximately 37.2%.

Diluted shares for the first quarter were 2.122 billion shares compared to 2.172 billion shares at the end of the first quarter of 2005. The reduction in outstanding shares is due to our share repurchase program. In the first quarter, we repurchased 14 million shares and cumulatively since 2002, when the program began, we have repurchased 291 million shares and spent $10.3 billion under our $10 billion authorization.

Now before we move to the balance sheet, I would like to share with you some operational metrics for the retail stores. During the first quarter we opened 23 new stores, including four relocations with four new stores in Canada and two new stores in Mexico. Approximately 10% of our store base is found in Canada and Mexico, and we are the market leader in those two countries.

Today we own 87% of our retail stores. Our real estate strategy going forward is to own our stores where we can and to lease the majority of our Home Depot Supply facility.

At the end of the first quarter selling square footage was 216 million, a 6.4% increase from a year ago. The average square footage per store was 105,000 square feet, down slightly from the same period last year, reflecting the changing mix in our store formats as we expand into new geographies and size our stores to meet the needs of the market. Sales per square foot were approximately $364 for the quarter, down slightly from last year but sales per square foot in our new stores increased by over 4%.

Tom talked about accelerating our merchandise reset activities. Our new stores have our new merchandising sets and given the positive sales trends we are experiencing in these stores, that's another reason for accelerating the activity.

Now turning to the balance sheet, at the end of the quarter total inventory was $13.4 billion, an increase of 18.5% from last year and inventory turns were 4.6 times, down slightly from last year. The growth in inventory is primarily due to new stores, and the acquisitions we made at Home Depot Supply. On a per store basis retail inventory increased by 1.6%.

Total working capital for the Company, which we define as receivables plus inventory less payables, was $7.4 billion, down from $7.8 billion at year end. That is notable as we acquired about $900 million of working capital with the Hughes acquisition.

Computed on beginning long-term debt and equity for the trailing four quarters, return on invested capital was 24.2%, an increase of 220 basis points from last year. We ended the quarter with $52.7 billion in assets, including $2.6 billion in cash and short-term investments. This is a cash increase of approximately $1.8 billion from the end of fiscal 2005, which reflects cash flow generated by the business of approximately $4 billion, along with the net proceeds of $4 billion of term debt.

This is offset by $3.3 billion paid to acquire new businesses, $705 million of capital expenditures, $554 million of cash paid for share repurchases, $900 million used to repay outstanding commercial paper, $500 million used to repay maturing senior notes and $318 million in dividends paid.

As I mentioned, we issued $4 billion of term debt in the first quarter to fund the Hughes acquisition and refinanced $500 million of maturing debt. With the $4 billion debt issuance, our long-term debt to equity ratio increased from approximately 10% at year end to now approximately 24%.

As we discussed at our January investor conference, our fiscal 2006 growth guidance is aligned with our 2010 vision to grow our sales by 9% to 12% and to grow our earnings per share by 10% to 14%. We also told you that with the acquisition of Hughes Supply we believed our 2006 sales would grow in the range of 14% to 17%, and our earnings per share would grow in the range of 10% to 14%. We are confident of the guidance we gave you in January and reaffirm our sales and earnings growth targets for the year and through 2010.

Thank you for your participation in today's call. We are now ready for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Deborah Weinswig, Citigroup.

Deborah Weinswig - Citigroup

Good morning, and congratulations on a great quarter. In terms of the SG&A strength that we saw in the quarter, can you provide a little bit of additional color? How should we think about that in light of future quarters? And was the majority of this improvement driven by redeploying capital to selling hours? What additional color can you provide?

Bob Nardelli

Let me give you an overview and then I will turn it over to Carol. I think you have seen our Company demonstrate its ability to leverage expenses commensurate with sales variation. I think that is a very, very positive sign for a retailer and I commend the entire team for taking on this initiative.

