Has the Depot “magic” gone?

Last month, Bob Vereen took us into the internal machinations of the world’s largest home improvement retailer, The Home Depot. Now he asks whether the company of today needs a change in strategy…

When founders Bernie Marcus and Arthur Blank started the company, they operated in a highly promotional fashion — advertising in weekly catalogues and cutting prices on a few items dramatically to bring in customers. The tremendous savings boosted unit sales to unheard-of quantities, but also resulted in frequent stock-outs and unbalanced inventories when items failed to sell as planned.

A typical Depot store front — each one identifies the state in which the store is located.

After watching Wal*Mart and conferring with its executives, the company shifted to an Everyday Low Price strategy like the discount chain. But selling some items at a 65% gross margin hardly seems to fulfill the Everyday Low Price strategy today.

While many manufacturing and retailing executives feel the strategies current CEO, Bob Nardelli is employing may well be needed to guide Depot into the future, they almost universally feel that he has been moving too far and too fast. Thus creating uncertainty with the “fear factor” that now seems to be permeating the company.

To his credit, Nardelli is willing to change direction when things don’t work out as planned. For example, his shift to a much higher percentage of part-time employees resulted in less qualified sales help on the sales floor. Reacting to customer complaints (and industry observations), the company is now hiring more full-timers and once again concentrating more dollars on training programs, but they may have lost some of their better sales people in the process.

In a report to analysts earlier this year, Nardelli forecast lower-than-expected sales and profits, but said funds would be increased to upgrade older stores and increase employee training. At the same time, the company projected same-store sales would show a 10% decline in the fourth quarter of fiscal 2002, which ended in early February.

Another Depot executive, speaking to analysts at that time, said she expects comp sales to be flat in 2003. Some sales gains will be lost due to cannibalising sales from existing stores with new-store openings, and the disruption caused by store re-sets and remodellings.

Independent retailers who compete with Depot never acknowledged that the company’s service was as good as their own and certainly, with the shift to poorly-trained part-timers, felt the gap widened substantially in their favour.

Store network
One of the major problems Nardelli is facing is the fact that a large share of Depot’s stores are simply old and shopworn. Depot stores have been generating so much sales volume over so many years that many of them show it, while Lowes, its principal competitor, has a core group of much newer stores. Even allocating $250 million to upgrading stores might not be sufficient for Depot.

In the book Built from Scratch, Marcus and Blank seemed to take pride in their unadorned, sometimes scruffy “warehouse look” and maintained this was a definite Depot advantage compared to Lowes. Which brings up another question: Is that attitude correct for today’s consumer?

Lowes, in fact, took a look at Depot’s warehouse format, and improved upon it by offering better lighting, far more — and better — informative signing, and a female-friendly format, though recent research shows that Depot attracts as many female customers as does Lowes, contrary to what many observers felt. But the important point is that the average age of a Lowes warehouse unit is probably 4-5 years, compared to 10-20 years for Depot.

Nardelli seems to believe that the old Depot look needs to be upgraded. In some test stores near Atlanta, fixtures are repainted into light gray or beige and the preponderance of orange throughout the store is lessened. Lighting has been improved, signing is considerably better, though still not equal to that of Lowes, and housekeeping is better than that in the average Depot unit.

Manufacturers generally agree that Depot’s merchandising is not as creative as it was. “They are just trying to stay alive,” says one vendor. Others say merchandise selection has deteriorated, with a lot of low turnover SKUs, poor presentation, merchandising by brand rather than by category management, and an increased used of private-branding where it is not truly needed.

Vendors feel Depot needs to improve store presentation urgently, decrease SKU count and bring better pricing strategies back into play. In some stores, particularly the newer ones, it is noticeably better, but in many others, it looks the same and lags that of Lowes or even Menard’s, the number three chain.

Another factor of concern might well be the new emphasis on installed sales. This increases the complexity of the business considerably. As one manufacturer put it, “The drive towards installed services is adding great complexity to the Home Depot business and is taking focus from the core business of selling hardware, lumber and other basic products.

“Associates are spending more time on installed services, design, installer follow up and the multiple special orders required to support these initiatives than on the basic business of helping customers to find the correct product in the store and assist in providing a satisfactory shopping experience for the customer.”

When Nardelli looks at the company’s financial performance under his leadership, he must feel somewhat frustrated. Whereas once Depot’s gross margin was in the 27% range, he has continued to increase it to its current 30.83% figure, up from the five year average of 29.26%. Net profits averaged 5.5% for the past five years; he boosted it to 6.5% in 2002.

Earnings growth in 2002 reached 45%, much higher than the five year average, but sales growth has fallen sharply. The five year growth average was 22%, in 2002 it was 16%. Meanwhile, Lowes, its nearest competitor, grew sales 20% in 2002 and earnings by 45%.

With profits up and sales continuing at a decent though not spectacular pace, Nardelli is watching the company’s price/earnings ratio plummet — from a high of 80 in the past five years to its current 13.63, well below that of Lowes and, indeed, lower than the average of other big-box retailers in the hardgoods field.

Still powerful
No one, however, should underestimate the continued strength of Home Depot, despite the outstanding efforts of Lowes in competing with it. Depot continues to be more than twice the size of Lowes, at more than $58.5billion in sales in 2002, and earned more in the second quarter of 2002 than Lowes did in all of last year.

Because Nardelli recognises Depot’s near-saturation of major metropolitan markets, he is leading the company into a variety of different formats and strategies, amplifying the diversification program begun under his predecessors, Marcus and Blank.

The most significant of these, depending upon its success, could be the development of smaller stores. These are being tested in urban settings — Brooklyn and Chicago, as well as in the conversion of the original four Villagers Hardware sites. If they prove successful, they might offer Depot an opportunity to move into some smaller cities where Lowes already has stores, especially down South where Lowes originated.

The other Depot formats target in a more direct way professional contractors and remodellers, two other market segments which Lowes once relied upon before moving aggressively into consumer sales. Its most aggressive such effort is its 54 Expo Design Centres, catering to upscale kitchen and bath remodelling, most often not a DIY project but an installed sale.

Depot’s other efforts like Maintenance Warehouse, flooring stores and garden centres, will also bear continued watching. They pose threats not just to other home centres but to specialty stores within those respective merchandise categories.

It recently expanded its new Landscape Supply stores from three stores in the Atlanta area to a projected five units in the Dallas region. These stores focus on the professional landscaper and the “avid” DIYer. The stores combine an indoor sales area with a large outside area and tool rental department.

So has the magic gone? The charisma of Marcus and the guiding hand of Blank are, but should Nardelli’s performance be faulted when profits increase as much as they have? Company directors, frustrated at a 54% drop in share value, may have another view of the situation.

Bob Vereen, Hardware Journal’s US correspondent.