Home Depot, Inc. (NYSE:HD)
Raymond James 35th Annual Institutional Investors Conference
March 3, 2014, 8:05 AM ET
Ted Decker - Senior Vice President, US Retail Finance
Budd Bugatch - Raymond James
Budd Bugatch - Raymond James
Good morning. It's 8:05. We're going to get started. My name is Budd Bugatch, I’m with Raymond James. My pleasure to welcome you to the presentation today for the Home Depot. With us today from the company making the presentation will be Ted Decker, Senior Vice President of Finance. Also from the company today we have Mark Brown, Regional Vice President for this area; Diane Dayhoff and Dan Aldridge from Home Depot's Investor Relations.
Ted, without any further ado.
Okay. Thank you, Budd. Good morning, everyone. All right, we'll talk a little about Home Depot this morning. Please be aware that we'll have some forward-looking statements. I won't read this, but we have some statements in the presentation to be aware of.
So we use this three-legged stool as our strategic framework. Enormous changes that impacted retail and Home Depot over the past several years, changes in our customers' expectations, changes in our competitive framework and changes in our business model. So the three-legged stool sets out an enduring strategic construct for us.
[Borrowing] [ph] from Jim Collins, we try to address the three core questions that every business should ask. What are we passionate about? In our case, customer service. What do we want to be the best in the world at? Product authority. And what drives our economic engine? Disciplined capital allocation, productivity and efficiency. We tile these together through interconnected retail, trying to strengthen the performance of all elements of the stool.
The first leg of our strategic framework is customer service. Customer service starts at investing in our associates. We pay our associates in above-market wage rate, and even during the housing crisis we maintained salary increases, continued our 401(k) matches and actually increased bonuses for hourly associates. 2006, we paid, as an example, $26 million in success share, which is our bonus program for hourly associates. This year, we'll pay almost $250 million, nearly a tenfold increase in the bonus for hourly associates.
We also recognize associates for great customer service. We have a home reward program where we recognize outstanding customer service and we paid out nearly $85 million over the last seven years.
We're also adjusting our learning and training efforts to incorporate interconnected retail, making our virtual store presence part of our Customer FIRST training. We use upgraded technology in the store to take advantage of interconnected capabilities. In a world where more data has been created since 2002, we try and simplify the loads of data and make it simple for the stores and not drown them with all the data.
Finally, one of the unusual elements of the Home Depot is the importance of our pro customer. While representing about 3% of our customers, our pros represent over 35% of our sales. And the needs of our pro customer have been evolving. Over the last 18 months, we rolled out programs that improve our day-to-day service for these pro customers. We hope to build increased stickiness through recognition and special programs that focus on the pro and help them build their business.
We help drive customer service by reducing complexity for our store associates. Complexity is a proxy for expense and a major distraction for customer service. One example of our efforts is Project Simple. The goal of Project Simple is to eliminate complexity, eliminate reports, reduce e-mails and cut meetings that remove store management from the selling floor. Project Simple has been a success. We've reduced reports by 40% and we've reduced e-mails by 20%. Meetings are much shorter and consolidated to only one day a week at the store.
Turning to product authority. For the Home Depot, the journey on product authority began with the fundamental restructuring of our supply chain. As you know, over the last several years, we've developed a new supply chain called Rapid Deployment Centers or RDCs. The RDC strategy along with improvements in our stocking in bulk DCs allowed us to improve our in-stock rates, improve churns and improve customer service.
The next step in our DC network is to build out a DC network for our dotcom business as well a new platform for store delivery and last mile delivery to our customers' homes. Along with supply chain improvements, our merchants with the support of the IT team had been putting in place the competencies we collectively call merchandising transformation. Just a few years back, we didn't have the basic technological competencies that other retailers had enjoyed for years. Developing these capabilities of assortment planning, space allocation and pricing has been an important part of establishing product authority. We're now at a point where the tools are largely in place and we can begin to use them to create value for our customers, associates and shareholders.
These developments are the enablers for the larger portfolio strategy that our merchants have been working on. The focus for our merchandising strategy remains the same, winning through value, innovation and speed to market. However, we need to adjust certain tactics as the Internet has evolved from being an external threat to being part and parcel of our interconnected portfolio of strategy. We now actively manage pricing transparency, demand for enhanced delivery option and the trade-offs between long-tailed demand and product curation.