We are using a variety of initiatives in here as you know, Deborah; Six Sigma is certainly gaining momentum, and Carl Liebert and the entire team has really embraced this tool, and we are seeing the benefit of it.

As you know our overarching core purpose is to improve everything we touch, and we are continually seeking out opportunities across the entire business, starting from suppliers all the way to customers. As Joe DeAngelo mentioned, certainly through our acquisitions our purchasing power has increased. Our logistics opportunities are increasing. So we are seeing opportunities for leverage almost in every area of our business, and we certainly see that continuing through the balance of the year. Carol, do you want to add anything more to that?

Carol Tome

Just to add, Bob, that we did see expense leverage in most of our major expense categories. The only place where we saw expenses running faster than sales is depreciation and amortization, and that is directly related to the investment activity that we have in our business.

Deborah Weinswig - Citigroup

Definitely impressive and definitely bucking the trends. Last question, can you talk about what you learned in the appliance business and best practices that you can apply to other categories? I think Tom talked about the fact there are endless opportunities within the store, and maybe in light of the appliance categories specifically and what you've learned there.

Bob Nardelli

Deborah, I think our focus on appliances over the last three years certainly demonstrates the strength that Home Depot has given the geographic reach of or stores and the convenience that we provide to our customers. Tom mentioned in his comments, we're very pleased with the mix in the assortment in the innovation. Tom will talk a little bit about how our success in that category certainly gives us encouragement to go faster and will be a big part of the 500 store resets through the balance of the year.

Tom Taylor

I think what we've learned and are looking to apply is in three things, one is shopping environment. I think we created a good shopping environment in the stores for appliances for customers to make a decision. Two, innovation, I think we've worked well with our vendor partners to bring in innovation, introduced new appliances quickly. And then three, as I think through Carl and my partnership, having dedicated staffing set up to that category in the store. I think that we are under a full year now of dedicated staffing in that department and it's really paying dividends.

Deborah Weinswig - Citigroup

Great. Congratulations again.

Operator

Our next question comes from Armando Lopez, Morgan Stanley.

Armando Lopez - Morgan Stanley

Just a couple of quick questions. On the appliance business you guys have made impressive gains there. Can you just talk about as you continue to add SKUs, maybe what areas of floor space you're pulling away from?

Tom Taylor

Well as we add we've got a couple of things we're looking at to increase our assortment. But today we're pleased with the assortment we have in the stores. We think we're showing enough appliances, as proved positive by our market share gains. In newer stores we are putting in larger appliance areas and as Bob mentioned, we're going to pilot some category expansions where we can shift product around the store, where we have unproductive square foot and we will put appliances into those areas.

Armando Lopez - Morgan Stanley

In terms of the organic growth in the Home Depot Supply I was a little bit unclear in terms of what the organic growth rate was. Could you just kind of go over that again? I know you touched on it.

Bob Nardelli

Carol, why don't you go back over first the definition of acquisition in organic and then the numbers one more time?

Carol Tome

Sure. We look at sales growth in this segment from both an organic and acquisitive perspective. For us, we define acquired sales as sales dollars acquired in any one fiscal year. So in the first quarter of 2006 we acquired, as Hughes Supply and the total sales in 2006 were $483 million. So if you back those out, the year-over-year growth in Home Depot Supply is 151%.

But then if you just look at the businesses we owned a year ago and said how did those businesses grow year-over-year, they grew by 18%. So very robust growth in the businesses that we owned a year ago.

Armando Lopez - Morgan Stanley

So the National Waterworks that you guys acquired a couple quarters ago, that is included in the 151%?

Carol Tome

That's exactly right. That's exactly right.

Bob Nardelli

Just for ease of reporting, We have selected a model that says if you are acquired within the year, that is acquisition. Once you get through the fiscal year it is part of the core growth. It just is a very easy and simple way for us to communicate to you how we are looking at this segment.

Carol Tome

But I can take it out for you if that helps for your modeling. The acquired sales that we bought in 2006 were $483 million. The acquired sales that we bought in 2005 were $876 million, and then the year-over-year change in the businesses we owned a year ago were $115 million. So that might be helpful to you.

