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

The Home Depot, Inc. (NYSE:HD)

F2Q08 Earnings Call

August 19, 2008 9:00 am ET

Executives

Diane Dayhoff - Senior Vice President, Investor Relations

Frank Blake - Chairman, Chief Executive Officer

Craig Menear - Senior Vice President, Merchandising

Carol B. Tome - Chief Financial Officer, Executive Vice President Corporate Services

Mark Holifield - Senior Vice President, Supply Chain

Analysts

Daniel Binder - Jefferies

Christopher Horvers - J.P. Morgan

Mitchell Kaiser - Piper Jaffray

Budd Bugatch - Raymond James

Matthew Fassler - Goldman Sachs

Colin McGranahan - Sanford C. Bernstein

Michael Lasser - Lehman Brothers

David Strasser - Banc of America Securities

Eric Bosshard - Cleveland Research

Gregory Melich - Morgan Stanley

Operator

Good day, everyone and welcome to today’s Home Depot second 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, Madam.

Diane Dayhoff

Thank you, Augusta and good morning to everyone. Joining us on our call today are Frank Blake, Chairman and CEO of The Home Depot; Craig Menear, Executive Vice President of Merchandising; and Carol Tome, Chief Financial Officer and Executive Vice President, Corporate Services.

Following our prepared remarks, the call will be open for analyst 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 homepage and the investor relations section. The replay will also be available on our site. If we are unable to get to your question this morning during the call, please call our investor relations department at 770-384-2387.

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 Blake.

Frank Blake

Thank you, Diane and good morning, everyone. Sales for the second quarter were $21 billion, down 5.4%. Comp sales were negative 7.9%. As Carol will describe, sales for the quarter were negatively impacted by about $160 million because of the seasonal shift associated with 53 weeks in fiscal 2007. Adjusting for that, comp sales were negative 7.2%. Diluted earnings per share were $0.71.

I think you all are well aware of the difficult environment in the housing and home improvement markets, so what I would like to do is discuss the areas where we are focused on for execution and give you a sense of the progress we are making and the ground we still have to cover.

For the past 18 months, we’ve been working on our five key priorities -- associate engagement, shopping environment, product excitement, product availability, and own the pro. I won’t go through each of these but I’ll highlight some of the key items.

On the product and merchandising side of the business, we have made significant progress. We have had better execution across the board. Craig and his team are implementing a portfolio approach to our merchandising efforts and this is already providing significant benefits.

In a time of increasing price pressure, they are managing through the areas where we need to protect critical price points for our customers and at the same time, they are addressing areas where we need to recognize the cost increases that some of our vendors are facing.

We are also managing our seasonal business more effectively. This allows us to redirect funds that would have been used in margin dollar eroding promotions and instead drive more coherent, better price points for our customers.

On product availability or supply chain, we have three rapid deployment centers or RDCs serving 300 stores. Although our current RDCs are meeting or beating most of the measurements of performance that we set out for them, we believe that full rollout will be more effective when we’ve improved some of the key processes in the facilities. That is what we have been focused on over the last 90 days.

Obviously we’d have preferred to keep to our initial rollout plan and to have hit no bumps in the road but this is a bump, not a detour. It impacts the timing in 2008 but not our overall timing. We remain committed to our RDC rollout strategy.

Our core retail pilot in Canada is now live in 36 stores with 20 coming online yesterday. It is going well and remains on track to be completed in all Canadian stores by year-end. Most important, we continue to make progress with customer satisfaction, whether we measure that through our voice of the customer surveys or through other third-party measurements.

One additional indicator that we’ve looked at is something known as the net promoter score. The net promoter score looks at the percentage of customers who rate their shopping experience as nine or a 10 and subtracts from that the percent of customers who rate the experience as a six or worse. The theory behind this is that the best way to grow is to get more customers who are promoters and fewer who are detractors.

Our net promoter score has improved 480 basis points year over year and is now at 52.9%. Industry benchmarks say the best-in-class retailers have net promoter scores of over 50%.

We still have a great deal of room to improve but it is encouraging that the investments we are making in the business are starting to make a discernible impact with our customers.

On share performance, we have stabilized our share loss rate but we have not yet turned the corner on total share gain. Of the 13 major categories we look at, we believe we gained share in five but in some of the categories where we lost share, flooring, for example, we believe that we will reverse that loss in the remainder of the year. Long-term, we believe there’s a benefit to our customers and our shareholders in driving to a compelling everyday value proposition, even if there are short-term share fluctuations.

As we look forward into the second half of the year, we see continued pressure in our markets. Housing and home improvement spend as a percent of GDP is now at 3.5% versus a 60-year historical average of 4.75%. From this data point on its own, you could foresee a near-term bottoming of the housing market but there are also pressures on the consumer from constriction of credit availability and increased costs of basic goods, so we remain cautious about our market in the back half of this year and into the first half of 2009.

From our own results, we see modest improvement in some of our markets. For example, we look at the percent of our top 40 markets that have positively comped in the quarter. In the third quarter of 2007, 20% of our top 40 markets positively comped. In the fourth quarter of last year, that percentage was 12.5%. In the first quarter of this year, the number was zero.

