Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

The Home Depot, Inc. (NYSE:HD)

Q4 2007 Earnings Call

February 26, 2008 9:00 am ET

Executives

Diane Dayhoff - Senior Vice President of Investor Relations

Frank Blake - Chairman, Chief Executive Officer

Craig Menear - Executive Vice President Merchandising

Mark Holifield, Senior Vice President Supply Chain

Carol B. Tome - Chief Financial Officer

Analysts

Steve Chick - J.P. Morgan

Matthew Fassler - Goldman, Sachs & Co.

Eric Bosshard - Cleveland Research

Danielle Fox - Merrill Lynch

Todd Duvick - Bank of America

David Schick - Stifel Nicolaus & Company

Budd Bugatch - Raymond James

Chris Horvers - Bear Stearns

Gregory Melich - Morgan Stanley

Operator

Good day, everyone, and welcome to today's Home Depot fourth 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 - Senior Vice President of Investor Relations

Thank you, [Matt], and good morning to everyone. Welcome to the Home Depot fourth 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, Mark Holifield, Senior Vice President, Supply Chain, and Carol Tome, Chief Financial Officer.

Following our prepared remarks, the call will be opened for analysts' 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 home page and the Investor Relations section. The replay also will be available on our site.

If we are unable to get to your question during the call, please call our Investor Relations Department at 7703842387.

Before I turn the call over to Frank, 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 Frank.

Frank Blake - Chairman, Chief Executive Officer

Thank you, Diane, and good morning, everyone.

I believe we'll look back on 2007 as one of the most difficult years ever for The Home Depot ever financially, but I also believe we'll look back on it as one of the most important years for the long-term health of the business.

On the financial side for the year, consolidated earnings per share declined 15% to $2.37. For our continuing operations, earnings per share were down 11% for the year. Our comp sales were negative 6.7%.

When we set our plan in the beginning of 2007, we thought that we'd see an improvement in the market by the fourth quarter. In fact, we saw conditions worsen. Markets that had been soft, like California, Florida and the Northeast, stayed soft, and markets that had been relatively strong, like the Southwest and Midwest, weakened. The fourth quarter was our worst comp performance this year at negative 8.3%.

But despite the difficulties in our market and the tough environment, I also believe 2007 has set the stage for the long-term health of the business. We are focused exclusively on our retail business. We set out our five priorities for investment in the retail business and committed resources to them, and they are the same priorities for 2008 and beyond - associate engagement, shopping environment, product availability, product excitement and Own the Pro. We have made significant progress on each.

On associate engagement, we realigned compensation and reward programs to ensure that our associates are being appropriately recognized. For example, despite the difficult second half, we had 50% more associates in success sharing than in 2006 and increased the average payout by almost 40%. Our objective is to once again set the standard for associate knowledge and customer service. It won't happen overnight, but we're taking the right steps.

In 2007, we hired over 2,500 master trade specialists - licensed plumbers and electricians - to work in our stores. We reintroduced Homer Badges to reward associates for great customer service. In 2008, we will be introducing a new TK Badge that will reward associates for developing enhanced product knowledge.

In 2008, we will also focus redeploying noncustomer facing expenses to selling hours, an initiative we call Aprons on the Floor. An example of this is that we are changing the way we handle freight in our lower-volume stores. In more than 1,100 stores, we are moving today receiving and inventory stocking in the early morning and late evening hours while the store is open. This increases our ability to staff more customer-facing hours and shift full-time associates to busier selling periods. Paul Raines and his Store Operations team have piloted and rolled out this major initiative in a fraction of the time that it would have taken in the past, a sign of both increased velocity of decision making and greater focus on regional implementation and ownership.

On shopping environment, in 2007 we completed an aggressive list of maintenance projects, with new lighting and basic cleanup activities for over half our stores, as well as more complex repair and maintenance activities for hundreds of other stores.

In 2008, we will continue to invest at levels significantly above prior years. We now have an established programmatic maintenance cadence for our stores. We have also set out new store standards across the company that address the clutter we had allowed to develop over the years.

On product availability, Mark Holifield will discuss the progress we've made on our supply chain transformation. In 2007 we piloted a new distribution concept. We're pleased with the results, and in 2008 through 2010, we will roll out new distribution centers. It is our number one initiative for 2008 and will help us lower costs, increase asset efficiency and improve the customer experience.

On product excitement, Craig will discuss some of the new products and activities that he and the Merchandising team are driving, but I'd like to give you a point of view on our merchandising organization that we haven't much discussed before.

Those of you who followed The Home Depot for awhile know that the company made a significant move several years ago to centralize all of our Merchandising functions. At one point we had nine divisions, each with its own merchandising organization. Then a few years ago we consolidated all those organizations into one in Atlanta. That centralization had a number of very positive impacts, but it also created some issues and gaps in strategy and execution as merchants lost direct touch with their markets.

Throughout 2007, Craig and his team, along with Store Operations and supply chain, have worked to build basic processes to fill the gaps and fix the issues created by the centralization. We're well along in the process. We'll continue in 2008. This work is critical for our performance in 2008 and will also position us for successful implementation of core retail.

On that point, we begin to pilot our new ERP system in Canada this spring. Once out of pilot, we will roll the new platform to all Canadian stores and expect to be fully operational there with the new system by the end of the year.

On our Own the Pro initiative, we have grown our bid room volume by over 200% this year, and in 2008 we will continue to leverage our customer analytics to drive a deeper relationship with these valuable customers.