One example of how we're using the new tools is localized product assortment. We're now giving our merchants advanced tools to plan assortments that will make it easier to get the right products in the right areas. An example of this is Symmons faucets in New England, which is a respected program. Another example is lithium-ion battery technology, which allows us to solve customers' problems in areas like California. For those customers that have smaller yards, they no longer have to mix or store gasoline in their garage. This technology also addresses issues around carbon emission regulations.
As we've developed these more sophisticated tools, we're able to dive deeper and meet our unique customer needs. The key here is our ability to scale these solutions. Home Depot, as you know, 2,000-odd stores across the United States, these may seem like fairly simple implementations of localization, but it's the ability of the tools to let the merchants sit in Atlanta and run these different portfolios across the entire country.
On interconnected retail, our goal with our online channel is to improve traffic and conversion in the store and vice versa. One of the major efforts we've undertaken over the last few years is linking the district systems developed over the years as the brick and mortar retailer. We're creating a technology platform that will support a seamless customer experience whether shopping online or in store.
Along with these foundational investments, we're also investing to improve the core functionalities of our site, as well as our mobile web and mobile app capabilities. Our head of online refers to the phone as a store in a pocket. Unlike the physical store, the virtual store requires constant upgrade, only with the virtual store the pace is a lot faster. We've made significant progress over the past 18 months, but the process will never end, the ongoing objectives to keep improving the ease of use, personalization and connectedness of our online experience.
For us, we think of interconnected retail as a virtuous cycle. Digital efforts to driving traffic and improving customer conversion in our stores and our stores will likewise drive traffic conversion to our digital properties. For example, customers are using technology millions of times a week to get real-time availability of product in our stores. We also see customers engaging online content, watching videos, reading reviews and accessing how-to information on their mobile devices, while they're physically in our stores.
We see over 10% of our online orders actually created in the store with the consumer or pro working side-by-side with one of our associates. In addition, over 30% of all online orders are picked up in the store and about 20% or one out of five customers coming into the store to pick up their online order buy another item to their basket while they're at the store.
Even outside of our stores, associate engagement drives conversion over the digital channel via Internet chat, and we're chatting with our customers thousands of times a day as they make purchase decisions over the Internet. The physical and virtual worlds are coming together for the customers' benefit. So interconnected retail is a huge opportunity for us. We made lots of progress, but we have more to do. And interconnected retail remains and will be in 2014 one of our major areas of investment.
Here is a summary of some of our larger accomplishments over the past 18 months, as well as some areas of opportunity. We believe we will achieve our 12-24 target, which is 12% operating margin and 24% return on invested capital a year ahead of schedule. That's clearly an accomplishment. What's even as important is the numbers that we've hit these financial targets, while gaining market share and while improving our customer experience. We also showed in the second quarter of last year that our business model is sufficiently flexible to handle dramatically stronger business momentum.
In the spring of 2013, we had a major stress test for the business for the spike in our spring sales. Our supply chain reacted favorably. Our associates in stores reacted favorably. We were able to record the highest quarterly US comp sales in 20 years for the business in the spring of 2013. And that's on much obviously larger base than we last stood at in 1999.
We've also shown in the last 18 months that our customers are responding positively to our investments in interconnected retail and we've been very encouraged by the recovery of our pro business.
On the opportunities side, our customers shift to mobile technology is occurring faster than we expected. And mobile is going to be a major focus of our investments. We plan to roll out a new solution for buy online deliver from store in 2014, because we know last mile delivery is an increasingly important competence. And we'll be rolling out a new FIRST Phone this year as well that will have internet-enabled capability on the phone. Lastly, we need to continue our overall push in interconnected retail and disrupt the muscle memory of the firm as a physical-only retailer.
Moving on to our financial results, in fiscal 2013, our business delivered results that exceeded our expectations. Comp sales finished up 6.8%, driven by growth in both transaction and ticket. Our gross margin expanded 18 basis points for the year, led by our supply chain transformation. The expenses leveraged the 106 basis points as we continue to focus on simplicity and cost out. Operating profit increased 18%. Our operating margin 124 basis points to 11.6%. And our net earnings increased 18.7%. For the year, we repurchased $8.5 billion or approximately 111 million shares and our diluted earnings per share increased 25.3% to $3.76 a share.
Here are the high level financial targets we laid out on our earnings call last week. For 2014, our view of US sales growth on a US GDP growth forecast is 2.8%, plus 200 basis points of growth coming from continued recovery of the housing market. We are projecting similar sales growth rates in Canada and Mexico. The total company sales growth will be approximately 4.8%. We are targeting seven new stores in 2014. Most of those will open in Mexico. We are projecting operating margin expansion of roughly 70 basis points, taking our operating margin to over 12%.
