The Home Depot, Inc. (HD) Earnings Call Transcript & Summary

It's Simeon Gutman, Morgan Stanley's hardline, broadline and food retail analyst. It's my pleasure to welcome you to the session fireside with Home Depot represented by EVP and CFO, Richard McPhail; and VP of IR, Isabel Janci. First, welcome to Home Depot. This is the first time I think you're at this event virtually. For whatever reason, the calendars aligned, so thanks for being here. I have to read a quick disclosure then maybe a quick intro, and then we'll get right into questions. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. I don't think Home Depot needs a very big introduction. This has been one of the best-performing retailers, I'd say, over the last 2 decades. The industry is great. The company has been managed extremely well over time. I think the constant motto of reinvestment back into different businesses and channels and TAMs has paid off over time. And they're in the midst of another big reinvestment, arguably transformation, which we're looking forward to how it's going to play out over the next several years.

So with that, Richard, I guess unashamedly, I've asked the same question on your conference call, I think for the last 2 or 3 quarters, and I'm going to ask it again to start. The biggest question of reversion versus retention and how you think about the industry sales growth, do we digest or do we continue to compound?

Well, thank you, Simeon, and thank you for having us on today and for joining us, everyone. And I'm sorry we can't be in person but I know one day, we will. So it's an interesting question, Simeon. The way that I would first kick this off is to say that we have observed very steady demand really over the past 5 quarters and into the first 2 weeks of the fourth quarter. And that steadiness in demand, if you just look at our kind of 2-year comp level, has really hovered at a very tight band over those last 5 quarters. A little bit of a bump in Q1, a positive bump, when we saw stimulus kind of flow through the economy in March, but otherwise steady. And so I'd tell you that we first anticipated there might be some reversion when the economy reopens towards the end of 2020. We didn't see that happen. And so our hypothesis to that was that our demand environment really began a transformation from kind of a COVID-driven environment to maybe more of a housing supported environment. We can't be sure of that. And so I'd say that it remains very hard to get a sense of what the short-term outlook might look like. There's a lot of uncertainty with respect to the impacts of fiscal response and of what the COVID environment in general might bring us. Over the long term, I think that there are very healthy elements of support for home improvement demand. And that's really where I'm paying a lot of attention. And so I'd say from a short-term perspective, we have learned how short cycle this business really is. And so we have become much sharper with respect to meeting demand where it is at the moment. But again, I'm putting a lot of time and effort into thinking years down the road to make sure that we're positioned to take advantage of what I believe is a healthy environment for home improvement. With respect to reversion and retention, I think home improvement is an interesting category to think about reversion and pull forward. I've tried to think about appliances for over a decade. When are we actually going to see a reversion to a mean or kind of the impact of a pull forward because we've seen such acceleration in that business? I gave up looking for pull forward and normalization in appliances years ago. And I think I kind of encapsulated in the statement, when are you truly done trying to increase your standard of living? I don't know when you reach that point. I know for me, my list of things to do around my house is never-ending. And the imagination that our customers have, the fact that they're leaning into projects and we see that not only in kind of the consumer side of demand but also the pro side of demand just tells us that there's great underlying demand to increase their standard of living through improving their home.

Yes, fair enough. Maybe 7 to 10 years ago, I remember having a conversation with investors that if we see another downturn, that the multiple of this business would go towards the market multiple, if not lower. And we were arguing why that shouldn't happen. And I think part of what you said, there's a case to be made why there's a pretty steady durable backdrop going forward without some of the extremes up and down. It's not really a question but maybe an observation. You sell durables and consumables. Consumables more in, I'm assuming light bulbs and trash bags, and that stuff is not that remarkable. But some of the durables, some of it is tied to home improvement demand. Some of it is maybe more discretionary. Is there any nuance within that as far as how those durables are behaving, meaning they've been stronger for longer and they're holding up even into the prior quarter. And therefore, that portends an even better trajectory from some of the categories that you would have already expected to fall off.