Finally, our international businesses performed very well in 2007. We are the market leader in both Mexico and Canada. Mexico posted double-digit comps for the year, Canada had positive comps, and China has posted positive comps since we re-branded our stores last summer.

On all of our initiatives, we are proud of what we have accomplished but realistic about all the work we have left to do. We have improved our voice of customer scores, but we are still too often perceived as lagging in customer service, and we know that in a down market, we have to work all the harder to earn our customers' confidence.

So as we look at 2008, we know that we have to continue to make investments in our business to drive our key priorities. We also know that we have to stop doing some things. We should be judged by the discipline we bring to executing on our key priorities and the discipline we bring to stepping away from activities that aren't priorities. Chief among the activities we are downsizing is new store growth. We will open about 55 new stores in 2008, of which only about 35 will be in the United States.

We expect 2008 to be another challenging year in terms of the housing and home improvement markets. There is a substantial inventory of houses for sale, continued pressure on housing prices, uncertainties around credit availability, and concerns around the overall economy beyond the housing sector.

Throughout this year I have referenced the data on private residential construction as a percent of GDP. At this time last year it had fallen from 6.3% at the beginning of 2006 to 5.3%. The 60year average is 4.8%, which suggested that there was still room for the market to fall, and it did. It dropped another 110 basis points and now stands at 4.2%. So we are now below the historic mean. We probably still have room to go, and the historic troughs in this indicator suggest that is the case. But this gives us at least some cause for cautious optimism as we look out through 2008 and into 2009.

Carol will cover our 2008 guidance in more detail in a few minutes, but in summary, we expect continued negative comps in 2008, with sales decreasing 4% to 5% as compared to last year. We also expect negative comps in the mid to high single-digit range.

Since, as Carol has described, every point of negative comp drives about 20 basis points in operating profit deterioration and since we expect continued cost impacts from our private label credit card, our earnings per share will decline by approximately 19% to 24%.

I'd like to go back to a comment I made on my first earnings call a year ago. The Home Depot is a company built on a strong set of core values. We have hundreds of thousands of associates who understand those values, believe them and live them. They make a difference for our customers, for our communities and for each other every day. They love solving problems. They are passionate about helping others. I want to thank them for their dedication and hard work. They make this a truly special company.

Now let me turn the call over to Craig.

Craig Menear - Executive Vice President Merchandising

Thanks, Frank, and good morning, everyone.

Our Merchandising departmental sales reflect the softness in the home improvement market. For the year, every department experienced flat to negative sales growth compared to 2006, with those categories most closely associated with construction - like lumber, building materials, electrical and millwork - posting double-digit negative declines.

In the fourth quarter, we experienced negative sales growth in all departments except one. The department that outperformed the company's average comp were Seasonal, Plumbing, Paint and Hardware. The one department that experienced positive comp sales was Seasonal, driven by strong performance in Holiday, Fireplace, and Chemicals. Flooring performed at the company average.

The weakness in the quarter came from continued softness in big-ticket and construction categories. January was particularly soft. The pros went home for the holiday and didn't come back until the latter part of the month. Special order Kitchens, Windows, Roofing and Madic Fasteners all had double-digit sales declines across all regions in the country except the Southwest. Additionally, we saw continued commodity deflation which impacted Lumber and Building Material categories like Dimensional Lumber and Gypsum. The combination of softness in the big ticket and commodity deflation negatively impacted average ticket, which was down 2.3% from last year to $54.96.

While we saw pressure across the store, there was relative strength in Repair and Remodel categories. Fasteners, builder's hardware, plumbing repair, pipe, along with the associated tools needed to make repairs, performed above the company's average comp in all regions except the hardest hit areas of California, Florida and portions of the Northeast.

We saw strength in seasonal categories. Fireplace, Heaters, Power Equipment posted positive comps for the quarter in every region of the country except the more temperate climates such as in California and Florida. Additionally, Holiday posted double-digit comps across the country as a result of our enhanced assortment and increased values for our customers.

I've shared with you throughout the year that we're focused on merchandising fundamentals. While some of my comments will seem obvious, let me tell you what's been done in 2007 and what my senior leadership team and I will continue to focus on in 2008.

First, to ensure that we are in touch with our customer's needs, every merchant is required to walk our stores at least one day a week. The objective is for our merchants to use this time to speak with customers and associates to get direct feedback on their assortments and merchandising opportunities.

Second, we have constructed a weekly meeting where merchandising leadership and our regional merchants, together with Operations and supply chain leadership discuss upcoming events and operational issues. This creates a sense of urgency, quickly resolving issues normally by the end of the day, and it creates a collaborative ownership of results.

Third, we asked our IT and finance teams to provide improved tools to help merchants more effectively do their job. We don't have time to wait for core retail, a multi-year initiative, to provide these merchandising tools. Our technology team delivered an enhanced assortment tool that makes it easier for our merchants to assort to a market and even down to a specific store.

They also provided a new forecasting tool. The new forecasting tool is essential because speed in decision making is more critical than ever in this business environment. Enhanced forecasting is particularly important in our seasonal businesses. We used this improved forecasting for spring planning and feel good about having the right amount of product in our stores for our customers at the right time.

Fourth, I've asked our merchants to accelerate implementation of our focused bay approach, our belief that not all bays are created equal, which drives our investment decisions. In 2007, we exited Consumer Electronics. This year we plan to exit Pet and Halloween categories.

My team knows that they need to make the tough calls in driving resources back to core home improvement categories. Even within core home improvement categories, we need to accelerate decisions on line structure, introduction of innovative products, and communicating the value proposition to improve our assortment productivity.