This past quarter, the number improved to 7.5% and two-thirds of our top 40 markets had better comp performance in the second quarter than the first. That is good news directionally. But some of that is undoubtedly due to the economic stimulus in the second quarter and may not be sustainable. It’s also important to bear in mind that our guidance assumes modest improved comp performance though still negative through the back half of the year, if only because of the easier comparisons from the back half of 2007 and 2006.

One of the positives we see in 2009, as Carol will discuss shortly, is the renegotiation of our credit contract. We have finalized a new deal with Citi that will reduce the volatility in our cost of credit.

On the international side of our business, Mexico remains very strong. It has posted double-digit positive comps for the 15th straight quarter. That is an outstanding record and is a testament to Ricardo Saldivar and our great associates in Mexico.

Canada’s performance was also solid though some of the economic ills of the United States have impacted them and they have posted low-single-digit negative comps. They were particularly affected in the areas impacted by the auto industry and the slowing economy in the Western provinces.

In China, we saw positive double-digit comp growth.

In that context, I would like to recognize our 37 associates competing in the Olympic and Paralympic Games this summer. We have men and women from across the business competing in everything from track and field to rowing and cycling. We are very proud of these associates, as we are very proud and grateful to all of our associates. We are transforming this business in the midst of a very difficult environment. We are investing in the core, betting controlling our operational and merchandising processes, and seeing significant improvement in customer service, all through the hard work and focus of our 300,000 plus associates.

We recognize our associates through a program called success sharing. At the end of the first half, 75% of our stores were eligible for success sharing and I am very pleased that we will be issuing success sharing checks in excess of $40 million, both company records.

Now let me turn the call over to Craig.

Craig Menear

Thanks, Frank and good morning, everyone. In the second quarter, all selling departments reported negative comps. Plumbing outperformed the company’s average comp and seasonal and kitchen and bath were at the company’s average comp. Lumber, building materials, hardware, flooring, paint, electrical, and millwork were all below the company’s average comp and with the softness in these project businesses, average ticket was down 1.2% from last year to $57.58.

Total company transactions were $361 million, down 4.2% from last year. Transactions in the $600-plus range comped down double-digit while transactions of less than $25 were down single digits.

Regionally, we saw positive comp sales in the Southwest region, with every department in that region outperforming the company average. The Northern Plains region, while still negative, outperformed the company average comp in part due to the floods that affected the Midwest in July. While these areas are performing well, we continue to see double-digit negative comps in California and Florida markets for the fifth consecutive quarter.

Despite the challenging environment in the second quarter, I am particularly proud of our execution. We focused on controlling what we could control. We managed our business by continuing to implement our focus bay approach, where every category has a specific role and intent, driving assortment, pricing, and marketing decisions. This, along with the better tools that we developed this year allowed us to tightly manage inventory and gross margin dollars during the quarter.

For example, with our forecasting tool, we’ve gone from forecasting sales, margin and inventory for 13 departments on a monthly basis to forecasting 200 classes on a weekly basis.

This type of insight helps us make better decisions with greater speed, which is invaluable when every dollar counts during these challenging times.

In addition, this quarter we continued to reduce promotions. We were less promotional overall compared to last year and consciously focused on eliminating margin eroding promotions. This is important as our customers are looking for great value every day and we want to simplify their shopping experience.

We have continued to see cost pressure in the quarter from price inflation in products that are metal and petroleum based. Our approach in dealing with this remains consistent. Each request is being handled individually with each supplier, since every situation is unique. Our pricing philosophy is to provide everyday great value and our retail pricing is set based on what the market will bear in conjunction with our focus bay approach, not cost.

Our improved execution through our merchandising transformation helped us offset the impact from cost pressure in the market during the quarter.

Despite the calendar shift, we saw solid sales in inventory performance in our seasonal businesses as a result of enhanced assortment planning at store level and tighter inventory management. Working with our new merchandising tools and our logistics partners, we planned and executed well in these businesses. For example, our home comfort categories experienced double-digit positive comp growth. Sales of air conditioning units and fans were up significantly as a result of the early hot summer experienced across much of the United States and we were able to respond effectively.

To put this in perspective, for the first half of the year our top seasonal classes, sales, gross margin dollars, and inventory productivity each performed two times better than the company average.

An area of relative strength remains basic repair. Customers are spending to maintain their homes. For example, in plumbing every major repair class in that department performed above the company average. We saw unit share gains against the market in several categories, including roofing, toilets, hardware, power tools and accessories, and electrical on a rolling 12 months, and all of these categories are essential to basic repair.

Additionally, we know that customers are value conscious and some customers are shifting their buying patterns to more opening price point products. We benefited by responding to our customers’ needs and added more opening price point products to our assortments during the quarter.