Armando Lopez - Morgan Stanley

Okay, great. Thanks a lot.

Operator

Our next question comes from Gregory Melich, Morgan Stanley.

Gregory Melich - Morgan Stanley

Just a follow-up on what is driving gross margin. I was interested in what financing costs did in the quarter. I know that interest rates are up and I think in the last quarter it hurt gross margin. I am just wondering if that is helping the mix get to those higher price points. Can you describe all that a little bit?

Bob Nardelli

I wish that was the case, but not necessarily. Carol, do you want to cover that?

Carol Tome

Well, we continue to see a great response and use of our private label credit card. The penetration of our private label credit card is now 27% of all tender type in our stores, so that is just great and our customers respond very favorably to our deferred interest programs. That is where there's no interest, no payment for six months or 12 months.

There is a financing cost associated with that. That financing cost runs through our cost of goods sold. Year-over-year there wasn't a material change, and it didn't have a material impact to our gross profit margin rate.

Gregory Melich - Morgan Stanley

And so zero percent financing wasn't up year-over-year?

Carol Tome

Not materially, no.

Gregory Melich - Morgan Stanley

Thanks.

Operator

Our next question comes from Daniel Binder, Buckingham Research.

Daniel Binder - Buckingham Research

Just a couple questions. First, with regard to a lot of the reset activity that you are doing in 500 stores, it sounds like that might be in reaction, to some extent, to some of the softness you saw this quarter. I just want to clarify if that is accurate or not. I was just trying to think about how that might impact expenses, particularly in Q2 as you start that up.

My second question was related to a comment that Wal-Mart made earlier today regarding possible a tax rate change as a result of possible non-renewal of the workers opportunity tax credit. I am just wondering if that is something that could potentially impact Home Depot.

Bob Nardelli

Let me just respond to your second question and reconfirm both Tom and Carol's comment. What we saw certainly in our new stores, as Carol talked about sales per square foot, Tom's comment about now that we are six to eight months into some of these new store sets certainly gave us the confidence. If you will recall some of the numbers he shared with you relative to unit growth rate, that would certainly reinforce that by accelerating the resets in those specific areas and the capital associated with it makes good sense.

If you look at our store base, the fact that we are well over 2,000 stores; and as you know in retail requires continual refresh, reset and innovation. So I think given the confidence and the results we've seen is reinforcing that we should move more aggressively in our existing stores to match the performance of our new stores.

Carol Tome

From a cost perspective the total cost of this program is around $81 million, of which $55 million is capital, the remainder is expense. In the second quarter the expense will be minimal maybe a couple million dollars.

To your last question about the workers tax credit, we have factored in our belief that that tax credit will disappear. We factor that into our tax provision guidance that we just gave you of 37.2% for the full year.

Bob Nardelli

Tom do you want to comment anymore about the sets?

Tom Taylor

Just that the sets were carefully selected out of our top-performing business sub-classes and with a focus on selection, presentation, innovation and improving the shopping experience> Historically we love the results that we see when we do resets and we're going to go into those stores and execute.

Daniel Binder - Buckingham Research

Maybe if I could sneak in one follow-up, with regard to the sales in the first quarter, you cited weather. I'm just kind of wondering from a labor standpoint how you felt about the staffing levels in the store, now both in the aisles and the front end in terms of the quality and quantity. Do you feel like you have the right labor levels to do the business?

Bob Nardelli

I think two points. One is as Tom mentioned, weather would specifically relate to department 28 which is outdoor power and live goods; and particularly as Tom referenced on the West Coast where we have a heavy concentration.

Spring was late this year, and if you look at any of the adjustment, it was relative to where we normally would have ramped. Carl and his team I think did an excellent job in looking at labor on a sales-adjusted basis. So we're pretty comfortable where we came out on the quarter. I think it demonstrates and reinforces again a credit to the team that they are able to vary expense with sales in appropriate way.