I think I have to revert to the way we think about it, which is really kind of project demand and what we observed with respect to large project demand. I don't think about a particular category of durables. I mean, even just go back to appliances, that many times is coupled with other projects spent at Home Depot. And so I think even in terms of project. And in Q3, we saw very healthy demand expressed through our pro customers, which obviously are serving our consumers eventually. And so I don't necessarily -- I wouldn't call it a durables category. I just think it is the demand conditions for remodeling. And so maybe don't think about durable but think about kind of permanent investment spend and the structure, I think, is as healthy as it has ever been, and we know the remodelers express through surveys that their backlogs are as healthy as they've ever been. So that's how I think about it, Simeon.

In the past, with Home Depot, we had discussed a GDP growth plus framework, the plus being drivers. How relevant is such a framework? Or is the business more -- are you looking more at the POS data to get a sense of beyond the run of how the business is trending?

One of the things that we've learned, I'll go back to kind of the short cycle management of this company, I think I have a greater appreciation for executing in the moment and making sure that we are agile and flexible to stay ahead of the demand that we see in the moment. So the way you've put it, POS data is what's driving our view of inventory and of staffing. And we've done well with that approach. At the same time, I think, I -- we have our eyes 5 years down the road. And so our investment cycle and the way that we think about investing is completely separate from running inventory replenishment and staffing, which are really kind of our 2 -- the 2 variable components of our operating model. So in short, I'd tell you that it's much more important to be able to react and stay ahead of demand in the moment than it is to be able to predict what demand looks like 4 quarters from now because we've proven that we can pivot quickly. And we've taken stances, for instance, in inventory where we've said, look, we're going to be ready for demand. You can see it in our balance sheet, Simeon. At the end of Q3, our inventory was up $4.4 billion year-over-year. Our payables were only up $400 million. And so that's kind of an artifact of us building inventory positions up at the end of 2020 that we have sustained through this year. So we feel great about our ability to meet that very short-term demand as it comes.

Do you think that the traditional housing metrics that we've watched, existing home sales, home price appreciation and even new home or new demand, new household formation, are those less reliable? And are there other metrics that we should look at? And then tied to this, existing home sales may not be as robust going forward but home prices continue to go up, and that seems to be the more relevant metric.

Well, I remember back in '08, I actually took over FP&A in '08. And for 3 years, we were trying to figure out this model and you mentioned GDP plus back then. I think the nice thing about how we perceive what drives home improvement in demand hasn't changed and it's pretty intuitive. And our customers reinforce this with us all the time. As your home increases in value, you're more likely to invest in it. As you turn over, you're going to spend more in a year that you turn over than you did a year that you didn't. But we think home price appreciation has been the most significant driver. I think as -- at the end of 2019, at our investor conference, we said, look, home price appreciation is still going to be a support but it's not going to be the tailwind that we had seen because it was normalized. It was still outpacing GDP, it was normalizing. So now fast forward to today, by the end of this year, we're probably going to see a 2-year home price appreciation number somewhere around 25%. That's unlike what we've seen in modern history. And so intuitively, we believe that, that is at least partly what has driven this willingness to invest. So there's the willingness to invest. There's also the means to invest. So you think about -- depending on how you measure it, $2 trillion in excess savings sitting in bank accounts. There's means to invest there over the long term. And you mentioned housing turnover. Housing turnover is actually staying right around historical percentages of the housing stock. But what's interesting about it is because there's a shortage, the homes that a buyer might be able to select from is just a narrower selection. So maybe you don't find that perfect house. Maybe there's more work that you would need to do to it than in a different supply-demand situation. And if you can't find a home, then maybe you think a better alternative is to remodel your home. Those are hypotheses. So I think the change now is 10 years ago, we were trying to quantify this and we had a directional model. I think at this point, it's really tough to quantify, but the support really seems there relative to other sectors of the economy. And so that's why we've taken an aggressive stance with respect to reinvesting in our business. We're doing it in a much steadier cadence than we did, say, in the 2018 to 2020 period, but we're optimistic about the home improvement environment. And so we're going to invest to make sure that we achieve capturing market share and delivering shareholder value.

One more on this, I guess, backdrop question is flipping my question about reversion and looking at the home market, the fact that prices have come up and there have been some constraints on getting labor to do that work, is there a big pipeline that's there? And actually, there's a lot more pent-up demand than maybe the market perceives and that we see. I don't know if you have anecdote from the pro side of things, but I don't know how credible that argument is.