Energy efficient products also performed well this quarter. In anticipation of high energy costs later this year, consumers are focused on energy conservation and we are already seeing customers begin to respond to these challenges by preparing their homes with these products. This is a trend we expect to continue in the third quarter. Products such as weather stripping, caulk, CFL light-bulbs, air circulation, pipe insulation, all performed well and in the Northeast, we are already seeing strong sales in our fireplace category as customers are stocking up on pellet fuel before the cold weather arrives.

As we head into the back half of the year, we are going to continue to pay attention to the trends in energy conservation as consumers further prepare to offset rising energy costs. We are introducing several new products, including the exclusive EcoSmart dimmable CFL light bulbs, water sense water saving faucets and toilets, and an innovative wall flush mount programmable thermostat from [Right Town]. In addition, we will continue to relevant Energy Star products, such as appliances, windows, furnaces, and water heaters.

2008 is going to continue to be challenging but the merchandising organization will remain focused on driving everyday great value for our customers using our enhanced merchandising tools and our focus bay approach.

And now I would like to turn the call over to Carol.

Carol B. Tome

Thank you, Craig and good morning. In the second quarter, sales were $21 billion, a 5.4% decrease from last year, reflecting negative same-store sales of 7.9%, offset in part by sales from new stores. Earnings were $1.2 billion compared to $1.6 billion last year. Earnings per diluted share from continuing operations were $0.71 versus $0.77 last year.

Comps or same-store sales were a negative 7.9% for the quarter, with negative comps up 7.3% in May and negative 8.1% in each of June and July. Our comp sales were slightly higher than our plan, reflecting we believe some benefit arising from the economic stimulus package.

In 2007, we had 53 weeks in the year. This shifted our 2008 fiscal calendar. Because of this shift, and given the seasonal nature of our business, second quarter sales on a like-for-like calendar basis were negatively impacted by approximately $160 million. Excluding the calendar shift, our like-for-like comp for the quarter was negative 7.2%.

In the second quarter, our gross margin was 33.2%, an increase of nine basis points from last year. Our gross margin reflects higher supply chain costs that negatively impacted gross margin by 18 basis points.

As Craig mentioned, our gross margin expansion reflects better merchandising execution across all stores and this drove 23 basis points of margin expansion. And we had some benefit from running fewer credit promotions in the quarter, and that added four basis points to our gross margin.

In the second quarter, operating expenses increased by 188 basis points to 23.4% of sales. In the second quarter, we recorded an $18 million charge related to the store rationalization decisions that we announced in the first quarter. Excluding the store rationalization charge, we deleveraged expenses by 179 basis points in the quarter. Our expense deleverage reflects for the most part the impact of negative sales.

Generally, we expect to deleverage expenses by about 20 basis points for every point of negative comp. In the second quarter, our expense deleverage per point of negative comp was closer to 13 basis points as we experienced favorability in expense categories like advertising, medical, and workers compensation, among others.

Further, as expected, in the second quarter we experienced about 73 basis points of expense deleverage due to a higher cost of credit associated with our private label credit card. And while we are on credit, let me comment on our private label agreement. Last week, we executed a new contract with Citi, our third party service provider. The contract will go into effect on January 1st of 2009 and run through January 2017. We are very pleased with the terms and conditions of this agreement. We are moving from a profit sharing agreement to a fixed fee agreement with some upside opportunity .

Effectively, the new agreement removes the volatility in our cost of credit and puts a cap on our cost. We are estimating that our future cost of credit as a percent of private label credit sales will be in the 1% area and in no event will it exceed 1.5% in any one year.

We will also receive an up-front cash payment of $220 million, which will be recognized as income over the life of the contract.

Now, our operating margin was 9.7% in the second quarter, down 180 basis points from last year. Net interest expense was $157 million in the second quarter, up $12 million from last year, reflecting a decline in interest income due to lower investable cash balances, offset in part by lower interest expense arising from a favorable tax settlement. In the second quarter, we had a favorable settlement with the Province of Quebec, the result of which reduced interest expense by $20 million and tax expense by $8 million.

In the second quarter, our income tax provision rate was 36.2%, due primarily do the favorable tax settlement, as well as lower state and foreign effective tax rates. We expect our tax rate to be approximately 36.4% for the year.

Diluted shares for the second quarter were 1.69 billion shares, compared to 1.97 billion shares last year. The reduction in our outstanding shares is due to our share repurchase program and includes the tender offer we completed last September. We didn’t repurchase any shares during the second quarter, and as we have discussed, we plan to complete our debt financed recap once the market stabilizes but in the meantime, we may use excess liquidity to repurchase shares.

Now, moving to our operational metrics, during the second quarter we opened 15 new stores, including one relocation and as planned, closed 15 stores for an ending store count of 2,257. Today, 251 stores, representing approximately 11% of our store base, operate in Canada, Mexico, and China.

At the end of the second quarter, selling square footage was 237 million, a 3% increase from last year. Reflecting the sales environment, total sales per square foot were approximately $350 for the quarter, down 8.6% from last year.