Daniel Binder - Buckingham Research

Are labor optimization efforts that you pursued in the last year or two pretty much done or is there still opportunity on that?

Bob Nardelli

No, I think two things, maybe three things. We're continuing, as you know, to invest in technology. Every time we do that Bob DeRodes, working with Carl, eliminates a task that allows us to redeploy and reallocate, whether it is the back end or whether it is across the entire store. So that is point number one.

Point number two I think if you look at just the overall store layout Tom and Carl are partnering very closely together on these resets to make sure we really take into consideration and minimize tasking labor that allows us to redeploy it to selling labor.

Daniel Binder - Buckingham Research

Okay, great. Thanks.

Operator

Our next question comes from Gary Balter, Credit Suisse.

Gary Balter - CSFB

A question that is a little bit longer term or strategic in nature. Bob, people don't seem to appreciate the direction that the Company is moving based on the way when we look at stock price and we look at even today's reaction.

Your coverage ratios are pretty strong. Your 24% long-term debt to equity right now, although that is an artificial number because of the buyback. What are your thoughts about what other steps you can take beyond just operational to show your commitment to the stock?

Bob Nardelli

Well, I think, Gary, it's a fair question and one that you and I have talked and many of us talk about, I will take you back to our strategy. We have never been more committed to enhancing our core, as evidenced in our comments today and the reacceleration into our installed base. We think the geographic reach that we have is certainly a compelling and a competitive advantage.

I think the multi-pronged approach, Gary, as you've commented and Joe talked about today; I think broadening to our platform and gaining access into a $400 billion market certainly strengthens our Company. I think over time the intrinsic value that we are demonstrating, our ability to be very acquisitive yet also deliver very strong integration results while attracting great businesses, great leaders, new suppliers, new customers; I think is a very compelling proposition for Home Depot and Home Depot stock. Carol, do you want to comment any further on that to Gary?

Carol Tome

In addition to what we are doing to grow the business, of course, is what we've done with regard to our shareholders in terms of returning capital. Since Bob came we have more than doubled our dividend, we increased the dividend by 50% alone in January. Repurchasing now about 13% of our outstanding shares and our Board has been extraordinarily supportive in our share repurchase program. You should take from that that we will continue to do the right things for our shareholders.

Gary Balter - CSFB

I agree with everything you both said and we have been buying the stock obviously we see the strategic opportunities and what you're driving, but the market doesn't seem to do that. So are there other steps you can take in your minds to get that message across to the market? Beyond just buying back stock or beyond just explaining where you're going on the two divisions?

Bob Nardelli

I think the only other thing I would add Gary, as you know, we are squarely on plan with almost close to $4 billion of CapEx back into our business. Carol mentioned over $700 million in the first quarter alone, about 90% of that was back into our retail business. We went out and borrowed $4 billion to make sure, and we took full advantage of probably one of the strongest balance sheets in retail.

We did leverage up, as Carol mentioned, over 20%. We were confident in going out and securing $4 billion to make the biggest and the most strategic acquisition with Hughes. We couldn't be more pleased, as Joe said, it closed in record time; the integration is off to a very good start.

I think certainly in the balance of the year and going forward we will look back and be very pleased with the fact that we're continuing to invest in the core. We're growing our service business. Our e-commerce business, as I mentioned will be $1 billion. It will double up again this year from last year. So I think this multi-pronged approach gives you a platform to handle a variety of economic situations.

Certainly to be able to handle some of the goes in's and goes out's from both a broad range from Do-It-Yourself to the Pro contractor, and I think that diversity should give tremendous comfort to our investors.

Carol Tome

If I could add and Diane you can jump in here as well, Gary I think we love our retail sell side analysts and we love our retail investors, but we need to broaden our investor base. Now we are of size in Home Depot Supply where we can justify that. So you say, what can you do? Well, Diane and Joe are on the road meeting with new investors, people who before may not have even considered The Home Depot as an investment of choice because they didn't understand our trade distribution growth strategy. So I don't know if Diane you want to add to that.

