Sector

ConsumerRetailHome-Builders

Background

Sean Stannard-Stockton is the CEO of Ensemble Capital. We cover Home Depot's customer acquisition strategy, the difference between DIY builders and Pros, and what drove their decision to stop growing its store count.

Cover

Date

November 2, 2022

Episode Number

81

Home Depot Business Breakdown

Background / Overview

Founded in the late 1970s, The Home Depot has grown into the largest home improvement retailer in the United States, with approximately 2,300 stores serving 90% of the U.S. population within a 10-mile radius. The company, headquartered in Atlanta, Georgia, pioneered the "weekend warrior" do-it-yourself (DIY) category, empowering homeowners to undertake significant home improvement projects. Its customer base is split evenly between professional contractors (pros) and DIY homeowners, distinguishing it from competitors like Lowe’s, which focuses more heavily on DIYers (75% DIY vs. 25% pro). Home Depot’s business model emphasizes convenience, inventory availability, and expertise, catering to customers who value functionality and immediate access over a polished retail experience. The company employs around 500,000 associates and operates primarily in the U.S., with some presence in Canada and Mexico.

Ownership / Fundraising / Recent Valuation

Home Depot is a publicly traded company (NYSE: HD) and does not have private equity sponsors. Specific transaction details, such as enterprise value (EV) or multiples from recent valuations, are not provided in the transcript. However, the company’s stock performance is noted as having delivered a 16.5% total return CAGR from mid-2007 through October 2022, outperforming the S&P 500 even through the 2008 housing crash. Valuation multiples or recent fundraising activities are not detailed, but the company’s market position and financial metrics suggest a premium valuation relative to peers like Lowe’s due to its scale and pro-focused strategy.

Key Products / Services / Value Proposition

Home Depot offers a wide range of home improvement products, including building materials, tools, hardware, plumbing, electrical supplies, paint, flooring, and garden supplies. Its value proposition centers on:

1. Convenience and Availability: Stores stock mission-critical items for pros and DIYers, with same-day or next-day delivery to 90% of the U.S. population. High inventory turns (8x) ensure products are readily available.
2. Expertise: Staff provide knowledgeable, if not always warm, assistance, particularly valued by pros and serious DIYers.
3. Omnichannel Experience: A robust app, online ordering, and in-store pickup (over 50% of online orders) cater to immediate needs.
4. Pro-Focused Services: Direct-to-jobsite delivery, large-order fulfillment, and flatbed truck logistics support pro contractors.

Segments and Revenue Model

Home Depot operates as a single-segment retailer but serves two distinct customer groups: pros (50% of revenue) and DIYers (50% of revenue). The revenue model is based on retail sales of physical goods, with a growing omnichannel component. Key dynamics include:

• Pro Revenue: Driven by frequent, high-basket-size purchases ($1,000+ orders growing faster than smaller baskets). Pros, despite being only 5% of customers, account for half the revenue due to daily or multiple daily visits for mission-critical parts. These purchases are often for small, high-urgency items (e.g., a $15 part for a $20,000 job) that prevent job delays.
• DIY Revenue: Driven by less frequent, smaller-basket-size purchases (average transaction ~$75). DIYers prioritize weekend projects and maintenance, valuing immediate availability to avoid project delays.
• Omnichannel: Low double-digit percentage of sales are online, with over 50% picked up in-store same-day, reflecting the need for immediacy.

Splits and Mix

• Customer Mix: 50% pro, 50% DIY by revenue. Pros (5% of customers) drive disproportionate revenue due to frequency and basket size.
• Geo Mix: Primarily U.S.-focused, with stores within 10 miles of 90% of the population. Minor presence in Canada and Mexico.
• Channel Mix: Majority in-store, with low double-digit online sales. Over 50% of online orders are in-store pickups.
• Product Mix: Diverse, with lumber and building materials dominating pro purchases, while DIYers spread across tools, paint, and smaller items.
• End-Market Mix: Tied to housing maintenance (1% of home value annually) and remodeling, less correlated to new home construction.

Historical Mix Shifts:

• Pro vs. DIY: Pre-COVID, pro outgrew DIY, but during COVID, DIY surged (e.g., 24% same-store sales growth in Q2 2020) due to homeowners investing in homes while pros faced permit delays. By 2022, DIY returned to trend, while pro growth remained strong (mid-teens in Q2 2022).
• Online vs. In-Store: Online sales grew, supported by investments in distribution centers (DCs) and omnichannel capabilities, but in-store remains dominant due to immediacy needs.

KPIs

• Revenue Growth: 6% CAGR from 2012–2019, outpacing nominal GDP (4%). COVID drove 30% growth in 2020–2021, equivalent to five years of normal growth.
• Same-Store Sales: Pro growth estimated at 20% in Q1 2022, mid-teens in Q2 2022; DIY normalized post-COVID surge.
• Basket Size: Growing high single digits, driven by pros and inflation.
• Inventory Turns: 8x, rising due to DC investments and omnichannel efficiency.
• Gross Margin: Stable at 34–35%, with minor volatility from lumber prices.
• Operating Margin: Increased from 10% (2012) to 15% (2022), driven by SG&A leverage.
• ROIC: 35–45%, reflecting high capital efficiency.