These actions, along with other investments, have allowed us to narrow our share loss in 2007. Specifically, these actions have helped us drive improvements in several product categories, such as Power Tools, Soft Flooring, Paint and Seasonal.

While we have made progress in many product categories, there are still others where we continue to lose share, and this represents an opportunity for us going forward. For example, in 2008 we are confident that we will improve our business results in Lighting, Kitchens, Bath Fixtures and Hand Tools by focusing on the fundamentals and leveraging these new tools.

Our suppliers are key partners and I know that we will always negotiate over price, but we are in this to drive business together and we are driving a more collaborative planning process, doing a better job of sharing information, and working together on product innovation.

These merchandising processes and stronger, better partnerships better equip our merchants so that they can leverage our regional merchandising teams in the field and sharpen our local merchandising efforts.

For spring, I have some great products that I'm really excited about. We have a new exclusive charbroil grill with infrared technology ensuring even cooking and the ability to sear or slow cook with a range of temperatures from 250 to 800 degrees. It's also energy efficient and self-cleaning, with a touch of a button.

We are introducing new patio sets that bring affordable luxury to our customers. This year we introduced Thomasville to our line up, complimenting Hampton Bay, both of which are exclusive programs. Our sets start at $399 and include everything from rust-proof aluminium frames with hard surface tops to wicker and cast aluminium sets and indoor/outdoor wood.

We are also introducing an electric start gas trimmer under our exclusive Ryobi brand. The new touch-start trimmer is a very innovative product, and it's the only gas trimmer sold in the United States that can be started with the push of a button as opposed to the standard pull cord.

Finally, I want to highlight our new fresh air paint from ICI, which is the only true VOC - or volatile organic compound - free paint in the market. It is a trend-forward color palette of 65 colors inspired from nature, and it is the one of the only paint products that is Greenguard certified. It's truly odor free, which makes painting a much more pleasant experience.

2008 is going to be tough, but we have a strong merchandising team that will remain focused on merchandising fundamentals and delivering long-term value for our customers.

And now I'd like to turn the call over to Mark.

Mark Holifield, Senior Vice President Supply Chain

Thanks, Craig. Good morning, everyone.

First, I'll walk you through our supply chain accomplishments this year and then I'll outline our plans for 2008.

In 2007, we started transforming our supply chain so we could deliver on the priority of improved product availability or better in-stock for our customers. One of our first objectives was to complete a comprehensive review of our supply chain, its capabilities and its limitations.

In terms of capabilities, not too surprisingly we discovered that our biggest opportunity is to radically increase our central distribution penetration. This will allow us to manage our inventory much more effectively both for our regular replenishment inventory and for our seasonal and promotional products.

The existing Home Depot supply chain worked great for high-volume stores, which had no trouble making frequent orders to vendors for direct-store delivery to allow them good in-stocks and inventory turnover. But in lower-volume stores, without an effective central distribution network, our store associates are forced every day to make the tough choice of being out of stock or overstocked due to vendor minimum order quantities, long lead times, and unreliable replenishment.

Given this need for much more central distribution, we developed an end-state vision for what an ideal network would look like for The Home Depot in the United States. This distribution network strategy effort employed industry standard techniques to map and analyze all of our existing and forecasted network product flows all the way upstream from our suppliers and downstream to our stores and customers.

Through this effort, we developed an optimal distribution center network strategy model that we will continue to use to guide all of our network development decisions in the future.

A few of the highlights about the optimal network strategy: Our goals are first, to move from a central distribution penetration of about 20% of product flow measured by cost of goods sold to about 75% of product flow.

Second, to operate fast-flow distribution centers, with the capability to process faster-moving goods which we will call rapid-deployment centers or RDCs. The optimal distribution center, or DC network, would include more than 20 of these fast-flow RDC facilities. Optimally, more volume will pass through these fast-flow RDCs than through traditional DCs.

Third, to operate lumber in bulk DCs along with traditional stockandpick DCs as we do today.

So the biggest opportunity in front of us was to develop these RDCs and to move quickly as the gap from 20% of central distribution to 75% is obviously quite large.

Concurrent with our supply chain strategy efforts, having a general idea of where the end-state supply chain strategy would take us, we began to pilot these fast-flow capabilities in our existing distribution network. In late March of 2007 we kicked off an RDC pilot in Atlanta that included 67 Atlanta area stores and 20 vendors, converting part of an existing Home Depot operated DC in Braselton, Georgia to these fast-flow or RDC capabilities.

The results of the RDC pilot were better in-stock at the stores, reduced lead times, improved shipment integrity, and improved inventory turnover. We ramped up more stores and more vendors, and today the Atlanta area RDC served 99 stores and processes almost 100 Home Depot vendors' products through it. We continue to add vendors to the mix weekly.

So we now have a DC network strategy, a proven concept of operations as its cornerstone, and we have begun to roll it out. Our second RDC was opened in Chicago in January, and we are ramping up volume there now. When we open an RDC, if there is a transit facility nearby - as in Chicago  we will close it and incorporate those existing processes and freight flows into the new RDC.

The keys to executing this strategy are getting more RDC buildings open and operating effectively and on-boarding vendors to the program. We will have several more openings in 2008, and we have a major push on getting vendors on board. Our target is complete 2008 and enter 2009 with 40% of our U.S. stores receiving RDC service and 30% of those stores' product flow measured in cost of goods sold on the RDC program.

To get to the 40% of stores targeted this corresponds to opening about six additional facilities this year, ending 2008 with about eight RDCs given that each facility will serve about 100 stores.