Diane Dayhoff

That is pretty succinct; the only one caveat that we have is that Joe actually has to pay attention to his business for a little bit. He has had a great start, but you will see us out there a lot more.

Gary Balter - CSFB

Here is my follow-up on that HD Supply, you mentioned Carol, 18% core growth or organic growth or whatever the proper wording is, and 140 basis points in gross margin expansion. What was the expense side of that equation?

Carol Tome

They also drove expense leverage in the businesses that we owned a year ago. As you would expect and as Joe has told you, when we acquire these companies we see lots of opportunities on the back office, if you will, to take out costs. So we saw expense leverage in those businesses.

Gary Balter - CSFB

So we are looking at like 250 to 300 basis points in margin expansion in the quarter, in the organic part, is that the way to think about it?

Carol Tome

Yes, that is the way to think about it.

Gary Balter - CSFB

Thank you very much.

Bob Nardelli

Gary, I would just say we are one quarter into this, and really one month of Hughes. But the fact is we're very pleased with the first quarter performance, the first month performance relative to what Joe shared with you as it would relate to the 2010 vision of growing and expanding margin in the supply business, and continuing to get the favorable leverage that we're seeing so far.

So I am very encouraged across our business. I think retail did a heck of a job in the face of some tough numbers. Whether it be service or E-commerce or supply, I think each segment is moving along extremely well.

Gary Balter - CSFB

Thank you. I will just add one final thought from my point of view, levered up the way I see [inaudible] doing or Sears doing I am fine with that.

Carol Tome

Thanks, Gary.

Bob Nardelli

I think we have time for a few more questions.

Operator

Our next question comes from Colin McGranahan, Bernstein.

Colin McGranahan - Bernstein

Good morning, Bob. I wanted to focus first on just the retail sales; I understand the weather was a little bit difficult. But if you look at the ticket growth of 4.3%, again you're facing some more difficult multi-year compares here, because I think you are really starting to see some very strong ticket growth kind of mid '03 on. But the weakest ticket growth in about 11 quarters, do you feel you're starting to anniversary enough that there is a limit to the amount the ticket can go up?

Is there any sense that maybe you pushed the prices in some categories a little bit above where the consumer is comfortable in the current environment, with high energy and high interest rate? Just to comment on how you're feeling about the ability to continue to grow ticket?

Secondly on the retail sales, just in flooring again obviously understand why they are seasonal, but in flooring do you think some of that softness is related to housing turnover? Obviously that's a category that sees a lot of strength in hot housing markets where is a lot of speculative or flipping going on.

Bob Nardelli

Colin let me first of all, let me address exactly your point. While we said some of the softness in the first quarter was weather, particularly as it relates to our biggest department given this time of year which is 28. But the other, as you accurately said, was flooring.

The short answer to your question about average ticket is, no. I really believe we have an infinite capability to continue to expand our average ticket. Let be also very quick to say, Colin, it is not pricing ourselves out of the market. Now while we've had some inflation in some commodities specifically like copper and gypsum, Tom and his team I think have done a superb job.

We have the most commanding assortment, for example in outdoor patio. We've had the most commanding assortment in grills where the functionality is more mirror imaging the capabilities of the indoor kitchen relative to burners, BTU's, etc. If you look at the tractor line-up and the fact that as Tom mentioned we think we have the broadest assortment; these are the things that are driving our average ticket.

We are pleased with the progress we made in the first quarter, and we think we have ample growth certainly through the balance of the year and beyond. We have over the last three years, as you know, we started talking about distinction and innovation, and through our innovation center and our merchants now we have a pretty good pipeline that will be rolling product out on a quarterly basis.

So as evidenced in some of the products whether it is Hampton Bay, Pegasus, Rigid, we are continuing to see unit growth opportunities. And I would certainly project that will continue the balance of the year and beyond. Tom you may put more color on it than me on that.