We anticipate earnings per share growth of approximately 16.5% based on both earnings growth and the impact of share repurchases. We intend to repurchase $5 billion of shares in 2014. With stronger earnings and our share repurchase plan, we project the return on invested capital to hit approximately 24% by the end of fiscal 2014.
In 2012, we set our targets of 12% operating profit and 24% return on invested capital by the end of 2015. We plan to hit those targets a year ahead of schedule. However, we will arrive there in a slightly different manner than what we thought, principally through higher sales growth driving greater operational leverage rather than gross margin expansion. Given higher sales growth, we are increasing our fiscal 2015 targets to 13% operating profit and a 27% return on invested capital. We think both of these are challenging targets, but achievable. Most importantly, we think we can continue gaining share and continue increasing our customer service scores, while we strive to hit these financial targets.
We have three shareholder return principles. First, our dividend principle is to target a payout of approximately 50% of our earnings, targeting an increase of our dividend every year. Our share repurchase principle is to use excess cash to repurchase shares as long as it's value creating. And finally, from the return on capital perspective, our goal is to maintain a high return on capital, benchmarking all use of excess liquidity against the value of our shareholders repurchasing shares.
Here is a visual depiction of our commitment to return cash to shareholders through our dividend. We've increased our dividend every year since 2009. And as we just announced on our Q4 earnings call, we increased our dividend 21% to $0.47 a quarter.
As for share repurchases, we have repurchased our shares since 2002. And through 2013, we have repurchased approximately 1.1 billion shares for $46 billion, an average share price of about $41 a share. Looking to 2014, we are targeting $5 billion of share repurchases, which would leave $3.5 billion remaining on our authorization. We plan to complete our authorization in 2015 and seek further authorization from the Board at that time.
Based on the numbers that we just shared with you, we are projecting cumulative free cash flow of $25.5 billion between 2013 and 2015. This number is after cumulative capital expenditures and reflects the $4 billion of incremental debt capital raise in 2013. Using our targeted 50% dividend payout, we look to pay cumulative cash dividends of $7.7 billion during this period. Using excess cash and with additional authorization from the Board, we project the ability to repurchase $17.8 billion of our shares through 2015. And this is the basis of our 2015 return on invested capital target of 27%.
If we were to layer in incremental debt, the amount of shares repurchased could exceed $23 billion or increase to $23.5 billion. When added to the amount of shares already acquired, that's over $60 billion of repurchased shares or about 60% of today's market cap. The power of the Home Depot to return to our shareholders has been and will continue to be seen in our financial results.
Thank you very much for the summary and I'm happy to take any questions.
Right, Budd would like to know how Home Depot thinks about growth in the market and what the market is tied to. Home Depot, we've talked in the past about different housing metrics and GDP and what are our thoughts now that it's going to drive the market. I'd say historically we had strong correlations of our sales growth, the home improvement industry sales growth with traditional housing metrics. So think of things like house formation, existing home sales, new home starts and sales and home price.
There was a disconnect, a very significant disconnect from those metrics when we went into the housing correction. And at that point when housing was going down, we started to turn and have positive comps. So we reset our thinking of the marketplace and said, fundamentally our sales have to start - industry sales have to start with GDP, what's the health of the overall economy, and then add or subtract from that with changes in the housing market.
In looking at that, pricing right now, housing prices we're seeing as more relevant to the changes in home improvement spend then housing turnover. So again, you think housing turnover, it's been up and down over the last few years based on some government policies, the tax breaks for buying housing. So you've had some pretty big swings with existing home sales up and down, but our sales have kind of grown through that. And what we're seeing particularly with our bigger ticket items as well as pro spend, it spoke confidence in the value of their home where they are ready to invest in the home again as opposed to necessarily a transaction.
And then in terms of PFRI, we still look very closely at PFRI, that's private fixed residential investment, as a share of GDP. Home Depot is a big component of that index. So in a certain degree, how the home improvement industry is going as well as new home construction determines what PFRI is. It bottomed out, I think, at something like 2.2% of GDP, has a sixty-year average of something like 4.6%. We've seen a recovery. We're at 3.1%. So that's obviously terrific. We've gone from low 2%s to low 3%s, still a long way to go to the traditional 4.5%-odd.
So that's a little bit of the flavor Budd of how we think about it. It starts with GDP, add housing and we think pricing is more relevant. We've done all sorts of looks at correlations. Turnover was much stronger correlation up until about 2010. From 2010 until now, pricing has had a much stronger correlation.
