Why Home Depot is thriving despite the Amazon-retail revolution

As many US brick-and-mortar retailers falter, Home Depot (HD) is trading near all-time highs after it reported a 6.5% rise in first quarter comparable store sales and raised its full-year earnings guidance. The home improvement chain’s management team attributed better-than-expected results to market share gains, productivity improvements and a strengthening housing market.

Perhaps the most notable win for Home Depot is its success in resisting the forces of pure-play online retailers like Amazon (AMZN).

Online is a key standout

Home Depot’s sales have been remarkably robust despite the rapid rise of low-cost competition from online retailers. It has seen growth in both in-store and e-commerce sales. In fact, Home Depot’s online business grew 21.5% in the most recent quarter.

In the past, Home Depot Chairman and CEO Craig Menear has said online competition could cut into 25% of its sales mix. But even those categories performed well this quarter, he said.

“If you think about those things that carry the highest level of risk would be those that are small package, reasonably high value, easy to ship product,” he said. “So you think about categories like power tools, faucets and so on … we had a tremendous quarter.”

In March, Barclay’s Matthew McClintock called out Home Depot’s retail prowess. "Home Depot is in the running with Nike for the best managed retailer we have ever covered," he said.

And this status includes its online dominance.

With $4.7 billion of revenue in 2015, Home Depot is one of the 10 largest e-commerce businesses in the United States. It has grown at a compound annual growth rate (CAGR) of almost 40% over the last three years, despite its large size, according to McClintock.  

How Home Depot’s online strategy works

“E-commerce offers an incremental value added proposition to both the DIY consumer and pro that more localized competitors lack the scale to match,” he said.

Home Depot’s key online strategy is called Buy Online, Ship to Store (BOSS), which provides customers with access to over 300,000 items that are available for pickup in the stores. The program was fully rolled out by the first quarter of 2013 and gives customers access to over 10 times the number of products stocked in a typical Home Depot store.

“This interconnected retail approach has resulted in over 40% of all online orders leveraging the actual physical store infrastructure for pickup, as well as 10% of orders taking place from a device within the store itself,” McClintock said. “Furthermore, approximately one-fifth of customers who come into the store to pick up items end up purchasing additional items as well.”

McClintock sees an e-commerce CAGR at Home Depot of at least 20% through 2020, which would have a positive impact on annual comps by an average of 140 basis points.

Most importantly, the housing market remains robust

The underlying strength of the housing market is also driving increased traffic. Home Depot’s CFO Carol Tome said people continue to spend more on their homes, which they often see as an investment.

“We've seen home equity values increase 94% since 2011. How is that possible? Because home prices are up to 25% and people have been continuing to pay down their mortgages. So there is a wealth effect that's occurring with homeowners,” Tome said.

“If you feel like your home is an investment and not an expense, you spend differently in your home and you can see that in our big-ticket categories,” she added.

Homes with negative equity have dropped from 22% at the beginning of 2012 to 8.5% now, she added.  

And, after extensive research Home Depot has conducted on the next 10 years of the business, it has concluded that millennials remain a driver of housing-related spending going forward.

“What our research tells us is that basically this is a delayed cycle that the millennial generation has many of the same desires that generations prior to them have,” Tome said. “We are seeing as household formation goes up, roughly a third or so of those formations are happening with millennials at that age group. It appears there is about a six-year delayed cycle here, but our research indicates that in many ways, they will act the same as previous generations.”

She added: “The average age of new homebuyers last year was 33 years old. So that is a proof point. At some point, they want to own a home too.”

Home Depot says it even benefitted from unseasonable weather and slumping oil prices, which have had negative impacts on other retailers.

“We estimate weather-driven demand positively impacted our US sales growth by approximately $250 million,” Tome said. Additionally, despite the oil issues, “Texas actually outperformed the company average in the quarter.”

As for the future? Tome and Menear say it is even brighter for Home Depot than now.

“While US GDP forecast have pulled back slightly since we built our 2016 sales plan, we continue to see strength in the housing market with home price appreciation, housing turnover, and household formation trending where we thought they would,” Tome said. “While we ordinarily don't raise our sales growth guidance so early in the year, we're going to roll forward some of our first quarter outperformance giving the underlying strength of the business.”

Tome said there is even more runway ahead.

“If you think about it from peak to trough we still haven't recovered all of our categories,” she said.

She also pointed to productivity improvements underway, including a new software project called Project Sync that’s aimed at optimizing the company’s supply chain.

And the current outperformance has been achieved within a credit-constrained environment, reflecting even more potential as lending standards ease.

“Lending standards … are changing ever so slowly. It's like a glacier melting … If there were to be easing in underwriting standards, that would be good news, because...if you can get a mortgage, the affordability index is something like 170,” she said. “That's awesome. So if you can get it approved, you can afford it.”

The bottom line: Despite a beat and raise report, Home Depot underperformed the market on Tuesday. Some investors, looking to decelerating comparable store sales throughout the first quarter, sold on worries about a top of rthe retailer. However, Home Depot and its peer Lowe's (LOW), which reports Wednesday morning, have both continued to buck the down-trodden retail trend, and management commentary points to more positives ahead.