Headline Financials

• Revenue Trajectory: Stable 6% CAGR pre-COVID, driven by same-store sales and basket size growth, not store expansion (flat at 2,300 stores since 2008). COVID accelerated growth to 30% over two years, but 2023 may see declines as DIY normalizes.
• EBITDA: Grew faster than revenue (10% CAGR) due to operating leverage, with margins expanding from 10% to 15% as SG&A dropped from 22–23% to 17% of revenue.
• FCF: Strong cash conversion (~60% of EBITDA), supported by low CapEx (1.8–2% of revenue) and high inventory turns. FCF margins stable at 9%.
• Capital Intensity: Low, with maintenance CapEx at ~2% of revenue. Recent DC investments elevated CapEx temporarily but are now normalizing.

Value Chain Position

Home Depot operates midstream in the home improvement value chain, between suppliers (e.g., lumber mills, tool manufacturers like PPG) and end customers (pros and DIYers). Its primary activities include procurement, inventory management, retail operations, and omnichannel fulfillment. The company’s competitive advantage lies in its ability to provide immediate access to a broad inventory, supported by a network of stores and DCs. Its go-to-market (GTM) strategy emphasizes convenience, expertise, and reliability, positioning it as a mission-critical partner for pros and a trusted resource for DIYers. Unlike upstream suppliers (commodity-driven) or downstream contractors (labor-intensive), Home Depot captures value through scale, inventory efficiency, and customer proximity.

Customers and Suppliers

• Customers: Pros (contractors, maintenance workers) and DIY homeowners. Pros drive high-frequency, high-basket purchases; DIYers focus on maintenance and smaller projects. Average customer income is $100,000, reflecting a wealthier homeowner base.
• Suppliers: Major suppliers include PPG (paint), lumber providers, and tool manufacturers. Home Depot fosters cooperative relationships, avoiding aggressive price compression seen in competitors like Walmart. During COVID, suppliers like PPG pivoted to produce hand sanitizer, showcasing partnership strength.

Pricing

Pricing follows an everyday low-cost model, with stable gross margins (34–35%) due to pass-through of input cost changes (e.g., lumber price volatility). Pros receive some discounts, but margins are similar across customer types due to the just-in-time inventory service. Pricing is driven by:

• Industry Fundamentals: Commodity prices (e.g., lumber) impact costs but are passed through.
• Mission-Criticality: Small parts (e.g., $15 item) are priced for convenience, not discounts, as they enable larger projects.
• Inflation: Basket size grew high single digits in 2022, in line with CPI, reflecting inflationary pass-through.

Contracts are not long-term; purchases are transactional, with no take-or-pay agreements noted.

Bottoms-Up Drivers

Revenue Model & Drivers

Home Depot generates revenue through retail sales across two customer segments:

• Pro Segment: Revenue from frequent, high-value purchases for maintenance and small jobs. Pros rely on Home Depot for just-in-time inventory, driving daily visits and large baskets ($1,000+). Key drivers:
• Volume: High frequency (multiple daily visits), low customer count (5% of base).
• Price: Stable, with minor discounts; inflation pass-through.
• Mix: Shift toward larger orders (e.g., lumber deliveries), growing faster than small baskets.
• DIY Segment: Revenue from less frequent, smaller purchases for maintenance and projects. Average transaction is $75, driven by weekend warriors. Key drivers:
• Volume: Lower frequency (weekly or less), higher customer count.
• Price: Stable, tied to inflation; smaller baskets limit mix impact.
• Mix: Normalized post-COVID surge, focused on maintenance.

Revenue Growth:

• Absolute: $155B in 2022, up from $110B in 2019 (6% CAGR pre-COVID, 30% during COVID).
• Organic: Driven by same-store sales (pro: mid-teens; DIY: normalized) and basket size growth.
• Mix Shift: Pro growth outpaces DIY, increasing basket size and revenue contribution.

Cost Structure & Drivers

• Variable Costs:
• COGS: ~65% of revenue, driven by commodity prices (e.g., lumber, low-margin). Stable gross margin (34–35%) reflects pass-through pricing.
• Labor (Store-Level): Tied to transaction volume, not revenue, enabling SG&A leverage.
• Fixed Costs:
• SG&A: Dropped from 22–23% (2012) to 17% (2022) of revenue, driven by larger baskets and omnichannel efficiency. Includes store labor, marketing, and admin.
• D&A: ~2% of revenue, tied to store and DC maintenance.
• Operating Leverage: SG&A tied to transactions (not revenue) allows margin expansion as basket size grows. Operating margin rose from 10% to 15% over a decade.
• Cost Trends:
• COVID Impact: SG&A rose 24% in 2020 (vs. 20% revenue growth) due to bonuses; normalized to 4% growth in 2021.
• Inflation: Wage pressure exists but mitigated by employee loyalty and training investments.

