Home Depot Continues to Build Its Dominant Position

We've raised our fair value estimate to $104 from $88 per share in response to the company's updated 2015 outlook, as well as a lower cost-of-equity assumption (now at 9% from 10%), adjusting for our updated inflation outlook. Wide-moat Home Depot remains one of the best-positioned businesses on our coverage list, with few meaningful competitors in either the brick-and-mortar or e-commerce channel. However, with the shares climbing more than 50% over the past year, they are trading at more than 22 times the midpoint of 2015 earnings, making them appear fully valued (since Home Depot expects low-double-digit earnings growth in 2015).

We believe investors are holding Home Depot at premium levels in pursuit of dividend security, strong cash flow, and limited exposure to foreign exchange (outside of the Canadian dollar). We do still see the home-improvement market with some upside ahead, as repair and remodel projects are likely to accelerate when interest rates begin to climb and homeowners feel less compelled to relocate. The company's 2015 outlook and capital-allocation plan includes top-line growth of 3.5%-4.7% (including foreign exchange headwinds), comparable-store sales growth of 3.3%-4.5%, earnings per share of $5.11-$5.17, and share repurchases of $4.5 billion. These metrics are largely in line with our prior 2015 forecast, which included revenue growth of 4.6%, a comp increase of 4.3%, and share repurchases above $5 billion (which we suspect will still be executed).

Home Depot rightsized and made its distribution channel more productive in recent years, partially through implementing rapid distribution centers. The commitment to improving the efficiency of the firm's supply chain led to healthy near-term operating margin and return on invested capital goals of 13% and 27%, respectively. In our opinion, the updated distribution process and widespread use of merchandise and planning tools across stores should help improve merchandising capabilities, which should allow for better store pricing and fewer markdowns, and we expect Home Depot to easily meet its operating-margin targets in 2015.

Opportunities for Expansion Since the domestic home-improvement retail industry is relatively mature, we expect demand should depend largely on changes in the real estate market, driven primarily by prices, interest rates, and turnover, as well as lending standards. We project that sales can grow at a mid-single-digit pace over the medium term (including 5% in 2015) supported by mid-single-digit same-store sales and low-double-digit unit location increases (mostly in Canada and Mexico), helped by offerings such as buy online/pick up in store and improved merchandising. We have forecast gross margins to expand modestly over the next decade (by roughly 140 basis points, to 36%) while the SG&A ratio leverages by 90 basis points (to below 20%) and the business continues to capitalize on its scale and supply-chain improvement initiatives. Ultimately, this generates operating margins of 15% over our explicit forecast, higher than the firm's current 13% goal.

We believe Home Depot's operating margins and ROICs could gain a boost going forward as the company hones its focus on the performance of its big-box locations; without distraction from China or the supply business (or other outside projects) weighing on management's time, operational excellence should ensue. Additionally, we think Home Depot has two opportunities to expand the business. The first is from growth in product lines with weak market-share leaders. For example, Sears has historically been a strong presence in appliances, but as the brand deteriorated, home-improvement retailers capitalized on this weakness. Having deeper product lines to cross-sell should add incremental revenue potential with some protection against online competitors like

Scale and Brand Equity Secure a Wide Moat for Home Depot The firm earns a wide economic moat rating because of its economies of scale and brand equity. We think the catalyst for top-line growth could come from the firm's cross-selling strategy, improved merchandising technology, and further penetration of selected customer product segments (like commercial). Additionally, expansion of both new and existing categories (like appliances) could offer unexpected upside to sales.

Home Depot's scale creates a low-cost advantage, generating significant bargaining power with vendors when it comes to products, advertisement, and rent, among other things. The company provides value and instills customer loyalty by passing along a portion of savings to consumers in the form of lower everyday pricing. We also believe the specialized nature of Home Depot's offerings provides some protection from mass merchants and large online retailers. Home-improvement retailers remain one of the best insulated sectors from e-commerce threats, as the high weight/value ratio of many products prohibit cost-effective shipping and the specialized knowledge base employees offer is difficult to replicate. These strengths have helped Home Depot deliver average returns on invested capital of 16% during the past five years, despite a massive housing downturn and integration issues related to its multiple business lines.

While Home Depot benefits from economies of scale and has produced strong historical returns as a result, operational excellence and concise merchandising remain key tenets of our long-term margin expansion assumptions. Shifting to a regional distribution network will help achieve these goals and allow all channels of the organization, including vendors, corporate, and distribution centers to speak clearly to each other. The success of implemented initiatives could offer structurally higher margins, surpassing prior peak levels.

In our opinion, the company has also been able to capture economic rents from its brand, offering an important intangible asset. The business has been built on a culture obsessed with customer service, knowledge, and innovation, which are best-of-breed in the home-improvement business--Home Depot has worked hard to ensure that the appropriate staff is on hand to solve any problems its customers may have. The reliability of information that consumers can draw on is unlikely to be replicated easily (

Lastly, while the threat of manufacturers creating their own retail network could jeopardize the availability of product in Home Depot's retail channel, we doubt such an endeavor would be successful longer-term. In our opinion, manufacturers would probably move more product by maintaining a beneficial relationship with a wholesale network like Home Depot's rather than on its own, and we expect that consumers would prefer to save time and effort by visiting one shop for all of a project's needs, rather than purchase products independently from each OEM.

We believe the company will continue to gain share in the home-improvement retail category, given its extensive economies of scale and brand recognition. As the firm's focus on operational improvement bears fruit, Home Depot's competitive position should strengthen. We believe there is ample opportunity for both Lowe's and Home Depot to expand sales and profitability in the large, fragmented U.S. home-improvement market (of which we believe Home Depot captures 19%). In our opinion, it would be difficult for another retailer to enter the market and threaten Home Depot's position, as smaller retailers would probably have a hard time building vendor relationships that would be strong enough to undermine the company's pricing prowess. We don't fear large international firms with deep pockets entering the market domestically either, as a lack of infrastructure would make distributing inventory prohibitively expensive from overseas, and the lack of real estate located properly and priced right could be difficult to acquire on a large scale. On the other hand, the lack of a rapid location growth trajectory for Home Depot currently prevents the business from gaining a wider global market share quickly.

New CEO Menear Continues Exemplary Stewardship

In our view, Home Depot's stewardship of shareholder capital is Exemplary. Home Depot veteran Craig Menear recently took over the CEO position after former Chairman and CEO Frank Blake announced he'd be stepping down in 2014. So far, Menear has followed Blake's strategic suit, which we expect to persist going forward. Before Blake's position at the helm, the firm was highly criticized for its empire-building mentality and its lavish executive compensation practices. Yielding to shareholder pressure, Home Depot scaled back executive compensation. In 2013, then-CEO Blake received total compensation of $11 million, of which roughly two thirds came in the form of stock and option awards. In our opinion, Home Depot's revised compensation policies are well-explained and closely align the interests of shareholders and management. The board of directors consists of Blake and 10 outsiders. Bonnie Hill, who serves as lead independent director, is president of a corporate-governance consulting firm. As of March 2014, Blake was the largest individual investor among Home Depot's executive officers and directors, but we note that Capital World Investors and