Tom Taylor

I think you answered it very well. I don't think that we're anywhere near where we can be an average ticket. I think our customers are continuing to upgrade and as we introduce innovation I think that our customers are accepting of that. We continue to see average ticket grow across multiple big ticket categories in the store.

We were soft in flooring and soft weather affected power equipment; those are two high ticket categories. So we are going to focus internally on flooring. We've got opportunities that we're working on and we're going to put some of our emphasis on resetting of the department in the flooring department. We are going to attack it from a product standpoint but there is multiple chains in the flooring purchase and we're not focused on one of them, we're focused on all of them.

Bob Nardelli

Colin, just to answer your final question, I would not attribute the flooring situation in the first quarter to housing, which would suggest a bigger economic issue for all of retail and in particular, home improvement. So I want to be very clear that there is no correlation there. We don't see any correlation relative to housing turnover and flooring in the first quarter for us.

Colin McGranahan - Bernstein

One quick follow-up for Joe or Carol, and obviously there is some strong commodity inflation; gypsum is up about 23%, plastic construction products about 21%. Of the 18% core organic growth, how much was commodity inflation?

Joe DeAngelo

It was minimal across the board; we don't sell any gypsum in my product category so we didn't have the run on that. We also had significant lumber deflation at the same time we are having commodity inflation. So you're talking a couple points at most.

Colin McGranahan - Bernstein

Finally just a comment I think it would be very helpful from my perspective if you did continue to report comparable store sales growth.

Carol Tome

Thanks for the feedback.

Diane Dayhoff

We have time for one more question.

Operator

We will take our last question comes from Joe Feldman, Telsey Advisory Group.

Joe Feldman - Telsey Advisory Group

Good morning, guys. Thanks. I wanted to ask just for a little more detail on the resets that you're doing in the 500 stores; maybe just to get a little more color on what exactly you are doing and how long you plan them to take, if they're going to be disruptive, the cost involved, all that kind of good stuff.

Bob Nardelli

In general, we will be a little guarded as you would appreciate from a competitive standpoint, to give you the specific resets that we'll be doing in the store. However, as Tom indicated, our plan today is to touch over 500 stores. We will be touching about 100 stores a month on average, and we will start that probably within the next 30 to 45 days. Tom, do you want to add more to that and Carol can reconfirm the numbers for you?

Tom Taylor

The plan is to not make this disruptive. The plan is to start it, as Bob said, in the next 30 to 45 days. We will impact 100 days in the store as Bob said, we are not going to talk about what days those are; but we will impact 100 days. They were selected out of our top businesses, so we are putting the emphasis where we think it makes sense.

Carol Tome

Relative to the cost its about $81 million in total, $55 million of capital, $26 million of expense and most of that will be borne in the third and fourth quarters of this year.

Joe Feldman - Telsey Advisory Group

Got it. One last follow-up; if you could give us any kind of update on China, if it is something you can talk about at this point, in terms of the stores and store rollout there?

Bob Nardelli

Again on China I would just reconfirm that it is our area of focus for international expansion. Frank Blake and his team obviously, and the people we have on the ground over there, are very vigilant of opportunities. I don't feel any pressure to make a [dumb] deal, so we are continuing to look at it. We are committed to being in the retail business in China. But I really don't have anything that I can report at this time of a concrete nature other than to say it is still a primary focus, and we believe we will be in China.

Joe Feldman - Telsey Advisory Group

Great, thanks and good luck with the quarter.

Bob Nardelli

Diane, I will turn it back to you.

Diane Dayhoff

Thanks, everyone for joining us today. And we look forward to talking to you next quarter.

Operator

Thank you, everyone. That does conclude today's conference. You may now disconnect.

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Source: Home Depot, Inc. F1Q06 (Qtr ended Apr 30, 2006) Earnings Conference Call Transcript (HD)

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