Well, the remodeling index put out by AHB says that at least the builders and the modelers are telling them, backlogs have never been healthier. And we know that backlog exists in small, medium and large project sizes. I think at these levels, it's sort of hard to say small movements in that index matter that much. I think that there's plenty of demand for our pros right now.

And you mentioned market share at the end of the last comment. If we took Home Depot's growth and compared it to the PCE data on home improvement, Home Depot has taken about 60 basis points of share above the industry every -- like on average over the last 10 to 20 years. That number accelerated significantly during COVID. I don't know if there's a philosophical way to think about it. In theory, your competitors got weaker, smaller ones did. They maybe have left the market. Is there a reason why you should be able to grow at an accelerated rate? Or does it actually have to moderate, given how quickly you took share over the last, call it, 24 months?

I think very short-term outlooks are very difficult. But I think over the long term, we've got a philosophy that we believe in and that we talk about every day with everything we do, particularly when we invest. If we have the best customer experience in home improvement, if we extend our already current position as a low-cost provider in the market, and if we extend our position as the most efficient investor of capital, it's going to be very difficult, in my view, to lose. And so that's the intention. I think one of the benefits of being able to remain at in-stock levels that I think are strong on a relative basis is that we're getting that traffic, and our customers are becoming exposed to new capabilities that we light up every month. We -- an example of that would be our flatbed distribution centers. We have one that's been live for a while in Dallas. And what our Pro customers tell us when we show them what's possible, the breadth of assortment, the depth of assortment, the reliability of delivery, they say, we had no idea that you could do this. And so what we're trying to do is get that response from the Pro and the consumer. And with the consumer, a lot of that is engagement on our digital assets. We have consistently improved traffic and conversion. And we believe the entire site experience, we think it makes it stickier for the consumer. So when I think about market share moving forward, it's all about having a better, easier experience than anyone else does. On the Pro side, specific digital assets being built for the Pro. The Pro app, we're seeing tremendous engagement with that app. It used to be that the Pro had an inventory lookup with certain products. That inventory lookup only extended to whatever store they were looking at. And so they might see a lumber product and they might see a depth of 100 pieces. Well, in certain markets, that's going to be different as we roll these FTCs out. You're going to see thousands when you look at inventory lookup. And so we think that makes a difference that -- getting in front of the pro, particularly the ways in which we can begin to win their planned purchase versus what we've historically been strong at, which is the unplanned emergency purchase is -- that's a big focus of ours. So we're just -- we're excited about taking share in the future.

So I think that's a great segue. My next question is about One HD, the supply chain and the transformation. I was going to leave it open-ended because I guess they haven't had an Investor Day in a while to talk about these investments. But I think they're beginning to be deployed. We're probably in early innings, but can we talk about the key initiatives? What are the key tenets of One HD supply chain or One HD?