Now, turning to the balance sheet, at the end of the quarter, retail inventory was $11.9 billion, down 3.4% from last year. On a per store basis, inventory was down 5.9%. Our merchandising, supply chain, and operating groups have all worked hard to manage inventory while maintaining high in-stock rates and their efforts paid off. But based on the sales environment, our inventory turnover was 4.3 times compared to 4.6 times last year.

Computed on the average of beginning and ending long-term debt and equity for the trailing four quarters, return on invested capital for continuing operations was approximately 10.7% but excluding the store rationalization charge, return on invested capital was 11.6%, down 210 basis points from last year.

We ended the quarter with $45.1 billion in assets, including $1.1 billion in cash and short-term investments. This is an increase of approximately $605 million in cash and short-term investments from the end of fiscal 2007, and it reflects cash flow generated by the business of approximately $4 billion, offset by $960 million of capital expenditures, $760 million of dividends paid, and $1.7 billion used to repay outstanding commercial paper.

In June, we told you that our 2008 capital spending plan was $2.2 billion. We now believe that 2008 capital expenditures will be $2 billion, primarily as a result of the timing of 2009 new store openings. As of the first half of 2008, we have spent 48% of our $2 billion forecast.

Relative to our plan, we had a solid second quarter. Our financial results reflect a company that is managing its business in a difficult environment. The economic environment remains very challenging. Based on our first half results and our view of the back half, we believe that fiscal 2008 sales will decline by approximately 5% and fiscal 2008 earnings per share from continuing operations will decline by approximately 24%, consistent with the low end of our previous guidance.

Now please note that our 2008 earnings per share guidance does not include the store rationalization charge.

Thank you for your participation in today’s call and Augusta, we are now ready for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Daniel Binder with Jefferies has our first question.

Daniel Binder - Jefferies

I was wondering -- could you give us a rough idea of what you think the tax rebate stimulus may have done for your sales in the quarter, either in dollars or on a growth rate basis? And then also, if you could quantify the benefits you think you may have seen from the Midwest recovery efforts due to the floods.

Frank Blake

First on the tax rebates, this is -- we don’t have a clear line of sight into it but I will give you kind of the ballpark of how we look at it, and this is -- we look at the $500 million plus shift in the first quarter, the $160 million shift in the second quarter, one to the negative, one to the positive, go okay, there’s $400 million there and we think about three-quarters of it, so $300 million is probably related to the stimulus package.

And in terms of the impact on the Midwest, that’s really -- it’s at a level of immateriality, probably around $10 million.

Daniel Binder - Jefferies

Okay, and then two other questions -- what was the contribution from international on the total comp store sales? And then, can you just remind us, Carol, what the cost of credit is this year so we can kind of figure out what the year-over-year benefit should be next year when you come down to something closer to 1%?

Frank Blake

So international was around 140 basis points. Carol, on the credit.

Carol B. Tome

And the cost of credit we estimate this year will be in the 2% area.

Daniel Binder - Jefferies

And do you think next year will be closer to the 1 or the 1.5?

Carol B. Tome

We’ll give you a better idea as we get into the year.

Daniel Binder - Jefferies

Okay. Thanks, I appreciate it.

Operator

Our next question will come from Christopher Horvers of J.P. Morgan.

Christopher Horvers - J.P. Morgan

Thank you and good morning. Can you talk about -- you know, it seems like it was a really good seasonal year here. You had stimulus checks, you had the weather drought recovery. Is there a way to look at your comps and say well, in the third quarter, if every category comped the same, how would your total comp change, given the mix change, ballpark?

Frank Blake

Every quarter has a different profile in terms of some categories go down, obviously seasonal goes down a little bit in the third quarter and other categories go up. So I’m not quite sure how to get a handle on your question of what -- Craig, do you want to give a shot at how that might look?

Craig Menear

If you think about just the garden business, for example, there the penetration actually shifts from slightly over 21% to slightly over 13% but at the same time, then you have things like fireplace that comes up, other seasonal businesses that actually kick in. So I don’t know that I can give you an exact number but there is certainly a change as a result of just the penetration of our garden business in the back half of the year.

Frank Blake

Is that helpful to you? I’m not sure we’re answering your question.

Christopher Horvers - J.P. Morgan

Yeah, it is. I mean, maybe if you could say -- if you think about everything you do in your backyard in the early Spring to early Summer, any sense on how those categories comped relative to the rest of the mix?

Craig Menear

Those categories actually performed above the company average in the quarter. Overall, as I mentioned, when we look at our core seasonal businesses for the entire season, the first half, if you will, they actually were two times better than the company average and we were certainly above what we anticipated in the quarter for those businesses. We actually exceeded our plans.

Christopher Horvers - J.P. Morgan

Okay, that’s very helpful. And then just one follow-up -- Carol, how should we think about the rest of the shift unwinding, the -- what was it, 290 basis points in 1Q, saw about 70 basis points in 2Q -- how does that play out in the back half, do you think?

Carol B. Tome

It should be negligible. Most of the shift is behind us, just because of the nature of our seasons, as you were just pointing out.

Christopher Horvers - J.P. Morgan

Okay. Thank you very much.