Beyond 2008 we will continue to open RDCs until we have reached 100% of our U.S. stores. We will also continue to ramp up vendors through the RDCs, making progress toward the in-state goal of 75% central distribution. Keep in mind that while RDCs will ultimately make up about half of the total product flow, the 75% distribution target includes the existing lumber DCs and the traditional stockandpick DCs.

We expect to complete our RDC rollout in 2010. At this point we estimate the required capital investment to be about $260 million through 2010. We will keep you posted as we progress on this very exciting initiative. We think that long term it means lower supply chain cost, better in-stocks and higher inventory turns.

Another important objective in supply chain was to establish a world class team of supply chain professionals. I've been very pleased with the supply chain talent we have on board here at The Home Depot, and we have augmented that talent with some key leaders who will help us to deliver on our commitments.

In addition to Mark Huffman, Vice President of Inventory Planning and Replenishment, and John Deaton, Vice President of Supply Chain Development, let me highlight a couple of leaders who have joined us recently and are already making big impacts.

Charlie Armstrong is our VP of Distribution and joined us in October. Charlie has years of transformation experience in retail supply chain, working with Ward's, Melville, GARR Consulting Group, and others. Charlie is accountable for all DCs and their operations as we radically increase our central distribution capabilities and roll out the RDCs.

Additionally, we hired a new VP of Transportation, Michelle Livingston, who also joined in October. Michelle is a lifelong transportation professional. She came to us from C&S Wholesale Grocers, a large distributor to over 2,000 retail stores. Prior to C&S, Michelle worked with J.C. Penny as Vice President of Transportation and was there during their retail transformation, so she also has experience with the scope of our effort.

So in closing, we are very pleased with our progress and excited about 2008 and the future as we transform our supply chain to the benefit of our customers, associates and shareholders.

And now I'll turn the call over to Carol.

Carol B. Tome - Chief Financial Officer

Thank you, Mark, and hello, everyone.

There are a couple of items I'd like to mention before I cover our results. First, our fiscal year consisted of 53 weeks, so our fourth quarter results reflect 14 weeks of operations compared to 13 weeks last year.

Second, fiscal 2007 results include seven months of HD Supply as a discontinued operation. HD Supply operating results, including the impact of the sale of the business, are found on a line item entitled Earnings from Discontinued Operations.

In the fourth quarter, sales were $17.7 billion, a 1.5% increase from last year. For the year, our sales declined by 2.1% to $77.3 billion.

The 14th week in the fourth quarter added approximately $1.1 billion in sales to the quarter and the year. Excluding the sales impacts of the extra week, our fourth quarter sales declined by 4.7% and our fiscal year sales declined by 3.5%.

We reported earnings per share from continuing operations of $0.40 in the quarter, down 4.8% from last year and for fiscal 2007, earnings per share from continuing operations were $2.27, down 11% from last year.

The extra week increased earnings per share by approximately $.04 for the quarter and the year.

Consistent with our guidance, the slowing housing environment significantly impacted our comp sales, which were a negative 8.3% for the quarter. Consolidated same-store sales were negative 6.6% in November, negative 7.2% in December, and negative 10.8% in January. We do not include the extra week in our comp calculation. For the year, comp sales were negative 6.7%.

In the fourth quarter, our gross margin was 34.3%, an increase of 67 basis points from last year, reflecting 47 basis points of margin expansion due to lower deferred interest associated with our private label credit card, and 20 basis points of margin expansion due to a number of factors, including a change in the mix of products sold and less promotions in the quarter. For the year, our gross margin was 33.6% flat to last year.

In the fourth quarter, operating expenses increased by 197 basis points to 27.2% of sales. Our expense deleverage reflects the impact of negative sales, where for every point of negative comp we expect to deleverage expenses by about 20 basis points.

With a negative comp of roughly 8%, we would expect to report expense deleverage of 160 basis points. In the fourth quarter, we experienced an additional 37 basis points of expense deleverage due to several strategic business decisions, including the closing of our Tampa call center and write-offs associated with certain future store locations that we determined we will not open.

Further, as we anticipated, the gain share from our private label credit card program was less in the fourth quarter than last year. The year-over-year decline in gain share is about equal to severance we paid out in the fourth quarter of 2006.

For the year, operating expenses increased by 188 basis points to 24.3% of sales. Operating margin was 7.1% in the fourth quarter, down 130 basis points from last year. For fiscal 2007, operating margin was 9.4%, down 186 basis points compared to last year.

Diluted shares for the fourth quarter were 1.68 billion shares compared to 2 billion shares last year. The reduction in outstanding shares is due to our share repurchase program and includes the tender offer we completed in September. Since our share repurchase program began in 2002, we have repurchased a total of 743 million shares or 31% of our outstanding shares.

Moving to our operational metrics, during the fourth quarter we opened 26 new stores, including five relocations, for an ending store count of 2,234. At the end of the fourth quarter, selling square footage was 235 million, a 4.9% increase from last year. Reflecting the sales environment, total sales per square foot on a 14week basis were approximately $279 for the quarter, down 8.7% from last year, and for the year were $332, down roughly 7% from fiscal 2006.

Now turning to the balance sheet, at the end of the quarter retail inventory was $11.7 billion, up 4% from last year. On a per-store basis, inventory was flat to last year. Inventory turns were 4.2 times compared to 4.5 last year.

