Performance Re-visited: Another Trip to HD's Woodshed
For some time now it's been the intention to revisit prior dissections of HD - where we ran a nice little series but also with the intent of using HD as an example of we outsiders taking a look at company performance. It seems like it might be time to re-visit that and for several very good reasons. As the set of postings on profits and earnings show company performance is a critical factor in many things. And, the point in yesterday's post on the Weekly Reader, there's a lot of examples of folks who deserve poking at.
Just to review the bidding the last HD posting id'd six major factors in digging into HD's performance and then worked thru them in some detail. The six are: 1) Economic environment and whether or not it was going to be worse, 2) Employee Morale and it's linkages to HD performance (an anlysis thread we dug into in several postings, and here), 3) Customer Service - a major area of old competitive advantage, current major breakage and bad image and one requiring major investments but not too major, 4) Operations - major changes in procurement, logistics and store operations to improve service and lower long-term operating costs, 5) Product Development - continue and expand the development of new products with higher value propositions and new services to support them ala Target and 6) revisions and extensions of the historical Business Model because the US market is pretty well saturated and new market niches will need to be developed to restore growth.
So the key questions are how're they doing, what's likely to happen and what can we do about it ? Below we present a summary table of the six factors along with some discussion and some implications. But before doing that let's review the last few months of headlines:
- May/Jun - Q108 same store sales down approx. -8%, buying back $25B of stock (a 1/4 of capitalization at the time) using $10B in proceeds from the sale of Hughes Supply plus $12B of borrowings. [Earlier on MSN Money over 10K e-mails were recieved with detailed stories of customer woes and complaints]. BigPicture rants about poor service.
- Jul/Aug - EPS for FY07 -15-18%, down from expectations of -9% with a 1-2% reduction in shares btw. Buyback set at $39-44/share. (7/26) Moody's downgrades all ratings, buyback reset (8/9) at $37-42/share, (8/26) Hughes prices drops to $8.5B with a guarntee of $1B in debt plus retaining equity.
- Sep/Oct (9/5) Buyback 290Mil shares at $37/share for approx which would be 1/2 way uisng $8B in proceeds plus $2.7B in cash, about 12.5% of the stock. Seperately outlook was revised and pessimism increased for revenue, profits and earnings. (10/10) HD Design Center concept announced - warm & fuzzy hardware stores targeted at women (?). (10/16) Same store sales down -16% and (10/30) Buffett rumored to be interested.
While those are the sorts of headlines you'd expect in the financial press, especially in these times,
notice that after a couple of quarters of "how-to-fixup-HD" articles the summer to date is primarily about buybacks, finacings and deteriorating sales with a little buyout thrown in to flavor the buyback. On the surface you'd have to ask yourself is this HD just being coy, preserving competitive information while it explores those options or is the lack of information a lack of action ?
Given a downtrending economy, increased financial pressures, and an imploding primary market then using scarce & expensive capital resources to buyback shares, especially when you're having to borrow and increase leverage to do it, doesn't make much sense. Even if you're a PE guy this outfit is going to spend the next couple of years fighting down pressures on EPS. Pressuring management to buyback shares makes sense if they're under-valued. Using scarce capital to hold back the tide and worsen performance is in nobody's interest. Or so it seems to me.
And judging by the stock chart so it would seem to Mr. Market. Now if you're buying back stock at $37 that then is worth $32 you better hope Warren buys it for $35 or more and reduces your loss. It seems to me that now would be a good time to hunker down, explain what's going on, make some judicious investments and get set for an upturn that would/will hopefully follow what's likely to be another two tough years. And for gosh sakes - tell your people that too. Not use borrowed money to prop up your stock and paper over the deep challenges.
Having set the table let's lay out the feast - which is captured in the accompanying table which lists 
each of the major improvement factors, status and assessment/ comments plus grade where possible. The data's from late summer and/or early Sept.