Operator

Mitch Kaiser with Piper Jaffray has our next question.

Mitchell Kaiser - Piper Jaffray

Good morning. I was hoping you could give us a little more detail on what you are going to do on the processes around the RDC, and then maybe what we need to see before -- I think overall you were taking that to 20 over time. If you could just give us a little more color on that, that would be helpful. Thanks.

Frank Blake

Sure, you bet, and we’ve got Mark Holifield here in the room, so I’ll turn that question over to Mark to address.

Mark Holifield

Good morning, everyone. Yes, we are slowing our 2008 openings but we feel we are on track for a 2010 completion where we would serve 100% of our stores. Our focus at this point is really ensuring a seamless rollout going forward, doing the right thing for our stores and our customers. The key things that we are focused on -- improving the in-stock at the stores, we’re pleased with where we are there. The RDCs have improved the in-stock for the SKUs that are covered by RDC. We’re improving our accuracy of shipments, the quality of timeliness -- and quality and timeliness of loads delivered to our stores and then our throughput productivity, and those are the things we are focused on as we go forward.

I would expect to see one or two openings between now and the end of our fiscal year.

Mitchell Kaiser - Piper Jaffray

Okay, and I think you’ve said a goal that 75% of your COGS will go through either the lumber DCs, stocking DCs, or RDCs -- is that still consistent with that you are looking for over time?

Mark Holifield

Yes, our end goal is to have 70% to 80% of goods covered through central distribution. Keep in mind though that that includes, as you’ve said, other DCs besides RDCs to get there.

Mitchell Kaiser - Piper Jaffray

Okay. Thanks, guys. Good luck.

Operator

Thank you. We’ll go next to Budd Bugatch with Raymond James.

Budd Bugatch - Raymond James

Good morning, everyone. Carol, you’ve said that the second quarter relative to your plan was solid. Can you give us maybe a little bit more color on that and hopefully quantify some of that? Did you beat your own internal forecast in the second quarter and if so, at what line items?

Carol B. Tome

Budd, we did beat our internal forecast. We beat our sales forecast, we beat our earnings forecast. Now, we did get a benefit from the Quebec settlement that I pointed out, which was $0.01 of earnings better than our plan but we were -- we had a solid quarter. And it’s not just on the income statement. We were very pleased with the performance of inventory. We’re managing inventory in a very difficult environment.

Budd Bugatch - Raymond James

So ex the Quebec settlement, can you give us an idea of how much you may have beaten your plan by?

Diane Dayhoff

We don’t give that type of information.

Budd Bugatch - Raymond James

I know you don’t give quarterly guidance. I was just trying to get to where you were on a look-backward basis. Okay, one other question I have is just Craig, when you mentioned the performance to the comp average on all of the categories, you only had one that was above the company average in the quarter. Can you elucidate on that, maybe how much above or how that could work mathematically?

Craig Menear

Again, plumbing was the one that was above the company average and seasonal and our kitchen and bath businesses were performing at the company overall. And when you look at the balance, we continue to see challenges in the project businesses and around those projects that are significant discretionary spend in particular or large projects, so that the reference that I made as it related to transactions above $600, you know, that’s where we still continue to see the significant amount of challenge.

Frank Blake

And I think just on the math, you’ve got the higher penetration on our outdoor business, so when that’s at the company average, that’s how the math works.

Budd Bugatch - Raymond James

Okay. Thank you, Frank. Thank you, Craig.

Operator

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

Matthew Fassler - Goldman Sachs

Thanks a lot and good morning. I want to get a little bit of color, Frank and Carol, on the comments you made about what you expect for the rest of the year. I think you said that your expectation is that comps will be a bit better in the second half of the year than they were in the second quarter. If you flow that through the P&L, I believe that the operating margin has to come under a little bit of incremental pressure versus what you saw in the quarter, so I guess given your macro caution, I’m a bit surprised that you are as optimistic as you are on sales at the same time and wondering why the operating margin wouldn’t improve a little bit from the implied guidance.

Carol B. Tome

Well, Matt, as you pointed out, we do believe our comps will be slightly better in the back half than they were in the first half. And on the margin side, there are components of margins, first starting with gross profit. We said our gross profit margin would be flat to slightly positive for the year. For the first six months, I think we are up 14 basis points. I wouldn’t anticipate that we would repeat that in the back half.

And from an operating expense perspective, we did have some expense favorability in the second quarter that we don’t think we’ll repeat in the back half of the year. So when we added it all together, we thought a realistic view of our business for the back half was consistent with the guidance that we had previously given, which is sales down approximately 5% and earnings per share down approximately [24%].

Matthew Fassler - Goldman Sachs

And just to amplify those a bit, Carol, is the gross margin -- expectation of some gross margin erosion a function of product price inflation or is there something else impacting that outlook?

Carol B. Tome

It’s a function of a number of factors, including mix changes.

Matthew Fassler - Goldman Sachs

And in terms of expense favorability, are there any call-outs that would get in the way in the second half of the year?