Computed on the average of beginning and ending, long-term debt and equity for the trailing four quarters, return on invested capital was approximately 14%, down 290 basis points from last year due to the decline in our operating profits. We ended the quarter with $44.3 billion in assets, including $457 million in cash and short-term investments. This is a decrease of approximately $160 million in cash and short-term investments from the end of fiscal 2006, reflecting cash generated by the business of approximately $6.2 billion, net proceeds from the sale of HD Supply of $8 billion, and commercial paper issuances of $1.7 billion offset by $10.8 billion paid for share repurchases, $3.6 billion of capital expenditures, and $1.7 billion of dividends.

As Frank mentioned, the home improvement market is very soft and it's difficult for us to know just where it will go in 2008. Our guidance reflects our best thinking at this point, and it's important to note that we have not factored into our thinking the impact of the economic stimulus package. We're going after our fair share, but we really don't know how the consumer is going to react in this environment.

We've detailed our guidance in our press release, so let me just hit the high points.

From fiscal 2007 reported results, we expect fiscal 2008 sales to decline by 4% to 5%, with negative comps in the mid to high single digit area. In the first three weeks of fiscal 2008, we are seeing mid single-digit negative comps, consistent with our plan.

For the year, we expect to open 55 new stores.

For fiscal 2008, we expect earnings per share from continuing operations to decline by 19% to 24%. Included in our earnings per share guidance is our view that gross margin expansion will be flat to slightly positive and that our operating margin will decline by 170 to 210 basis points as we expect expense deleverage due to negative comp sales and expense pressure from our private label credit card program.

Let me take a minute and comment on our private label credit card program. By way of background, we currently offer six products as part of our private label credit card portfolio which range from three consumer-oriented cards to three cards that serve our professional contractors.

As of the end of fiscal 2007, almost 30% of all sales tendered were tendered through the use of our private label cards. The cards are offered and administrated by a third party in a program that includes a profit sharing provision.

There are three main components of the program that impact the earnings statement.

First, deferred interest - we are charged a flat fee which we call deferred interest every time a customer uses one of our deferred financing programs like No Interest, No Payment for Six Months. This flat fee is treated by us as a cost of goods sold.

Second, interchange - we are charged a fee each time our pros use their card. It's like an interchange fee for VISA or American Express, and we treat this charge as an operating expense.

Third, gain share - this is our share of any profits in excess of a targeted turn. The portfolio has been much more profitable than the targeted return, so we've been enjoying a gain share which is treated as a reduction in operating expenses.

The sum of all three totals the total cost of credit. Since 2004, the total cost of credit as a percent of credit sales has dropped by over 100 basis points, and in 2007 was less than 1% of private label credit sales.

Under our credit agreement, the cost of credit can increase if the portfolio decreases in profitability. In fact, we project that the cost of credit will increase in 2008 and a major factor to this increase is less gain share due to higher losses in the portfolio. We believe the total cost of credit will reach 2% in 2008. While the year-over-year increase is large, 2% is in line with the cost of credit for traditional bank cards.

Now moving to capital allocation, our capital spending plan for 2008 is $2.3 billion, down 32% from what we spent in the retail business last year, primarily due to lower new store openings. Approximately 50% of our capital spending plan is for new stores and the remainder will be used to invest in our existing stores in support of our key initiatives.

Given that this is a transition year for our supply chain, we are not planning for any inventory turnover improvement, and given the sales environment, we may see slight deterioration in our turns.

Finally, I want to give you our latest thinking on our recapitalization plan. In 2007, we completed almost 50% of our $22.5 billion recapitalization plan. Late last year, we put the recap on pause given market conditions. 2008 is going to be another challenging year, and we think the prudent thing to do is to keep the program on pause until we see stabilization in our business and the credit markets.

So thank you for your participation in today's call, and Matt, we're ready and we'll be happy to take your questions.

Question-and-Answer Session

Thank you. (Operator Instructions) We'll go first to Steve Chick with J.P. Morgan.

Steve Chick - J.P. Morgan

Hi, thanks. Hey, I guess, Carol, first off, just in terms of the credit card, the 2% that the private label card will cost you in '08, I'm calculating that that's about $440 million or so. And I know you gave us what the numbers were for the second half of '07. Can you just give us what the - well, confirm if that absolute number is right and what the total increase will be year-over-year that you're projecting at this point?

Carol B. Tome - Chief Financial Officer

Steve, you're a little bit high on your analysis, and let me give you a bit more color on how to think about our private label credit card.

There are three aspects of the program that impact the earnings statement. If you think about deferred interest, that is treated by us as a cost of goods sold. Your year-over change is going to be very little. In fact, we'll have fewer credit promotions days in 2008, and we expect very little change in the cost of deferred interest.

As you come, then, to the selling and store operating expense line, clearly we'll have a lot less gain share than we had in 2007. I'm thinking that the amount of deleverage that we'll get year-over-year because of lower gain share is the amount of about 50 basis points.

Steve Chick - J.P. Morgan

Okay. Okay, so I just - so 50 basis points will be the portion within your selling and administrative expenses?

Carol B. Tome - Chief Financial Officer

Yeah. In the operating margin decline guidance that we gave of 170 to 210, there's as much as 50 related to the gain share.

Steve Chick - J.P. Morgan

Oh, okay. All right. Great, that helps. Now the second thing, you know, this quarter, you know, your comp gap with your competitor narrowed pretty nicely, and it looks like it was in the months - the last two months of the quarter. You know, are you - can you speak to that a little? I mean, is it, you know, maybe this quarter might have been kind of an anomaly, or do you really think that, you know, some of the cultural things and the things you're implementing at the store level are starting to gain traction relative to the marketplace?