Well, I'll take you through it, Simeon. If you want to kind of off-ramp on anything, that's fine, too, because there's a lot here. The 1 supply chain concept was drawn up years ago, and it kind of manifests itself in changing our downstream distribution capabilities. We call it downstream, it's really just delivery to the customer, right? And along with that came investments upstream, I'll get to that in a second. But what we're most excited about are our customer-facing capabilities that we're building. So I'll just start where I began with those flatbed distribution service. First of all, I'll talk about really kind of 3.5 platforms, and all told, probably about 150 facilities. Now what we've learned is it's important to be agile. And so there isn't a particular hard target for building type, although there haven't been major changes in how we originally envisioned it. So flatbed distribution centers, several levels of value creation. So historically, we have delivered sales, delivered orders on a flatbed truck from our store to our customer site. So in our march to remain a low-cost provider, you can think of that as being a very high-cost activity, very inefficient. You're literally stocking bays with product and then you were picking those bays to stage onto a flatbed using associates who aren't warehouse associates per se, and picking is not their primary skill set. And then you're maneuvering that flatbed truck through a parking lot with a bunch of customer vehicles. It severely limited our ability to offer delivery. So just the physics of the number of deliveries we could pull off in any day was limited. And the cost of it is not optimal. So at the very first level, those flatbed DCs are designed to shift those delivered orders to a lower-cost, higher-efficient model. Those flatbed DCs carry not only much deeper inventory, so we're always in-stock with job lot quantities, which by the way, is a big deal because a lot of times, a Pro may have a job lot need that we don't have in one store and we have to fulfill from several stores, just bad from a cost perspective. A flatbed DC always in stock with a broader assortment of think long-length lumber that we don't carry in the stores, now the Pros can order that, shorter delivery windows, more dependable delivery. And we know that when we show the Pros what we're able to do, they say, we had no idea you could do this. And so those are -- those capabilities are winners. The first level of value creation is shifting those high-cost deliveries. The second order is winning more business, winning that planned purchase with the Pro that we have not had the capability to do in the past. And so we're building on that. There's a long way to go but there's a huge market opportunity out there, too. It's very fragmented and so we're excited about that. The second layer is what we've called, some of you may remember the term MDCs, market delivery centers. We have kind of adjusted our view of those, and that's why I said 3.5 platforms. A few years ago, we saw MDCs as kind of separate from our traditional DFCs, which were oriented towards fulfillment of homedepot.com orders. Probably the most important agile pivot we made was when we bought HD Supply, we were in the middle of trying to understand, should we use those MDCs as MRO distribution? With the acquisition of HD Supply and the combination with Interline, we now have the best-in-class supply chain that is purpose-built for that MRO customer. So that allowed us to reposition the MDCs to really just become, again, DFCs of core home improvement product, the nature of which is going to be more big and bulky. So think about those things that aren't the most efficient to deliver from a store or for a customer to carry home: a vanity, a grill, a patio set, all these things, the vision will be that you can get those -- you can come to the store and you can see them, you can order them, and they can be at your house the next day. So that's kind of the second platform. And then the third -- and by the way, that platform works in concert with the flatbed distribution center. Think about being able to satisfy the pro in a much broader sense than any one company has ever been able to do before. It's not that the orders travel on the same truck necessarily but having that capability across our assortment is important. MDOs, so market delivery operations, are -- so those first 2, Simeon, are -- they're definitely early, right? But we've had a few open on the ground. We're very happy with them. But we're going to take our time in full commercialization. We want to get these -- we feel great. Early returns are fantastic but we want to optimize the performance. And a lot of that is just learning about what sells and about what our customers are going to demand and how we satisfy them. MDOs were really a -- that was a move we made to say, okay, appliance as a category is important to us. But one of the most disappointing experiences that our customers have had with us traditionally is that appliance delivery experience. Historically, we relied on a third party to deliver those appliances. And we didn't have line of sight into when the customer had a problem. It was too long a period of time before we knew about the problem and could do anything about it. And we didn't even own the assets to be able to do anything about it. So MDO is all about, at the very start, moving up the value chain with respect to appliances. And really, I'd call it -- maybe the better way to put it is owning the experience, owning that appliance purchase and delivery experience. We still have the same inventory model, very light capital requirements. But the delivery experience is different. We own it. I was actually just touring one of our MDOs a few weeks ago, and it's amazing when you have a long-tenured Home Depot associate in charge of an MDO operation, who lives and dies by customer service and just has the pride of knowing that we're making a difference in our customers' lives. We've seen improvements in DOC. We know that just the nuts and bolts of the delivery experience, dependability are much different with us than with a third party. So that's kind of the third important leg of 1 supply chain. That's a little more developed, so you'd say that very roughly half of our appliance orders are now being executed through our owned MDO network.

That was very comprehensive. What happens to working capital with these additional sites? How does it play into the overall network?

