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Home Depot’s 3 Part Recipe For Success

By Dan Moskowitz – Jul 25, 2014 at 9:00AM

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This is a different kind of stool, one that pertains to Home Depot’s future and potentially your investment portfolio.

Home Depot (HD 0.58%) launched its interconnected retail strategy early last year. Now it's time to see if it has been effective, and if it's likely to aid Home Depot's growth going forward.

Interconnected Retail
The seat of Home Depot's three-legged stool is Interconnected Retail. The three legs holding up the seat are customer service; product authority; and disciplined capital allocation, productivity, and efficiency. 

Interconnected Retail is intended to connect the three key initiatives listed above (three legs of the stool) to build a seamless and competitive experience platform across all commerce channels.  

Customer service
Customer service is what Home Depot is most passionate about. The ultimate goal is to build an emotional relationship with customers. 

If you have walked into a Home Depot on the weekend recently, then you might have noticed many more smiling employees saying hello to you. This is a nice improvement, but try visiting during the week during off-peak hours. You will not receive the same greeting. In order to be great, Home Depot must offer this excellent customer service at all times. However, numbers don't lie, and Home Depot's Net Promoter Score has consistently improved since 2007.   

The easiest way to explain the Net Promoter Score is that it's based on the number of customers who would recommend shopping at a specific retailer. Home Depot sees this as important information since it used the Net Promoter Score as part of its 2014 Oppenheimer Consumer Conference presentation.

In 2007, Home Depot sported a Net Promoter Score of 50%. Without any annual declines, that score has improved to 73% in the first quarter of 2014.

Additionally, Home Depot has gained traction with its Pro Xtra loyalty program, which now has more than 1.5 million enrollees. Pro Xtra provides customers with discounts on useful business services, exclusive product offers, and streamlined payment and receipt tracking tools. Pro Xtra member shopping frequency, ticket size, and size of basket all increased in the first quarter.

Customer service and loyalty are important, but they're still just one leg of the three-legged stool. In order to drive new (and repeat) customers to its stores, Home Depot also needs to sell highly appealing merchandise.

Product authority
Home Depot is focused on product innovation, assortment, and value. Examples include expanding LED light bulbs from Cree, introducing a gas-powered lawn mower from Toro that folds up in your garage and saves 70% storage space, and adding KitchenAid to its appliance assortment.

Home Depot deserves a healthy check mark in this category. Now let's move on to the matter shareholders care about most.

Disciplined capital allocation, productivity, and efficiency
In order to build shareholder value via higher returns on invested capital and total value returned to shareholders, Home Depot will focus on continuous store and supply chain operational improvements. Home Depot hasn't provided many details on how it will improve its supply chain, but there are some important numbers you should know.  

Home Depot's annual dividend per share has increased from $0.95 in 2010 to $1.56 in 2013, and it's forecast to reach $1.88 this year. Home Depot's annual dividend yield is currently 2.3%, considerably higher than the 1.1% yield for S&P Retail ETF and slightly higher than Lowe's (LOW -1.16%) at 2%.

In the first quarter, Home Depot generated $2.6 billion in cash flow from operations. With that, it spent $1.25 billion on share buybacks, $646 million on dividends, and $287 million on capital expenditures. The return on invested capital came in at 21.2% versus 17.7% in the year-ago quarter.

Cash flow from operations provides Home Depot with a significant source of liquidity. This is very important for investors in a time of uncertain economic growth for the United States. If the economy falters, then you want to rely on a company that will still take care of its shareholders. While Home Depot and Lowe's both take care of their shareholders, Home Depot generates more cash flow:

HD Free Cash Flow (Annual) Chart

Home Depot Free Cash Flow (Annual) data by YCharts

And it's generating its cash flow at a faster pace:

HD Free Cash Flow (Annual) Chart

Home Depot Free Cash Flow (Annual) data by YCharts

When it comes to efficiency, the same story unfolds for return on invested capital:

LOW Return on Invested Capital (Annual) Chart

Lowe's Return on Invested Capital (Annual) data by YCharts

Once again, Home Depot is growing its ROIC at a faster pace:

LOW Return on Invested Capital (Annual) Chart

Lowe's Return on Invested Capital (Annual) data by YCharts

The bottom line
The first two of Home Depot's three-legged stool initiatives should lead to maximized top-line and comps growth. The third leg of that stool (based primarily on shareholder returns) looks very sturdy. This is imperative in one of the most uncertain and unpredictable economic times in history. 

Dan Moskowitz has no position in any stocks mentioned. The Motley Fool recommends Home Depot. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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