Carol B. Tome

Nothing that’s material, Matt -- it’s a lot of one, two basis point type of activities.

Matthew Fassler - Goldman Sachs

The second question that I have tries to dig a bit deeper into the distribution question. It sounds like the facilities that you have are doing okay versus your plan. You spoke about where you are going to focus your work in the existing DCs. I guess what was it that you saw that led you to slow down the rollout? There must have been something in performance or in your analytics that suggested you needed to do some more work here.

Frank Blake

I’ll give you my view on that, Matt, and also invite Mark to add his comments. As we have talked about before, when we opened the Dallas RDC, we saw that that had some significant operational issues in terms of what we had planned. And then we go back and you look at our pilot project in Braselton, the rollout in Chicago and Dallas, and you go gee, there are some significant process improvements that it would be good to make. And you have a choice -- you can say I want to make those significant process improvements as we go and keep to the original schedule or you go gee, this would be a good time to pause, get the operational improvements in now, and then roll.

And to be candid, we had a lot of discussion about that amongst our senior leadership team and the advantage of a rollout like this in my view is we’ve got three RDCs up. It’s kind of a perfect time to have that pause, get things really the way you want them before you continue the rollout.

And Mark can comment on this and we’ve said it before -- this is a big undertaking. I mean, we are trying to do in a very short period of time what other retailers would take 2X or 3X the amount of time to do. It’s valuable to -- the more you can replicate what you are doing and not have to make improvements on the run, the better off we think we’ll be in the rollout and the easier the integration with the store side of this and the merchandising side. So that was the thought process and I’ll ask Mark if he’s got some additional comments to add.

Mark Holifield

I think Frank has summed it up very well. I think we are sure the concept is sound based on what we’ve seen and we’ve been pleased with some of the initial indications of success. The work we are doing right now is really to ensure that we can do a fast rollout and achieve our 2010 objective.

Matthew Fassler - Goldman Sachs

I didn’t mean to cut you off, Mark, but are there any financial consequences, positive or negative, in the short-run from the changing of timing here?

Carol B. Tome

Not included in the guidance that we’ve given. Clearly we’ve secured some real estate that we’re not optimizing. It’s empty right now but that’s factored into the guidance that we gave.

Matthew Fassler - Goldman Sachs

Understood. Thanks so much.

Operator

We’ll go next to Colin McGranahan with Sanford Bernstein.

Colin McGranahan - Sanford C. Bernstein

Good morning. First, just on market share, it sounds like maybe a little bit of the improvement in momentum you had has stabilized here. It sounded to me like maybe the flooring category. Do you think that was just a function of some of the promotions that were run in the space? And if you could comment just a little bit more broadly on the general market share direction, especially relative to some of the competitive closings that we’re starting to see from the independents and just your general outlook on where you think market share goes from here.

Frank Blake

I think first, your comment on flooring, that is how we look at it and we see that in some other categories. Again, I’d emphasize that one of the things Craig and the merchandising team are doing is really putting some discipline around driving to every day compelling value propositions, trying to pull ourselves off of a lot of the promotional activity that we were doing. And that’s going to drive some short-term fluctuations in share but we think the long-term direction is right.

I think versus some of our competitors, we look obviously at there are differences by quarter and we are particularly pleased in the second quarter, if you kind of look at historically where we’ve been in the second quarter, we think we’ve picked up ground from where we’ve typically been.

Colin McGranahan - Sanford C. Bernstein

Okay. And then just second, briefly on the cost of credit, assuming that you are down to 1% next year, my math would say that’s like about a 30 basis point positive impact for next year. And then how did you -- that’s excluding the three bps of the $200 million -- how did you possibly get a $200 million cash payment out of Citi at this point?

Frank Blake

I think both sides, Colin, this is -- I think this is an instance where we’ve had a good partnership with Citi over the last several years and we both sat down and worked out a new agreement that I think hit a lot of the concerns that they had, frankly, with our prior deal and addressed some of the concerns that we have. And Carol and her team did just an excellent job on I think setting the right path for the company on our credit agreement over the next -- you know, from 2009 through ’17.

Colin McGranahan - Sanford C. Bernstein

And did you shop that competitively then?

Carol B. Tome

We didn’t shop it competitively but we utilized a third-party advisor who is an expert in this field to assure that the terms and conditions of our agreement are market or better, and as Frank pointed out, we really had the benefit of an open book with Citi over the past five years, which allowed us to mutually come to agreements that work really well for both of us.

Colin McGranahan - Sanford C. Bernstein

Okay. Thank you.

Operator

Our next question will come from Michael Lasser with Lehman Brothers.

Michael Lasser - Lehman Brothers

Good morning. Thanks a lot for taking my questions. As you look at it today, what percent of sales are related to basic repair items? You’ve talked about relative strength in those areas for the last few quarters, so I’m curious -- if you trend that relative strength out for the foreseeable future, at what point does the mix shift towards those categories drive overall growth in the total sales? Because at some point, you comp negative on top of negative and the basic repair items will continue or non-discretionary items will continue and that should drive positive growth as some point.