And we have Mark Brown here with us who was one of our leaders in pro as well. So he can answer some questions as well that I miss. So pro is, as I said in my earlier prepared comments, a big piece of Home Depot, about 3% of the customer base, over 35% of the sales. And just to stratify the pro for you a little bit, we have number of different pro segments. We've got national managed account pros, so we're looking at organizations that think of either hotel chains or fast food chains that are buying across state lines, buying throughout the country. We have managed accounts and these are our biggest accounts. And think of these folks as well over $100,000 in sales purchases from the Home Depot. And those accounts get a very high touch with managed account representative that we have out in the field. We have field sales folks who are working day in and day out with those managed accounts.
Then we have our core pro, certainly the highest number of pros that are coming into the store everyday. And we bifurcate those pros over $10,000 in spend and pros under $10,000 in spend. So as you can imagine, a pro under $10,000 in spend is either a light pro or a pro who is not buying all the principle product from the Home Depot. So your job as a contractor if your full time job working 52 weeks a year our average pros spending $6,000 with the Home Depot, you're going to be buying more than $6,000 worth of product to complete your activities over the course of the year.
So we're getting varying shares of wallet from these different pros. A pro who is an electrician or a plumber might be buying a lot of their core product from the trade and doing pickup purchases from us. Someone who we refer to as the shoulder trade, someone who is doing projects at a home building a deck, working alongside one or two people, they're probably remodeling a bathroom, doing a project but not a major renovation to a house, they're probably more likely spending more of their share of wallet with Home Depot.
So again, the framework is large national people, big companies buying big spend with us, so we give a high touch with a managed account rep, a field sales person to someone who comes in our store and spends a lot of money, but we don't know them at all. So the whole idea of a program like Pro Xtra is to build stickiness with all those customers, but most importantly those two lower groups of just under $10,000 and over $10,000. So it's a loyalty program, where you sign up for Pro Xtra, you're going to get access to business solutions at a lower cost like we run background checks for their firm.
We have just enabled now online and now on an app, where you can check a number of business initiatives for the pro. And one of the biggest things they want to know is are you in stock. If they're coming in the store, they want to know how many items you have of a particular product, they don't want to waste a trip. So we show inventory of their home store as well as inventory of geographically close stores. And we send e-receipts. So if they registered their e-mail address, we'll send the pro e-receipts, so you don't have to have the file folder of all the receipts of the job.
And then most interesting and exciting and new benefit that Pro Xtra has is that a pro registers their card, we will track and hold for them digitally, think as a library of all their spend at the Home Depot. So by store, what they bought, what they paid for every item, so cataloging all their spend for them.
And then we'll have a higher touch CRM, so customer relationship management with these pros, because we’ll have their e-mail address, they have our app. We understand what they're doing, what they're buying. So we're able to identify, hey, is this a painter, is this an electrician, is this a plumber, then we can have a much higher touch to send them relevant communications to them.
So that's sort of a broader review of the pro and Pro Xtra.
Well, right now, we like our invested position at $41 a share, as we trade over 80. First and foremost, we're going to invest in the business. So we go through our annual strategic planning process, which starts up late summer and goes through the fall and we identify all the areas of the business. And we've been spending and our target for this year is $1.5 billion in capital expenditures. And we don't really have a governor on the capital. It's more a capacity of the firm to get the projects done with excellence. So we've done one in a quarter, A$1.4 in the last couple of two years and we expect to spend about $1.5 billion a year going forward.
A lot of that spend is IT. A lot of that IT enabling spend is for interconnected retail. So it's a capacity issue and not a dollar governing how much we're going to spend on CapEx. And then we generate tremendous amounts of cash, as you know. And to the point of where we can, for example, raise debt for a net debt cost or dividend cost, so that was trading value to buy shares rather than pay the dividend. And we have our own intrinsic model. So obviously we're running out our strategic plans and our long-term financial plans and we look at within the present value of that flow is and we think we're in good shape to keep buying shares. We haven't hit the value.
Sure. So two changes we made. Craig Menear who had been our Executive Vice President and Chief Merchant was promoted to be the President of US Retail. And Mark Holifield who was our Senior Vice President of Supply Chain reporting to Craig in Craig's prior role was promoted to Executive Vice President of Supply Chain. And he will also assume responsibility for the private brand import portfolio run by John Deaton. So the core team is intact with a couple of promotions.
Budd Bugatch - Raymond James
Thank you very much. We will continue this in the breakout room.
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