New Tricks in Home Depot's Toolbox?

The home-improvement giant is counting on new store concepts, foreign expansion, and an emphasis on services to generate growth

By Sam Jaffe

For years, Home Depot's (HD ) strategy for growth was as simple as hammering nails: Just build more stores. In management's eyes, the world would be a better place if Home Depot had one of its gargantuan stores within 30 minutes of every possible customer in the U.S.

Today, Home Depot has just about reached its goal: The mega-hardware and building-supply outlet covers almost the entire urban and suburban population of the country. Now comes the hard part.

Home Depot's profits rose just 16%, well below its five-year annual average of 25%, in its fiscal first quarter of 2001, which ended Apr. 30. Blame a slowing economy, as well as an inability to manufacture any more growth by opening new stores. "They're certainly at or near their store-saturation point," says Wachovia Securities analyst David Buchsbaum, who has a neutral rating on the stock. "From now on, they have to garner growth through more efficient operation of the existing store base."


  Not that the company isn't dreaming up ways to boost growth. From international expansion to branching out into new store concepts to updating its information technology (IT) system, the Atlanta-based retailer has its thinking cap on. And it has a new chief executive officer, Robert Nardelli, who cut his teeth achieving this type of internal growth while running General Electric's power-plant business. "We doubled sales in the past four years [at Home Depot], and I'm projecting that we'll do it again," Nardelli said at the shareholders' annual meeting on May 30.

So far, investors seem to trust that Home Depot will figure out a way to maintain its growth trajectory. The stock is trading at around $50 a share, up some 40% from its 52-week low of $34 in November. And some analysts believe the stock still could maintain its fairly steady 30% annual appreciation rate even though Home Depot's earnings growth last year was 10%.

For starters, the company is involved in numerous technology overhauls. Its most successful so far is a mobile inventory-monitoring system that immediately reorders merchandise as soon as a customer pulls an item off the rack. Also, it has launched a paperless reorder system that already is responsible for 70% of its merchandise orders.


  The company also is installing a new IT infrastructure. Its computer system was designed in the late 1980s, and advances in supply-chain management and customer tracking have convinced Home Depot execs that it's time to upgrade. For example, Home Depot has little of its enterprise software linked directly to the Internet. "There's an enormous amount of room to improve margins just by advancing its information technology," says Robert Morse, manager of the Wall Street Fund (WALLX ), which lists Home Depot as one of its top-10 holdings. "Its growth curve is just beginning in that area."

New software alone, however, won't transform the company's margin growth. To do that, it has created a new store concept called Expo Design Centers. These stores, located in the toniest suburbs, boast at least 100,000 square feet of display space that showcase expensive design accoutrements, from lighting fixtures to furniture. To date, the company has opened 26 Expo Design Centers and plans to double that number within two years. And this is a much higher-margin business than selling nuts, bolts, and lumber.

Another new-concept store is Villager's Hardware, a more traditional hardware store designed for the average consumer rather than the mix of professional contractors and weekend warriors who call Home Depot their home away from home. Four have already opened, and the company has plans for more of them over the next several years.


  Even more fertile field for expansion lies in other countries. To date, the company has concentrated on South America, with nine stores in Chile, Argentina, Mexico, and Puerto Rico. Home Depot expects to maintain its Latin American focus for at least the next two years, although it isn't releasing any store-opening projections.

An even bigger change to the Home Depot model is a new emphasis on revenue-generating services. Stores have begun renting heavy tools, such as floor-board joiners and pneumatic power washers. It also is spreading its at-home service tentacles. "Last year, we were the largest retail seller of carpeting," Nardelli told shareholders. "There's no reason for us not to go from being the largest retailer to the largest installer."

All these concepts look good on paper. Executing them for profit will be tougher. Not every analyst believes they're sure bets to keep the company's growth turbine running at full power. "Some initiatives, like Expo and Villager, will take years to affect the bottom line," says Danielle Fox, a JP Morgan analyst who rates Home Depot a buy. "Meanwhile, the company is heading into a more sluggish economy and more reluctance to spend on the part of consumers."

Home Depot, though, is counting on the economic downturn to be shallow and short-lived. It still plans to open an additional 200 stores worldwide this fiscal year, a 20% growth rate. The company admits in its annual report that the new stores could cannibalize existing stores' customers. But it claims that the new stores are merely a response to customers' desires to have a Home Depot closer to their doorstep. Maybe management has a sense of what it's like trying to find a parking space at Home Depot on the weekend.


  Home Depot also is keeping a cautious eye on its last-standing competitor. That would be Lowe's (LOW ), which is also undergoing a respectable 14% store-expansion rate and is trying to pick off affluent Home Depot customers who might live a little too far from the nearest Home Depot location.

Regardless of Home Depot's long-term outlook, the retailer did one thing early and right: Last winter, it reduced earnings guidance, voicing concerns about excess inventory. Today, inventory has been pared back, so the outlook going into the second-half of 2001 is far brighter than it was in the fall of 2000. The company is talking about how much profit it will make this year, not how much money it will lose. Not many companies are doing that these days.

Analysts who track the stock have a consensus estimate of 37 cents in earnings per share for the fiscal second quarter, which ends July 30, compared to 36 cents last year. And Home Depot's price-to-2002 earnings ratio is 40, which isn't too bad for a company that has in the past produced 25% earnings growth. The question is whether it can continue to do that, and there are reasons to believe it can.

Jaffe writes about the markets for BusinessWeek Online in our daily Street Wise column

Questions or comments? Please visit our Ask Sam Jaffe interactive forum

Edited by Beth Belton

    Before it's here, it's on the Bloomberg Terminal.