Craig Menear

Michael, I can’t give you an exact percentage as it relates to our business in total because these repair categories cut across several of our reporting departments. But certainly our focus, our main focus is to continue to certainly drive the project business overall, which drives attachment sales and as a result right now, we’re seeing the consumer is certainly under these circumstances that they are facing with cost pressure in their own lives, basically focusing on doing things that they need to do to maintain their home, so whether it’s replacing water heaters or replacing a roof our patching a roof when something happens to their home, they are certainly making those kind of decisions. But over the long haul, it is about driving the project business, which is what will then achieve attachment sales and drive comp performance over time.

Michael Lasser - Lehman Brothers

Thank you. As a quick follow-up, as part of the new credit agreement, will any of the terms for new or existing cardholders be changed such that the availability of consumer credit under your private label program will be reduced next year?

Carol B. Tome

Not per the terms of our new agreement but I will tell you that this year, we have made some changes -- we being the collective we. For example, where we saw delinquencies in the past, we had not reduced the credit line. This year, we reduced the credit line to the amount of the outstanding because we thought that was prudent in the current environment.

Further, we saw significant erosion in FICO scores and Citi pulls a credit report every month. There was significant erosion. There were some credit line reductions. But the more important aspect of all of this I believe is that we approve 68% of all credit card applications, so that continues to show us that the portfolio is robust.

Michael Lasser - Lehman Brothers

Can you quantify in any way what sort of impact the change in terms or the change in philosophy might have had on either the sales result or the portfolio?

Carol B. Tome

We don’t think the change in terms has had a material impact to the portfolio other than it helps a bit on the profitability side. We are being more selective in the type of promotions that we offer. Our everyday value proposition is if you use our private label credit card and you spend $299 on the card, it’s no interest, no payments for six months. From time to time, we offer 12 months no interest, no payment programs and we’ve cut back on those programs a little bit. Have they had an impact on sales? We can’t tell but we have cut back on the programs a bit.

Michael Lasser - Lehman Brothers

Sounds great. Thanks for the commentary. Best of luck.

Operator

We’ll go next to David Strasser with Banc of America.

David Strasser - Banc of America Securities

Thank you. I know you had talked about the impact of gross margin on inflation and so on with vendors, but just from a bigger picture, not so much numbers, what are you seeing with your customer and your ability to pass that through? And what is -- and where are you with your vendors? And as you sort of look out into the back half of next -- early ’09, do you think that gets to be a bigger issue for you guys, or do you think you are seeing kind of most of it now?

Frank Blake

Let me make a couple of general comments and then turn it to Craig. So what we’ve seen so far is you really almost have to take it category by category and vendor by vendor. So that’s both in terms of how Craig and the merchants approach the vendor requests, as well as what we see on the customer reaction. And one of the things I think Craig and team are doing a very good job at is, as he indicated, focusing on opening price points and also focusing as there are necessary price increases and trying to add value in the product, along with the price increases.

Craig, maybe you want to add some commentary to that.

Craig Menear

I think what we are really trying to do is obviously work, as Frank said, individually with our suppliers because each situation is unique but at the same time, really trying to apply our focus bay approach in terms of how and where we might pass on retail. And it’s important to understand that from a merchandising direction that we’re giving in our team, is your retails aren’t linked to your cost. Retails are linked to what’s happening in the marketplace and what our portfolio strategy says that we want to get done. And then we work the balance of that. Cost obviously is independent of that.

So right now, as we look forward, again certain things seem to be making moves. Lumber is starting to stabilize, it appears at this point. Framing lumber is not significantly different than last year, copper is pretty much flat to last year. Still obviously when you look at comparatives as it relates to steel or petroleum, there’s certainly pressure against last year, and I think that pressure will continue as we go through the back half.

I’m not seeing anything right now that would indicate that we’ll see a dramatic fall-off in that.

David Strasser - Banc of America Securities

And just along those lines, I mean, looking at lumber, it’s a good one. Not only is it stabilizing, it actually seems to be going up in price, just from when we look at it, as a lot of other commodities seem to be declining in value. Any thoughts to why that would be happening? Is there anything you are seeing from a demand standpoint that would be driving that?

Craig Menear

Well, demand in the market overall with the current housing environment is down, so it is -- you know, it’s kind of a -- it’s strictly a supply/demand type of issue. So folks out there are trying to get what they can for the product that they are producing, so you are right. I mean, you are seeing sheet goods actually at a higher rate than the previous quarter. Dimensional lumber hasn’t quite reached that point but it’s close.

David Strasser - Banc of America Securities

It’s just surprising to see that, I guess, in this environment where you see housing, so I just figured I’d see. Anyway, thanks a lot.

Operator

Our next question will come from Eric Bosshard with Cleveland Research.

Eric Bosshard - Cleveland Research

Good morning. Two questions, I guess the first for Craig; on the EDLP focus you talked about or the comment was made that you gained share in five of 13 categories, or I guess lost share in eight of 13. Can you just talk about the rational benefit payback and commitment to continuing with this strategy and how you think that’s going to play out in that market share performance as we move forward?

