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Home Depot: A Fixer-Upper Stock

The home improvement chain has retooled--and may be able to outperform despite the struggling housing market.

By Mina Kimes, reporter
Last Updated: February 25, 2009: 2:46 PM ET

NEW YORK (Fortune) -- Wherever the housing market goes, so too does Home Depot. The home improvement retailer's earnings have historically grown or struggled alongside home sales.

Because of that correlation, Home Depot's shares fell on Wednesday after the National Association of Realtors announced that existing home sales tumbled 5.3% in January, their lowest levels since 1997.

Yet despite the mortgage market's malaise, Home Depot (HD, Fortune 500) has managed to gratify investors, outperforming the market in 2008 by dropping just 12%. And on Tuesday, HD's stock jumped 10% after the company reported earnings of $0.19 a share, which beat analyst forecasts of $0.15.

Housing woes

The implosion of the mortgage market has hammered Home Depot, which is the second largest U.S. retailer after Wal-Mart (WMT, Fortune 500). Its quarterly profits have declined for more than two straight years. But the company's latest announcement of earnings suggests that internal cost controls and operational improvements are paying off.

"Despite the tough sales environment, Home Depot has been doing a very good job of managing expenses," says Michael Lasser, an analyst at Barclays Capital. "That's going to benefit them in 2009."

Lasser says that companies in the home improvement sector went down before the rest of the market, and they're likely to rebound prematurely as well. "Home Depot is an early cycle stock," he says. Lasser thinks its shares will bounce back before the mortgage and stock markets recover.

The canary in the coal mine

The pain started earlier for Home Depot than it did for most retailers because of the company's dependence on the housing market, which began to collapse in 2006. "Historically, Home Depot's sales have been highly correlated to housing turnover--both new and existing sales," says Lasser. "When people move into new homes, they're far more likely to make improvements."

Raymond James analyst Budd Bugatch estimates that, before the crash, Home Depot derived 40% of its sales from new home sales and another 40% from refurbishment projects. Both lines of business have since plummeted, and so too have the company's sales of more expensive items such as kitchen counters and lumber for decks.

"The day to day business--light bulbs, filters--has held up relatively well," says Bugatch. "But the big ticket project business is where they've felt the pain, and that's worth a lot more in revenues per sale than a dozen light bulbs."

A boost in home sales would put more dollars in Home Depot's wallet, says Greg Melich, an analyst at Morgan Stanley. Melich says that new home homeowners--who typically make purchases in the first six months after buying a house--will continue to fix up their properties, recession or not.

He warns, however, that while new home sales bring business to Home Depot, the size of that business will be smaller if home prices stay down. Due to the overabundance of cheap, foreclosed properties for sale, the median existing home price declined 15.3% in December.

"People's willingness to spend on their houses is directly related to what they think their homes are worth," Melich says. "For example--say you need to renovate your kitchen, and you're not even thinking about selling your house. You're still more likely to get the fully fitted, awesome kitchen if you believe your home is worth more. It's proportionate."

Rather than relying solely on existing home sales to forecast Home Depot's revenues, Melich also factors in home prices, 30-year mortgage rates, and average hourly wage rates. His metric improved slightly in December, but he still projects weak demand over the next six months.

Waiting for Depot

Home Depot's customers may be backing away from big projects, but the retailer itself is undertaking a major remodeling. Blake announced in January that Home Depot will saw off its Expo arm, a largely unsuccessful chain of 34 stores that sell premium products like expensive tiling and fixtures. While the move produced 5,000 job cuts, it was lauded by analysts as a smart divestiture.

"They're refocusing the business back on the traditional orange box," says Bugatch. "Home Depot has done a very good job of controlling its costs--it's maintaining its discipline through these difficult times. He points out that the company has managed to shrink its operating expenses even though sales at stores open for a year or more have been negative--a difficult feat for a retailer.

Lasser says that Home Depot's cost cutting, while well-targeted, is largely impressive only because it had so much room to cut. By comparison, Lowe's--viewed as a superior investment by most analysts--has a slightly healthier balance sheet and still has room to cut expenditures. Its debt to EBITDA ratio is 0.9, while Home Depot's is 1.6.

Another edge that Lowe's has over Home Depot is distribution. Lowe's (LOW, Fortune 500) sends the majority of its products through 13 regional distribution centers, hubs that make it easier for the company to control inventory. Home Depot only recently rolled out four of these centers

But Home Depot's management says that its attempts at improving supply chain efficiencies are already paying off--and its latest earnings, which were more impressive to analysts than Lowes', suggest they may be right.

RBC Capital Markets analyst Scot Ciccarelli says that the returns on the supply chain investment may not be fully visible for a few years. "When a company is in turnaround mode and their industry is under a lot of pressure, improvement is hard to see," he says.

Ciccarelli thinks that home improvement retailers are the safest plays in the housing sector. While it's unlikely that Home Depot will see positive sales for at least another year, the company's improvements have set its profits--and its stock--on the road to recovery.

"All of Depot's efforts are better positioning the company for an eventual rebound," says Lasser. In a year or two, the operational foundation that Home Depot is building will be ready--and so will its customer base of new homeowners. To top of page

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