1. Outlook - Blake admitted to a worsening outlook but it's been a bigger surprise. Outlooks will likely have to be revised down so a C/C+ may turn out to be optimistic. Watch out for excess cost cutting to maintain quarterly earnings. Bad..bad idea.
2. Morale - Blake's been more down to earth, eating in the cafeteria, etc. which helps but no programs of employee development and compensation have been announced - which also feeds forward to service. Again a B- may be optimistic.
3. Customer Service - the heart and soul of the HD that was, the quickest path back to protecting business and growing it anew (a saving grace - a recent retail study found that HD's locations bought in the good times so far outweigh Lowe's better layout, service, ambience and quality. Since my local stores are across the parking lot from each other, well....). On the other hand Blake apologized extensively and good some good feedback. C+, at least in contrast to Nardelli. IF there's no follow-up and bunches of PO'd customers continue to swirl around this will boomerang - risks of D/D- very high.
- Putting serious efforts and funds into employee training, recruitment, compensation, store layout, cleanliness, purchasing and stocking as well as supporting marketing and sales efforts, e.g. more readily accessible experts which are still non-existent, are very high strategic priorities. Since everybody can see all this for themselves here's a major factor to judge how things are going.
4. Operations/Product Development - here we effect a timeframe shift. Whatever we're buying and putting into the stores in the next 18 months is most likely what we've agreed with the supplier base to sell us. Similarly how we run the warehouses, stores, transportation and buying operations is also pretty fixed. Yet these are major opportunities for huge performance improvements (the whys and wherefores are discussed in previous posts). Not being on the inside (fair disclosure) it's hard to tell what's in train. At the same time after all the supposed internal deep-dives on Six Sigma you'd think a) the analysts and the MSM types would have an interest and b) the analysts certainly would. Unfortuately it takes a certain level of understanding of how these operating functions actually work, and their critical role in the overall Retail enterprise, to know why you should be digging.
That said it's definitely in HD management and shareholder interest to at least let the world know these are serious issues for serious people - which are getting, or planned to get, serious resources. HD has NO better set of strategic opportunities once short-term fixes are funded, designed and underway. If I was one of the PE or Hedge folks poking at this company this is where I'd put some attention. Bottomline NG/NG since we have no observables. You have to wonder though if it shouldn't be an F.
These are the sorts of major strategic initiatives that when you start evaluating HD's recovery chances that you should be looking for, monitoring and, if possible, encouraging.
5. Innovation -again a low to no-observable though the announcement in Oct. that there's trialing of some warm and fluffy versions of design centers is work a look. That's encouraging - so is it a NG, a D+/C- because it looks little and late and needs to be improved (what'd your teacher used to write - you've got talent but need to apply youself ?). Or an F because so far it's not much and way late ?
Certainly HD has the smarts, people and resources to be running some major innovation efforts. In fact when the old Business Model cratered at the end of the 90s and Nardelli was brought in this is the sort of combination, blended and balanced recovery agenda he should have applied. It's the sort of thing Kilts did at Gillette over 5-10 years, that Boeing has done over the last ten and Cisco as well. It is in fact what Nardelli needs to come up for Chrysler now that it's his watch again.
But what we have here is an evaluation framework that looks at Business Model & Strategy, key operating functions, people and service issues and lays them out over immediate, tactical and strategic timeframes. And is a foundation for investing in HD should you care to apply it.
In that wise you've got a couple or three tacks to consider. As things begin to flatten and turn around with Housing HD is likely to improve. Spotting that a couple of quarters ahead of time makes you a worthy value investor. Of course without the other initiatives HD will crater again for the same reasons.
What makes us mini-Buffetts is if we spot the long-term turnaround taking hold, down the blueprint, and get in early enough. Or contrawise if we want to be speculative Buffetts (huh ?) it's realizing when the Street's recovery fantasies are going to be disappointed and getting out :) !
Good luck and let me know how it works.