Fool on Call: Building a Better Home Depot

Slowing sales in the housing sector and increased worries regarding the subprime mortgage market have created a very challenging year for Home Depot (NYSE: HD  ) . The company's recent performance and its underlying stock have suffered as a result.

Not all of the home improvement retailer's current woes are a result of external factors, however. It pleased me that in the company's latest quarterly earnings conference call, management spent very little time on the macro forces negatively affecting sales, and instead appeared most concerned with how Home Depot can do things better.

This edition of "Fool on Call" will highlight some steps the company is taking to improve the in-store experience for its customers. What we will find is that while these measures may not lead to radical improvements in the short term -- it is a tough retail environment out there, after all -- the current investments to build a better Home Depot today have the potential to pay off handsomely for the patient, long-term-minded shareholder.

Improving the customer experience
Early in his prepared remarks, CEO Frank Blake indicated that Home Depot is making strides in terms of the number of customer transactions on a comparable basis. He noted that while same-store transactions were still negative, they are improving. But just as a football team wouldn't declare victory for losing to an opponent by only 20 points this year instead of 40 the year before, so, too, Blake realizes that losing, even if it is losing less, is still not winning:

"And for our overall market, we have reversed our market-share loss. Or in other words, we're not losing market share as fast as we were. But as that last phrase indicates, we have a long way to go to get where we need to be. We don't want to be losing less share. We want to be gaining share and outperforming our market."

In large part, the company plans to get back to winning by improving its customers' shopping experience. To do that, Home Depot is investing in its stores and the people that run them.

One step it has taken is broadening the Success Sharing program -- an incentive-sharing initiative for hourly store employees. In the first half of last year, only 33% of its stores, or 86,000 employees, were part of the program. But in the first half of this year, more than 200,000 employees, or 74% of its stores, will be awarded a payout. Blake believes that the increased payout is having a positive effect on employee retention. And a happier employee is one step closer to having a happier customer.

Competitive pricing is always important in driving sales growth, but taking care of those who actually run a store or restaurant is vital. Target (NYSE: TGT  ) has found success despite competing against the King Kong of discount retailers in Wal-Mart (NYSE: WMT  ) , and that's arguably because it's been able to find a niche doing something a little better than Wal-Mart: providing better customer service. Chipotle's (NYSE: CMG  ) (NYSE: CMG-B  ) leadership has repeatedly attributed part of its success to investing in its managers.

Home Depot is taking other steps to improve the customer experience, including continually reassessing merchandise to improve the product mix. Management provided carpeting as an example -- Home Depot is now offering an additional 40 new styles, and it's enhancing its flooring displays and changing the way it presents the products to customers. Also related to merchandising, Home Depot is retooling its inventory-management system. Much more detail on this initiative came out in a recent investor conference.

Finally, the company is in the process of remodeling restrooms, polishing floors, and enhancing store lighting. It is now more than halfway finished with these maintenance projects, and already management is getting positive feedback from customers.

Improvements come at a cost ...
I think that in its effort to better compete with Lowe's (NYSE: LOW  ) , Home Depot's management has it right: Making investments to improve the customer experience should be a major priority. The downside, however, is the cost. During the second quarter, for instance, total expenses as a percentage of net sales increased 147 basis points to 21.6% from the same period a year ago. This increase is a result of both higher costs and lower sales. Payroll expenses also rose 79 basis points higher than year-ago levels.

... but they'll pay out later
In the Q&A session of the call, an analyst asked whether gross margins have the potential to be higher five years out than where they are at today. The response from management was clear: With the investments today to improve the retail experience and logistics systems, the company's margins "should grow."

Home Depot is making substantial investments right now to improve the "shopability" of its stores. It needs to take these steps to gain market share and outperform its industry. Yes, the investments come at a cost, but this is where it behooves investors to see the forest, and not just the tree. While these costs sting a bit right now, the gains could be substantial for those who extend their investment horizon from a short-term lens to, say, three to five years out.

Wal-Mart and Home Depot are both selections of the Motley Fool Inside Value newsletter service. To find out what other inexpensive moneymaking machines we're recommending, try the service free for 30 days.

Chipotle is both a Rule Breakers and a Motley Fool Hidden Gems recommendation -- the "A" shares in the former and the "B" shares in the latter.

Fool contributor Jeremy MacNealy has no financial interest in any company mentioned. The Motley Fool has a disclosure policy.


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