How much of the 2004 margin improvement came from accounting changes rather than operations?

The EITF 02-16 adoption reduced cost of merchandise sold by $891 million, adding about 122 basis points to gross margin. Excluding this effect, gross margin would have been 32.2%, up from 31.7%, so underlying improvement was about 50 basis points. The accounting change also reduced fiscal 2004 EPS by $0.04, with the pro forma EPS impact being about $2.30 versus $1.88 in fiscal 2003. Operating expense also rose by $1.0 billion from reclassifying advertising co-op allowances, so the net effect on operating income was smaller.

How sustainable is the 5.4% comparable store sales growth?

Several one-time or cyclical factors helped. Hurricanes in the Southeast boosted building materials sales, and lumber price inflation added about 100 basis points to comparable sales. Cannibalization from new stores reduced comparable sales by about 2.2%. Management's fiscal 2005 forecast of 4%–7% comparable store growth is net of about 2% cannibalization and relies on higher traffic, transaction conversion, and average ticket growth. The 2004 average ticket rose 7.3% to a record $54.89, which may be difficult to repeat.

Is the company's balance sheet and capital allocation strong enough to support its growth and shareholder returns?

Yes. The company had $2.2 billion of cash and short-term investments and a return on invested capital of 21.5%. Total debt-to-equity rose to 8.9% from 6.1%, mostly from $1.0 billion of 3.75% senior notes issued in September 2004, and remains moderate. Management says cash flow and the $1.25 billion commercial paper program should cover capital spending and debt maturities. About 86% of stores are owned, and operating lease commitments total $7.9 billion, which are off balance sheet. Capital expenditures are planned at $3.7 billion for fiscal 2005.

What are the main risks and cost pressures highlighted for fiscal 2005?

The filing cites rising depreciation (about $250 million higher, to roughly $1.6 billion), stock-based compensation up $125 million (partly from SFAS 123(R) adoption in Q3 fiscal 2005, which the company estimates will reduce pre-tax earnings by $34 million and $31 million in the third and fourth quarters), and higher incentive program expenses. Risks listed in the forward-looking statements include economic conditions in North America, competition, the success of expansion and acquisitions, the ability to attract and retain associates, and the success of technology initiatives. The company is also self-insured for several liabilities, and changes in claims trends could affect results.

HD 10-K FY2005 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed April 11, 2005. Cited figures are marked; the original filing is the authoritative source.

The Home Depot's fiscal 2004 (year ended January 30, 2005) was a record year.

Net sales rose 12.8% to $73.1 billion^a, comparable store sales grew 5.4% (its best since 1999), and net earnings increased 16.2% to $5.0 billion, with diluted EPS of $2.26, up from $1.88. Operating margin reached a record 10.8%, and gross margin hit 33.4%, the highest in the company's history. Part of the margin gain is an accounting effect: adoption of EITF 02-16 moved $891 million of vendor co-op allowances out of cost of merchandise sold, which added about 122 basis points to gross margin but reduced EPS by $0.04.

On a pro forma basis, the EPS impact is about $2.30^b versus $1.88 in the prior year. The company remains highly cash generative, with $6.9 billion of operating cash flow funding $3.9 billion of capital expenditures and $727 million of acquisitions (White Cap Industries and Home Mart Mexico). It also returned $3.8 billion to shareholders through $3.1 billion of buybacks and $719 million of dividends, and the board added $2.0 billion to the repurchase authorization.

Balance sheet strength is evident in $2.2 billion^c of cash and short-term investments and a debt-to-equity ratio of 8.9%, up from 6.1% mainly due to $1.0 billion of new 3.75% senior notes. The company opened 183 net new stores, ending the year with 1,890 locations, and management guided to fiscal 2005 sales growth of 9% to 12%, comparable store sales growth of 4% to 7%, and diluted EPS growth of 10% to 14%.

Key pressures for fiscal 2005 include higher depreciation (about $250 million^d more), roughly $125 million of additional stock-based compensation (including the SFAS 123(R) adoption), and ongoing reliance on new store growth. Comparable store sales were also aided by hurricane-related demand and lumber price inflation, which added about 100 basis points, so investors should weigh how much of the 2004 performance is repeatable.

02—Key points

Key Highlights

Net sales rose 12.8% to $73.1 billion, driven by 5.4% comparable store sales growth, the best since 1999, and 183 net new stores.
Net earnings grew 16.2% to $5.0 billion, and diluted EPS rose to $2.26 from $1.88 (about 20%).
Record gross margin of 33.4% and operating margin of 10.8%, though the EITF 02-16 accounting change contributed about 122 basis points of the gross margin gain.
Strong cash generation: $6.9 billion of operating cash flow funded $3.9 billion of capex and $727 million of acquisitions, with $3.8 billion returned to shareholders.
Shareholder returns: $3.1 billion of share repurchases in fiscal 2004, dividends raised 21% to $719 million, and a new $2.0 billion buyback authorization in February 2005.
Fiscal 2005 guidance calls for 9%–12% sales growth, 4%–7% comparable store sales growth, 10%–14% diluted EPS growth, and 175 new stores.
Rising cost base: depreciation expected to increase about $250 million and stock-based compensation about $125 million in fiscal 2005.

03—Questions

Frequently Asked Questions

How much of the 2004 margin improvement came from accounting changes rather than operations?
The EITF 02-16 adoption reduced cost of merchandise sold by $891 million, adding about 122 basis points to gross margin. Excluding this effect, gross margin would have been 32.2%, up from 31.7%, so underlying improvement was about 50 basis points. The accounting change also reduced fiscal 2004 EPS by $0.04, with the pro forma EPS impact being about $2.30 versus $1.88 in fiscal 2003. Operating expense also rose by $1.0 billion from reclassifying advertising co-op allowances, so the net effect on operating income was smaller.
How sustainable is the 5.4% comparable store sales growth?
Several one-time or cyclical factors helped. Hurricanes in the Southeast boosted building materials sales, and lumber price inflation added about 100 basis points to comparable sales. Cannibalization from new stores reduced comparable sales by about 2.2%. Management's fiscal 2005 forecast of 4%–7% comparable store growth is net of about 2% cannibalization and relies on higher traffic, transaction conversion, and average ticket growth. The 2004 average ticket rose 7.3% to a record $54.89, which may be difficult to repeat.
Is the company's balance sheet and capital allocation strong enough to support its growth and shareholder returns?
Yes. The company had $2.2 billion of cash and short-term investments and a return on invested capital of 21.5%. Total debt-to-equity rose to 8.9% from 6.1%, mostly from $1.0 billion of 3.75% senior notes issued in September 2004, and remains moderate. Management says cash flow and the $1.25 billion commercial paper program should cover capital spending and debt maturities. About 86% of stores are owned, and operating lease commitments total $7.9 billion, which are off balance sheet. Capital expenditures are planned at $3.7 billion for fiscal 2005.
What are the main risks and cost pressures highlighted for fiscal 2005?
The filing cites rising depreciation (about $250 million higher, to roughly $1.6 billion), stock-based compensation up $125 million (partly from SFAS 123(R) adoption in Q3 fiscal 2005, which the company estimates will reduce pre-tax earnings by $34 million and $31 million in the third and fourth quarters), and higher incentive program expenses. Risks listed in the forward-looking statements include economic conditions in North America, competition, the success of expansion and acquisitions, the ability to attract and retain associates, and the success of technology initiatives. The company is also self-insured for several liabilities, and changes in claims trends could affect results.

04—Continue

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