Frank Blake - Chairman, Chief Executive Officer

You know, Steve, we - I guess the right way for us to think about it is not with respect to any one particular competitor but to think about it in terms of the market as a whole. As Craig said, we were pleased in some of the areas where we think we picked up share, but there are lots more opportunities out there for us to continue to gain share.

Steve Chick - J.P. Morgan

Okay, thanks. And last, a clarification point, if I could. Carol, the guidance for D&A, which I think you said is $1.9 billion, is that the D&A that's on the face of the P&L or is it the total depreciation and amortization that you disclose separately?

Carol B. Tome - Chief Financial Officer

It's the total depreciation and amortization that we disclose separately.

Steve Chick - J.P. Morgan

Okay, so that's $1.9 billion compared with 1.82?

Carol B. Tome - Chief Financial Officer

That's correct.

Steve Chick - J.P. Morgan

Okay. All right, great. Thank you.

Carol B. Tome - Chief Financial Officer

You're welcome.

Operator

We'll go next to Matthew Fassler with Goldman Sachs.

Matthew Fassler - Goldman, Sachs & Co.

Thanks a lot and good morning. I'd like to focus today primarily on distribution. If you could talk about the decision to go with the RDCs versus other distribution alternatives, the stock and fixed DCs specifically, what the cost difference is, and just sort of the thought process beyond that call.

Mark Holifield, Senior Vice President Supply Chain

Yeah, Matt, it's Mark Holifield.

On the decision to go to fast-flow as opposed to stock-and-pick, what I would point out is that we do have stock-and-pick distribution centers today that we use primarily for import products but also for domestic products. So we had capabilities in that arena already.

Given our gap of 20% to 75%, where we want to go, these fast-flow facilities are much simpler to set up, much smaller in general and much lower in capital investment, so we felt that this was the fastest way to make that acceleration from 20% to 75% central distribution penetration.

Matthew Fassler - Goldman, Sachs & Co.

And just one follow up - thank you for that, Mark - you know, Carol, you talked about the quarter-to-date same-store sales trends, you know, down mid-singles is a pretty sharp improvement from the numbers that you saw in January.

How would you characterize or what would you attribute it to, and how do you think about that in the context of your expectations for the rest of the year?

Carol B. Tome - Chief Financial Officer

Well, clearly we think the first half is going to be softer than the back half, as you can appreciate given the comps that we're up against. We did have a very, very strong President's Day weekend, and so that's obviously contributing to our year-to-date performance.

But as Craig pointed out in his comments, in January the pros - they went home for the holidays, and they just didn't come back. But we're starting to see them come back in our stores.

Matthew Fassler - Goldman, Sachs & Co.

Fair enough. Thanks so much.

Operator

We'll go next to Eric Bosshard with Cleveland Research.

Eric Bosshard - Cleveland Research

Good morning.

Frank Blake - Chairman, Chief Executive Officer

Morning.

Eric Bosshard - Cleveland Research

Two things I'd love to get some guidance on. First of all, in terms of the delta in Capex, Frank or Carol, can you talk about where the investment is changing in '08 relative to '07? I know you that indicated that store openings is an important [inaudible] with that, but where else is there delta taking place there?

Carol B. Tome - Chief Financial Officer

Sure. In 2008 we decided to spend $2.3 billion, which is down $1.1 billion from what we spent in the retail business in 2007. $900 million of that is directly related to new store openings, so that's the biggest change. The remainder decline is in areas where we spent money that we don't need to spend in 2008. For example, we put radio call boxes in our stores in 2007. We don't need to repeat that in 2008.

We're being very judicious on our merchandising resets. As Craig mentioned, we are accelerating merchandising resets that assist the product line review process, but for those major transformation resets, we're pulling back on those a bit because we think that makes the most sense for the business.

Eric Bosshard - Cleveland Research

Great. And then secondly, for Craig, can you comment about what you're seeing in terms of sourcing costs, specifically your direct import program - if you're seeing the influence of Chinese inflation and how you can react or respond to that?

Craig Menear - Executive Vice President Merchandising

Yeah, certainly, Eric. No question that there is cost pressure in the market as a result of the taxation change in China. We're working hard with our suppliers to try to offset those costs wherever possible. We have, you know, taken some and in other cases we've been able to work with them to offset costs and forego that.

So there is pressure there, but at this point it's not something that we don't feel is unmanageable.

Eric Bosshard - Cleveland Research

Great. Very good. Thank you.

Operator

We'll go to Danielle Fox with Merrill Lynch.

Danielle Fox - Merrill Lynch

Thanks. Good morning. Could you talk a little bit more about the financial impact from the rollout of this optimal supply chain strategy? Should it be earnings dilutive, neutral or accretive over, you know, the next few years?

And on a related note, how do you manage the potential for disruption as you make major changes to your distribution network?

Thanks.

Carol B. Tome - Chief Financial Officer

Danielle, on the financial impact, as you can appreciate, as we're rolling this out it will be earnings dilutive, and it's included in the guidance that we gave you for 2008. As Mark mentioned, we expect to be fully functioning in 2010, and that's when we'll see the economic benefit starting to flow through in terms of lower supply chain costs and higher inventory turns.

On the disruption, we are planning for that. Mark, you might want to comment.

