Before the bell on Tuesday, August 20th, Home Depot (HD) reports its Q2 earnings results. The echo chamber of news organizations focusing on the Federal Reserve's Quantitative Easing policy, and the potential for it to be changed or tapered amid rising interest rates, indicate that earnings day may not bode well for Home Depot. Its earnings will provide a clear snapshot of the health of the consumer and the strength of the housing recovery during what is shaping up to be a potentially strong summer. Feria expects the strength in housing starts, homebuilder confidence, and the seasonal elements of the quarter to propel HD to beat earnings estimates and reassure investors. And we are not alone, as analysts expect revenue to jump 6% and EPS to jump almost 20%.
Although narrowly missing analyst expectations, July housing starts were nonetheless up almost 6% from a year ago. Importantly, June starts were revised upward, showing an 846,000 unit pace rather than the previously reported 836,000 unit pace. Housing starts are an indicator of home builder activity, and offer a picture of the supply of housing trying to keep up with demand. Home retailers like Home Depot and Lowe's stand to profit nicely from increased activity in new home production, as anything from drywall and lumber to appliances and gardening are positive sales contributors when more homes are being built. The positive growth of housing starts month-over-month signals a strengthening housing recovery that continues to flex its muscle even in light of rising mortgage interest rates. The positive numbers following homebuilder sentiment also dovetail with starts; builders are maintaining confidence that the housing recovery will continue, that more new homes will be built, and consequently, retailers like Home Depot are poised to benefit from the strength.
The robust spending of the consumer has been in focus recently as well, as retailers like Macy's (M) and Walmart (WMT) showed weakening numbers, albeit for a variety of reasons. From Macy's earnings call, CFO Karen Hoguet explained that for some reason, consumers decided to spend money on other goods besides Macy's offerings. And where did Ms. Hoguet suggest consumers decided to go? Home improvement: "We believe much of our weakness is due to the health of the consumer and to the fact that the consumer is choosing to make purchases in non-department store categories such as cars, housing and home improvement," she said. The sentiment around a weakening consumer may perhaps be a bit overblown then, as Gallup surveys on spending suggest.
Two wild cards for Home Depot's earnings that could propel the revenue and earnings numbers higher could be the late arrival of spring in many areas across the country, and the strength of the "pro" segment. During the Q1 conference call, management identified many positive trends, including rising comparable store sales (almost +5%), the doubling of mobile traffic, growth in big ticket sales (quantified as sales over $900), and additional storm-related sales from Hurricane Sandy. Importantly, garden sales, which characterize a large portion of the small ticket sales (sub $50) appeared to have been deferred to Q2 as a result of weather, and management is confident in their ability to recapture them. "Garden sales that were deferred in the first quarter will be realized in the second quarter" said CFO Carol Tome, and that although not all the sales will be recovered, management estimated that a majority of the "$188 million" in losses are set to be recovered and are thus not really "lost" so to speak. Indeed the late-advent of spring led management to describe the garden business as driving down sub $50 tickets by approximately 1.6%, a statistic unlikely to repeat itself in the current quarter. As the weather should play less a factor in deferring sales in the current quarter, we expect these recovered "losses" to contribute positively to topline growth for Home Depot.
Another aspect of Home Depot's business that we would like you to keep a close eye on is the growth of the "pro" segment; management explained that for the first time, pro segment sales outpaced consumer segment sales. CEO Frank Blake was very reluctant to give much credence to this new phenomenon, and management could be underrating its potential to contribute to more sales growth at Home Depot: "A lot of the smaller pros basically shut their businesses down and started to work for the larger pros. And so as the business and the market improves, there are more jobs available and a lot of smaller pros are venturing out again to open up their shops and they are back in business. But it's very early. But the trend is positive. We just hope that it sustains," said EVP Marvin Ellison. Indeed it is very early, but the conservative outlook management is offering may be lowering expectations in a way that could be ripe for a nice surprise. Should sales in the pro segment continue to perform well, revenue could be higher than expected, as big ticket items are snapped up amid larger projects and developments.
Given this, and the upward revisions to earnings and sales guidance for the year from the last earnings call in May, Home Depot is poised for another nice surprise on earnings day. Especially in light of the continuing US housing recovery, and the nice 2% dividend Home Depot pays, we expect the stock to continue to perform well for the remainder of the year and in the near future. Focusing on the potential for upside surprise as a result of increasing activity from homebuilders, improving balance sheets of consumers (and their apparent tendency to prefer spending on home and home improvement), and the weather-related deferments from the last quarter, we recommend HD.