It's too early to tell, Simeon. I think there's a primary kind of consideration there and then a secondary one with respect to the stores. The primary is we're going to learn what the optimal assortment is and we're going to be flexible. That's the beauty of these buildings. Just like our DFCs, you're not resetting a physical store. When you decide on what your physical store set will be, you're not changing that very often, right? That takes capital. It's hard to move. In the DC, you can flex with demand. So I don't quite know what the working capital profile is going to look like, but obviously, we're trying to optimize ROIC at the end of this, which is the name of the game to me. On the secondary benefit, okay, now you're moving those delivered sales out of the store. So what do you do with your in-store assortment? I view that as an opportunity. I don't view it as -- it's certainly not a requirement to make the investment [ dance a while ] but it's just one of those nice secondary opportunities that presents itself. What do you do? Is there a way to rethink space optimization in the store? But we're going to learn and develop as we go along in that.

Great. Transitioning, one of the takeaways from the prior quarter was how well gross margin and in light of -- or despite the headwinds from supply chain costs. And maybe one of the connected observations is that this business has pricing power. You're able to manage a whole host of things to offset supply chain issues. Curious about pricing power, elasticity of demand, and I guess just the rationality, the oligopoly pricing within the industry.

Well, I view retail pricing as a function of how well you understand elasticity and then a function of how much innovation and really kind of special value that the merchant brings to our assortment every day. And so we know that -- what we really focus on is that second piece. Our assortment, as we've said before, we might sell same categories that others do, but we don't sell the same products in the same SKUs. We believe we're in an advantaged position from a brand perspective and a product perspective. And so we think innovation drives pricing. I think on the -- look, we're in a cost environment that is pressured and it's pressured across the economy. Now we're not immune to it. And when we experience that cost pressure, we do our best to work with our vendors to understand it and mitigate it. We have a great cost finance team who advises our merchants on what product cost is and what transportation cost is. And we do our best to mitigate it with our suppliers. And we've done a good job with them of taking advantage of the power of substitution, frankly. One of the most important elements of our in-stock position, the ability to have sustained a solid in-stock position over the last few quarters is understand that we can narrow the assortment and really deepen inventory levels in those SKUs that are highest velocity and can be substituted. And so that's something we work with our vendors often. When then you sort of separate cost from retail, they exist independently. And so we're always going to be our customers' advocate for value. Value isn't always about price. It's about quality, it's about innovation, it's about experience. But we're going to watch those elasticity models. We're going to make sure that we are perceived as the advocate for value. And we've been very pleased with our performance year-to-date.

So we have 2 minutes, I think -- and there's no questions from the audience. I think this will be the last question. EBIT dollar growth versus EBIT margin. I think on our side, we probably have an over-obsession with margin. That's how we used to think about retail models and growth. I think you've tried to focus our attention more on dollar growth. And so especially now with the margin of the business close to an all-time high and you are coming off of these investments, why shouldn't we still think about margin? And I guess, how do you -- what -- in the future, when we hear from you about a framework, is it going to be more about EBIT dollar growth versus margin?

I think EBIT dollar growth drives the value of the company. And I think you can look at one line, our earnings or our pretax earnings and say, how well has that line grown? I think if we deliver that and if we deliver an exceptional return on invested capital, then I think we're going to be happy with the shareholder value that we've created. Operating margin, to me, it's sort of a byproduct of a few things. We want to take share. We want to do it in a way that enhances shareholder value. So when I think about gross profit, I want to see those gross profit dollars growing. I want to optimize that. What margin rate might look like depends on the opportunities in front of us to take share. And we always talk about the appliance example, but a decade or more ago, we said we can lean heavy here. We have a competitor who's slipping. This is a category that's below company average. Should we do it? The answer is absolutely. And it's got superior ROIC and we're glad that we did it. And I think we're going to take advantage of opportunities to take share where we can drive return on investment. With respect to operating expense leverage. Look, we're committed to driving operating expense leverage. It may vary quarter-to-quarter. We are committed to continuously investing in this business and being agile and taking advantage of opportunities to do that. But that's embedded in our CapEx sort of outlook of kind of 2% of sales and embedded in our P&L. And so we fully intend to continue to drive our operating expense leverage in the business. Ultimately, the name of the game is operating profit dollar growth.

On that note, I think we can leave it there. I appreciate you being here with us, and very helpful discussion on One HD supply chain. I wish you a great holiday season, success in '22. Thanks again.

Thanks, Simeon. Thanks, Morgan Stanley. And thanks to everyone for being with us.