FCF Drivers

• Net Income: ~$15B (15% operating margin on $155B revenue).
• CapEx: ~2% of revenue ($3.1B), primarily maintenance and DC upgrades. Historically 1.8%.
• NWC: High inventory turns (8x) minimize working capital needs. Cash conversion cycle is short due to rapid inventory turnover and transactional sales.
• FCF: $14B (9% margin), with strong cash conversion (60% of EBITDA).

Capital Deployment

• CapEx: Focused on maintenance (2% of revenue) and recent DC investments for pro fulfillment. No significant store expansion since 2008.
• M&A: Limited; early growth included acquisitions, but recent focus is organic.
• Share Buybacks/Dividends: Not detailed, but high ROIC (35–45%) suggests capital returned to shareholders.
• Synergies: DC investments enhance pro fulfillment, driving higher basket sizes and margins.

Market, Competitive Landscape, Strategy

Market Size and Growth

• Total Addressable Market (TAM): $900B annually in U.S. home improvement spend.
• Home Depot Share: ~$155B (17% share).
• Lowe’s Share: ~$95B (10% share).
• Growth: Tied to housing maintenance (1% of home value annually, ~$800/unit) and remodeling. Less correlated to new construction or interest rates. Market grew 6% CAGR pre-COVID, with COVID driving a 30% surge.

Market Structure

• Fragmented: Home Depot and Lowe’s hold ~27% combined share, with the rest split among local hardware stores (e.g., Ace), Walmart, and specialty suppliers.
• Competitors: Lowe’s (primary), Walmart, Amazon (minimal threat), local players.
• MES (Minimum Efficient Scale): Large, due to inventory and distribution requirements, limiting competitors. Home Depot’s scale (2,300 stores, DCs) creates a defensible position.
• Cycle: Post-COVID surge normalizing; maintenance spend remains steady.

Competitive Positioning

Home Depot leads due to its pro focus, scale, and convenience. It positions itself as a mission-critical partner for pros and a reliable resource for DIYers, contrasting with Lowe’s DIY-centric, friendlier approach. Amazon’s e-commerce model is not a significant threat due to structural barriers (e.g., same-day needs, heavy items).

Hamilton’s 7 Powers Analysis

1. Economies of Scale: High. 2,300 stores and DCs enable inventory efficiency (8x turns) and SG&A leverage (17% of revenue). Competitors like Lowe’s (13% operating margin) lag.
2. Network Effects: Low. No significant network effects, as purchases are transactional.
3. Branding: Moderate. Home Depot’s reputation for expertise and pro-grade products supports pricing power, but it’s not a premium brand.
4. Counter-Positioning: High. Pro-focused model (50% revenue) is hard for DIY-centric competitors (e.g., Lowe’s) to replicate without dual inventory systems.
5. Cornered Resource: Moderate. Exclusive supplier relationships (e.g., PPG’s hand sanitizer pivot) and proximity (10 miles to 90% of population) are hard to replicate.
6. Process Power: High. Omnichannel fulfillment, DC investments, and high inventory turns create operational efficiency.
7. Switching Costs: Moderate. Pros rely on Home Depot for mission-critical parts, creating stickiness. DIYers have lower switching costs but value convenience.

Strategic Logic

• CapEx Strategy: Defensive (store maintenance) and offensive (DC investments for pro fulfillment). Low CapEx (2% of revenue) maximizes FCF.
• MES: Achieved, with no need for store expansion. Diseconomies of scale are avoided by focusing on same-store growth.
• Horizontal Expansion: Limited; focus on pro and omnichannel growth rather than new geos or products.
• Stakeholder Value: Cooperative supplier relationships and employee investments (e.g., COVID bonuses) reduce “off-balance sheet liabilities,” enhancing resilience.

Risks

• Short-Term Revenue Decline: Post-COVID normalization may reduce DIY spend, with 2023 potentially seeing declines.
• SG&A Leverage Limits: Operating margin expansion may slow if SG&A stabilizes.
• Supply Chain: China-related disruptions could impact inventory availability.
• Competition: Lowe’s pro focus is a long-term threat, though it hasn’t gained significant share.
• Macro: Recession could reduce remodeling spend, though maintenance is less cyclical.

Conclusion

Home Depot’s business model is unique due to its balanced pro-DIY focus, high inventory efficiency, and omnichannel convenience, driving stable revenue growth (6% CAGR pre-COVID), margin expansion (15% operating margin), and high ROIC (35–45%). Its pro segment, mission-critical for contractors, creates stickiness and supports large basket sizes, while DIY maintenance ensures steady demand. Low capital intensity (2% CapEx) and strong FCF ($14B) enable resilience through cycles. The company’s cooperative stakeholder approach and operational scale provide a defensible moat, positioning it for long-term growth in a $900B market, despite short-term normalization risks.

Transcript