Mark Holifield, Senior Vice President Supply Chain

Yeah. I think we roll these out over the course of about three or four months as they open up and get to full volume. We have learned a lot from the Braselton test, and we learn each time we're going. You know, we're working very closely with the stores to ensure that our store partners understand the process. And, you know, I won't say we've perfected the program, but through the Braselton pilot, we've stumbled across just about everything we can stumble across and we believe we'll have a good rollout going forward.

Danielle Fox - Merrill Lynch

Okay. Thank you.

Operator

We'll go next to Todd Duvick with Bank of America.

Todd Duvick - Bank of America

Good morning. I had a quick question for you, and I appreciate the comments on the recapitalization program. I'm just wondering if you can tell us if that precludes any opportunistic share repurchases as we go throughout the year until you do feel the time is right for the recapitalization program?

Carol B. Tome - Chief Financial Officer

Well, what we've said all along is that we will use our excess cash to return capital to our shareholders through share repurchases. As you can see by looking at our balance sheet, we don't have any. We have $1.7 billion of outstanding commercial paper, and we need to run the business with about $500 to $1 billion of cash.

So we anticipate based on the guidance that we gave that we will be in the commercial paper market in 2008.

Todd Duvick - Bank of America

Okay. But in terms of any large debt issuance, you're just going to kind of wait and see when the business improves, and following that, you're going to plan to finish the transformation program?

Carol B. Tome - Chief Financial Officer

Yeah, we are committed to the recapitalization program, but given our business as well as the conditions of the credit markets, we think it's prudent to pause.

Todd Duvick - Bank of America

Okay. Thank you very much.

Carol B. Tome - Chief Financial Officer

You're welcome.

Operator

We'll go to David Schick with Stifel Nicolaus.

David Schick - Stifel Nicolaus & Company

Hi. Good morning. A question, really, I guess for Mark.

If you think out maybe five years - and I know it's just 90 days of data on Braselton and Chicago - but you think about product costs and gross margin versus sort of inventory turns or driving comps or product availability, can you rank order that opportunity or at least, you know, talk about what's bigger and what's smaller in those opportunities?

Mark Holifield, Senior Vice President Supply Chain

Yeah. I would point out that we have almost a year of experience with the Braselton RDC. As I said, we opened that in late March of '07 so we've got a fair amount of information on that and experience with that.

In terms of the business case for RDC, it's really based upon logistics costs, which we expect to lower through improved transportation and handling, improve inventory turnover through a better allocation process and lowering the lead time and the amount of time it takes for products to travel to stores from the vendors, and improved in-stocks leading to greater sales through the process of lowering the lead time and improving the responsiveness to inventory changes in the store.

In rank order, it's kind of tough, I think. Logistics cost is very clear. You can measure that very clearly. Inventory turns, there's a whole lot of things that impact inventory turns, so it's a little bit tougher to point to a specific benefit there because there's a lot of moving parts; same thing with in-stock. But we do expect all three of those to improve greatly as we roll these out.

Carol B. Tome - Chief Financial Officer

But if you love cash, one full turn improvement in inventory is over $1.5 billion of cash. So Mark, I don't know about you, but I'd put that high on the priority list.

Mark Holifield, Senior Vice President Supply Chain

Yes.

David Schick - Stifel Nicolaus & Company

Thanks a lot.

Operator

We'll go to Budd Bugatch with Raymond James.

Budd Bugatch - Raymond James

Good morning. Just a couple of quick questions.

Carol, in the past you've given us the 5% change in sales begets a 10% change in EPS and the 20 basis points to operating margin for every 100 basis points of change in comps. Do those still hold? Do those still hold for the long term, with the exception of the credit cost issue that you had this year?

Carol B. Tome - Chief Financial Officer

Right. Excluding the private label card portfolio, we think our rule of thumb of 20 basis points of deleverage for every point of negative comp holds.

I think that would change in an environment if we were at pro-loan double-digit negative. We're not there. But clearly, we have minimum staffing levels in our stores that we need to be sensitive to.

But we've modeled this, and we're comfortable with the guidance that we've given.

Budd Bugatch - Raymond James

Okay. And Mark, for you, I'm just a little confused on the difference between the fast-flow facilities of Braselton and what you had - I think you had 10 transit facilities that also served about 100 stores each, if I remember right - and can you give us a difference of what's - what's the difference between those two physically and maybe operationally?

Mark Holifield, Senior Vice President Supply Chain

Sure, Budd.

The transit facilities, the easiest way to think about those is they're really more of an in-house LTL dock - a less than truckload freight handling dock.

We place an order that's a store-level order direct to the store, and it simply passes through the transit facility where it's aggregated with other store-level orders going direct to the store. So it's really - the easiest way to think about it is in-house LTL dock.

Budd Bugatch - Raymond James

Right.

Mark Holifield, Senior Vice President Supply Chain

An RDC is different than that. We place a DC-level order, a single order, for the 100 stores, so we reduce the number of purchase orders that we send to the vendor by 99%, we reduce the number of orders that he has to pick by 99%, and we reduce the number of shipments by the same amount.

So it's a single bulk shipment into the RDC, and at the RDC, then, we break that down by store and use the information we have on inventory at that point - what's needed in each store - to allocate what's needed to the store.

So it's more handling in the RDC, but we gain benefit in terms of the in-stock and inventory turn. And as we roll vendors on this, we work with them to take the costs out that they're saving in terms of fewer orders to process.

Budd Bugatch - Raymond James

Got you. Okay, thank you very much.

Operator

We'll go to Chris Horvers with Bear Stearns.

Chris Horvers - Bear Stearns

Chris Horvers from Bear Stearns.

Carol B. Tome - Chief Financial Officer

Hi, Chris.

