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This post describes our model of Home Depot's (NYSE: HD) Income Statement for fiscal 2010's fourth quarter, which will end on 30 January 2011.

The purpose of the model is to establish a baseline for identifying surprises, positive or negative, in the quarterly results the company will report. Estimates for each line of the Income Statement are derived from management's guidance, the company's historical financial results, and other publicly available data.
We begin by reviewing background information about Home Depot and the business environment in which it is currently operating.

The Home Depot, Inc., is the largest retailer of do-it-yourself merchandise, which includes building materials, home improvement supplies, and lawn and garden products. The company at last count has 2,244 retail stores, 88 percent in U.S. states or territories. Home Depot also operates in Canada, China, and Mexico.

Home Depot earned nearly $2.7 billion in fiscal 2009, which was nearly 18 percent more than in 2008. Revenue slipped 7 percent to $66.2 billion. (Fiscal 2009 ended on 31 January 2010.)

In the last couple of months, Home Depot's market value has increased from $50 billion to $60 billion, on a fully diluted basis. The market value is much less that it had been a decade ago, partially as result of share repurchases.

A big drop in sales in 2008 affected most retailers, and stores dependent on the housing market were doubly challenged. Home Depot chose to consolidate operations and reduce capital outlays. The first step, announced in May 2008, was to relinquish 50 planned stores in the U.S. and to close 15 existing stores. The second step, taken in January 2009, was to exit the EXPO Design Center and a few other peripheral businesses. These actions led to asset impairment, severance, and other charges over $1.1 billion.

Retail sales have, more recently, been rising in the U.S., but results for many store operators continue to be pressured by high unemployment.

The still-fragile housing market and weak consumer sentiment in the U.S. remain very significant concerns for retailers, especially those with ties to housing. At Home Depot, economic uncertainty is reflected in parameters such as the average "ticket," which fell 0.8 percent in the October 2010 quarter on a comparable store basis. Similarly, there was a 3.4 percent decline in the number of tickets valued at $900 or more.

Home Depot competes with Lowe's (NYSE: LOW), cooperatives such as Ace and True Value, and a multitude of smaller hardware stores. These rivals took advantage several years ago of lapses in Home Depot's customer service, which had deteriorated. Frank Blake, who took over as Chairman and CEO in early 2007, has made improved customer service a high priority. The company's current investments in technology upgrades are evidence that this effort continues.

Home Depot is also working to reduce inventory costs by streamlining product distribution. New Rapid Deployment Centers are key elements of this effort. These regional warehouses receive mass deliveries from manufacturers and dole out the products to 100 or so area stores. This distribution model is similar in form to Wal-Mart's (NYSE: WMT) exemplar of efficiency.

In early 2007, Home Depot sold HD Supply to a consortium of private equity firms. Home Depot kept a 12.5 percent stake in HD Supply, which serves professional contractors. Unfortunately, this investment cost the company $325 million that it subsequently wrote off. Home Depot also guaranteed $1.0 billion of HD Supply's debt.

Home Depot, Inc., earned $0.51 per diluted share on a GAAP basis in the October-ending third quarter of fiscal 2010, up 24.5 percent from $0.41 in the same three months of last year.

Readers wanting to take another look at Home Depot's October 2010 quarter might wish to review our Income Statement and Financial Gauge analyses.

We are now ready to look specifically at the January 2011 quarter.

When Home Depot reported third-quarter results on 16 November 2010, it updated its guidance for the fiscal year.

Updated Fiscal 2010 Guidance

Based on its year-to-date performance and expectations for the remainder of the fiscal year, the Company updated its fiscal 2010 guidance and now expects sales to be up approximately 2.2 percent for the year. The Company expects diluted earnings per share from continuing operations as reported to increase by approximately 25 percent to $1.94 for the year. This earnings per share guidance includes the benefit of the Company’s year-to-date share repurchases, but excludes the impact of future share repurchases.

The expectations quoted above were supplemented with additional comments during the ensuing conference call (transcript available from Seeking Alpha).

On 8 December 2010, Home Depot slightly adjusted the guidance when it held its 2010 Investor and Analyst Conference.

Updated Fiscal Year 2010 Sales and Earnings Per Share from Continuing Operations Guidance

Based on its year-to-date performance and expectations for the remainder of the fiscal year, the Company updated its fiscal year 2010 guidance and now expects sales to be up approximately 2.3 percent for the year. The Company expects diluted earnings per share from continuing operations as reported to increase by approximately 27 percent to $1.97 for the year. This earnings per share guidance includes the benefit of the Company's year-to-date repurchases through the third quarter of fiscal 2010, but excludes the impact of future share repurchases.


Home Depot also described during the conference its financial outlook for fiscal 2011. We will examine the 2011 numbers in another article.

Given that Net Sales in fiscal 2009 totaled $66.176 billion and given the guidance to expect sales growth of 2.3 percent, sales in the entirety of fiscal 2010 should be close to (1.023 * $66.176) billion = $67.70 billion. Revenue in the first three quarters of the fiscal year was $52.87 billion, which leaves $14.83 billion for the final three months.

We have rounded this figure up to $14.85 billion and made it our Revenue target for the January quarter. It is 1.9 percent more than Revenue of $14.6 billion in the January 2010 quarter.

Based on the company's results to date, and normal seasonal patterns, we are assuming the fourth quarter's Gross Margin will be 34.8 percent of Revenue. The estimates for Revenue and Gross Margin translate into a forecast for the Cost of Goods Sold of (1-0.348) * $14.85 billion = $9.68 billion.

Our estimate for Depreciation and amortization expenses in the current quarter is $400 million, the same as in the October quarter.

Sales, General, and Administrative expenses in the two previous January quarters were 26.5 percent and 26.6 percent of Revenue. However, the company has become more efficient in the last year, which led us to use 26 percent as the SG&A target for the current period. Using the Revenue estimate above, we're targeting the SG&A expense to equal 0.26 * $14.85 billion = $3.86 billion.

Subtracting these operating expenses from Revenue yields an estimate for Operating Income of $907 million in the fourth quarter, nearly 25 percent more than last year.

Our target for interest and other non-operating items is a net expense of $140 million, roughly the same as last quarter.

An effective income tax rate of 36.5 percent (as per the guidance) would lead to Net Income of $487 million (about $0.30/share) for the quarter. Depending on the extent to which Home Depot reduces its share count through repurchases, our fourth-quarter estimate would result in a fiscal year EPS of $1.96 per share. This is within one cent of the latest guidance from the company.

In the fourth quarter of 2009, Net income was $342 million ($0.20 per share).

Please click here to see a normalized depiction of the projected results next to Home Depot's quarterly Income Statements for the last couple of years. Please note that our organization of revenues, expenses, gains, and losses, which we use for all analyses, can and often does differ in material respects from company-used formats. The standardization facilitates cross-company comparisons.

Full disclosure: Long HD and WMT at time of writing. No position in any other company mentioned.

Source: Home Depot: Looking Ahead to January 2011 Quarterly Results