Craig Menear

Again, we feel pretty strongly that listening to what our customers are saying through various research that we do, the customer is looking for us to simplify their shopping experience. The promotional activity complicates that for them. It focuses them into periods of time where they need to buy to feel like they’ve got the best deal. It also puts pressure up through the supply chain, through our suppliers when you have that kind of activity. So we feel pretty strongly that over the long-term, by providing a great value to our customer every day and having them understand that we have that great value every day, it will drive the confidence level for them to shop with us. And so I think over the long haul, that should in fact pay out in share for the Home Depot.

Eric Bosshard - Cleveland Research

And how long is the long haul, do you feel? How long does it take until this process starts to really incrementally create value for you?

Craig Menear

It’s a journey, Eric. I don’t know that I can fix a date out there. As we really work our focus bay approach and recognize that we have both assortment marketing, pricing elements to fix as we put those in place -- you know, this is a journey that we are going to take over the next probably couple of years.

Eric Bosshard - Cleveland Research

Okay, and then second question on SAP, understand that you had 20 stores put up and running but I guess prior to yesterday, you still had 16 up and running. It seems like the rollout in Canada has been more deliberate, which makes sense but understanding how deliberate it’s been up until yesterday, what gives you the confidence that you get through all of Canada by the end of the year and are there any experiences that have caused you to move at such a measured pace to this point?

Frank Blake

So it’s actually pretty consistent with what we had planned. I mean, the way the pilot was -- you know, it’s kind of the geography of the pilot was you do a couple of stores, do a dwell time, do a limited number of stores, have a dwell time, and the you start hitting a more rapid rollout pace of 20 to 25 stores that have clipped, and that was always the way it was laid out, so -- and again, it’s not that dissimilar from the RDC in terms of how you structure your pilot and initial rollout. There’s a little bit of pause at the start as you shake out the bugs and make sure you’ve got something that can really withstand a 20-store clip.

Now, we just turned those 20 stores on on Monday, so that’s yesterday, so we’re so far, so good. And if you can do 20 at a clip, then you can move it up to 20, 25 and easily make the end of the year.

Eric Bosshard - Cleveland Research

And through the first 16, has the feedback or implementation been basically where you thought it would be?

Frank Blake

Yes.

Eric Bosshard - Cleveland Research

Okay. Thank you.

Diane Dayhoff

Augusta, we have time for one more question.

Operator

Thank you. That will come from Gregory Melich with Morgan Stanley.

Gregory Melich - Morgan Stanley

Thanks. Carol, you mentioned before that there were a few things in SG&A that were favorable this quarter that you didn’t see sticking in the back half. Could you sort of call those out or another way, look at the 3% growth in SG&A dollars -- is that a rate that we can maintain or is it going to go back to that more sort of 5% or 6%?

Carol B. Tome

Well, we talked about favorability in a number of expense categories like advertising, medical, workers’ compensation. I don’t see that favorability continuing into the back half, for example.

Gregory Melich - Morgan Stanley

Okay, and if we were to look at the growth from a dollar perspective, do you think the first quarter was more representative or is there -- because I mean, a 3% growth in dollars is impressive. We should be thinking about it is the fact that they grew a couple hundred bps more would be more normalized?

Carol B. Tome

I think the first quarter is more representative than the second quarter.

Gregory Melich - Morgan Stanley

Okay, great. And then a second question is the payables year over year -- I mean, the inventory looks nicely controlled. Also saw the payables come down. Is there something that was driving that uniquely or is it just the timing at the end of the -- or just fewer receipts? I mean, how should we look at that drop in payables?

Carol B. Tome

Sure. The way you should look at it, and our payables ratio at the end of the second quarter was 60%, so that’s pretty good but it is down from about 63% a year ago. And that’s actually because of some transition disruptions we had a year ago. We outsourced all of our payable functions to India and ran into a bit of disruption as a result, which we don’t like. We’re back in line now in terms of our service level agreements with a third party, in terms of our on-time payments with our suppliers. And that 60% ratio is the one that we would like to maintain.

Of course, there’s a seasonal element to that, as you know -- it will always drop off at year-end but then it should come back up to the 60% range.

Gregory Melich - Morgan Stanley

Okay, great. And just one last, just as a follow-up to the first question -- if you talk about that 20 bps of deleverage that you’ve used historically, as you go into next year, if it is another down year, do you think that that’s still the right number or do you think that could end up being higher?

Carol B. Tome

We just started our 2009 planning activities, as you can appreciate, and we are working off of that same 20 basis point rule of thumb. And as we get closer to the end of the year and we firm up our plans, we’ll give you some more color.

Gregory Melich - Morgan Stanley

Okay, great. Thanks.

Diane Dayhoff

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

Operator

That does conclude our call. We’d like to thank everyone for their participation. Have a great 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: Home Depot F2Q08 (Qtr End 8/3/08) Earnings Call Transcript
This Transcript
All Transcripts