Chris Horvers - Bear Stearns

Stepping back on square footage growth, you cut back the growth this year. Can you talk about how you're thinking about longer term - what your longer-term square footage growth be, how many stores you might think about in 2009 and 2010, domestic versus international?

Frank Blake - Chairman, Chief Executive Officer

Well, first let me take the domestic side, Chris.

You know, we've said for awhile that you should look at our new square footage growth as pretty much matching the market. And so obviously, as the market growth has come down, then our plans going forward on new square footage growth is coming down.

So I would not expect, you know, at least within our planning horizon much change from what we're going to do in 2008 and if there were a change, it would probably be slightly decremented, not going up.

Internationally, we continue to see opportunities in Mexico. You know, we really haven't even started to roll out China. We've stayed with the initial dozen stores from a year ago, just working through that business model. So we haven't really even put on the table yet what's a new store growth plan for China.

Chris Horvers - Bear Stearns

Okay. That's very helpful. Frank, in prior conference calls you've talked about your relative market share gain or loss versus the market and how you saw some improvement. I'm not sure if I missed it. Could you review that?

Frank Blake - Chairman, Chief Executive Officer

Yeah, and I think Craig mentioned it just in passing.

The way we look at is we think we've still lost share to the market. We think we've  I don't want to do a double negative here, but we've reversed the rate of our decline, so it's improving. But we don't see in our performance now that we're picking up share to the market yet.

We feel like we're on that trajectory, but we're not there yet.

Chris Horvers - Bear Stearns

Do you have the '07 versus '06, what the numbers were by chance?

Frank Blake - Chairman, Chief Executive Officer

I don't off the top of my head.

And truly - we can get that back to you - ballpark, I'm remembering we've kind of cut it in half, the rate of decline, something like that.

Diane Dayhoff - Senior Vice President of Investor Relations

Chris, this is Diane. I'll get back to you with that.

Chris Horvers - Bear Stearns

Okay. And then finally, Craig, can you talk a little bit about trends in the Appliance category? You didn't really call it out. How do you feel you're making progress there, and how do you look at that from a market share perspective?

Craig Menear - Executive Vice President Merchandising

We improved our share in the quarter again from 10.8% to 11.8%. So we had a positive gain in the quarter.

The industry in total is contracting, but we still feel that, you know, based on the share information, that our assortment and line up is something that the customer's responding very positively to.

Chris Horvers - Bear Stearns

Excellent. Thank you very much.

Diane Dayhoff - Senior Vice President of Investor Relations

Matt, we have time for one more question.

Operator

We'll take our final question from Gregory Melich with Morgan Stanley.

Gregory Melich - Morgan Stanley

Hi, thanks. I had a couple questions.

One, on the credit, Carol, you mentioned that you thought it was 50 bps of hit this year. Now is that where essentially it's no longer making money for you, or in '09, if credit continued to deteriorate, could it go further? In other words, how profit making is this credit overall?

And then a follow up on distribution.

Carol B. Tome - Chief Financial Officer

Well, remember, there's always a cost to credit. While we share in the profitability of credit, when you add it all up there's always a cost. The cost has been declining. It's now less than 1% of sales. It will increase, we believe, to 2% of sales. It all depends on the profitability of the portfolio.

Could it go higher? Yes. It really depends on what happens within the portfolio.

We have stress tested this and put it through the wringer, and we don't think it could get any higher than 4%. And we're certainly not predicting that.

But, you know, we said bankruptcies jump and delinquencies increase and we stressed it and went into a prolonged recession scenario, and that's the output of that analysis.

Gregory Melich - Morgan Stanley

And that compares to the 2% you talked about this year?

Carol B. Tome - Chief Financial Officer

Yeah, 2% for 2008, yeah.

Gregory Melich - Morgan Stanley

Right. And then the second is on distribution. Like, Mark, you gave the number of $200-some million for Capex. I assume you're - are you leasing these DCs, and if you are, what is the cost for that? What would be the implied cost?

Mark Holifield, Senior Vice President Supply Chain

Yeah. The number's $260 million. That does not include the land and equipment - excuse me, the land and building; we lease those. That includes our leasehold improvements and our systems that go into it.

Carol B. Tome - Chief Financial Officer

The lease costs are included in the guidance that we gave you. As you can appreciate, the locations of these facilities are not the same as our stores, where we seek for A-related real estate. These are in C locations, so the rent expense is very reasonable.

Gregory Melich - Morgan Stanley

Okay. So the number, you would say, if you were to add all those lease costs, it's not billions?

Carol B. Tome - Chief Financial Officer

Oh, no, sir. No.

Gregory Melich - Morgan Stanley

Okay. And on that, as you get these DCs rolled out, does it increase your likelihood  and Frank, in terms of doing the stores three or four years from now  to go into more rural markets or to do more in-fills, or is that really not the purpose of the exercise?

Frank Blake - Chairman, Chief Executive Officer

That isn't really the purpose of the exercise, but for sure it could be the case that our improved distribution network could facilitate different stores than we have now.

But that really isn't the purpose, and that's not what we're looking to it to do.

Gregory Melich - Morgan Stanley

Great. Thanks.

Diane Dayhoff - Senior Vice President of Investor Relations

Well, thank you, everyone, for joining us today. We look forward to talking to you next quarter.

Operator

And that does conclude today's call. Again, thank you for your participation. Have a good day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: The Home Depot, Inc. F4Q07 (Qtr End 02/03/08) Earnings Call Transcript
This Transcript
All Transcripts