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Wednesday, November 15, 2006

Analyzing Home Depot (HD)

By Yaser Anwar, CSC of Equity Investment Ideas

Yesterday morning HD reported disappointing 3Q results. The stock was up over 4% in a strong market which has me thinking that

1) Possible rumors about an M&A activity or...

2) The Street thinks its found a bottom (which I kind of doubt)

...but the most likely catalyst seems to be...

3) The Fed comments about the economy & wholesale inflation is easing, raising hopes that the Fed will cut interest rates in early 07.

HD reported revenues of $23.1 bn, vs Street estimates of $23.4 billion, driven by a faster than anticipated deceleration in housing, absence of hurricane activity, commodity pricing, and softness in discretionary projects.

HD's comps fell 5.1% and 4th Q comps are expected to be down in the mid-single digits, while EPS is expected to decline 12%-16% YoY, leading to 4%-5% EPS growth for 06.

CEO Nardelli expects the housing decline to affect HD in 4Q'06 and into 2007. HD’s 3Q gross margin decreased 92 bps YoY to 32.6% due to a mix shift towards the lower-margin.

"Housing-related issues came faster and deeper than we thought," CEO Robert Nardelli said during a conference call. "They will pressure throughout all of '07, and we think there is deeper to go." With 10 consecutive months of declining housing turnover, the housing market is beginning to significantly impact HD’s results.

Management noted that, relative to other players in the home improvement sector, HD may feel more pressure from its exposure to the housing market, given its large number of stores in bubble markets in the Northeast, California, and Florida.

Management now expects earnings of $2.83 to $2.86 per share on revenue of approximately $91.29 billion. HD's previous guidance was for earnings to be at the low-end of its earlier guidance range of $2.99 to $3.10 per share on revenue of $92.92 billion to $95.36 billion and the current consensus earnings estimate is $2.96 per share on revenue of $92.42 billion for the year ending January 31, 07.

Sales in Mexico were strong during the quarter, with double-digit sales growth. According to management, Canadian sales also showed strength. Management also stated that it expects $1 billion in sales from its catalog and Internet business in 06. The home services segment grew 11.3% to $1 billion due to strong growth in countertops, HVAC, and exterior patio projects.

From 03 through 06, HD has had a 3-year CAGR of about 12% in sales. This sales growth has been a function of modest growth in SSS, new store additions, and acquisitions in the Professional market. Home Depot's ROIC has increased steadily over the past 5 years, to 20% in 06.

While some analysts believe that the worst is now behind HD, I'm not convinced. Based on trends in the housing market, I believe HD's results will likely get worse before they begin to improve.

With a stagnating housing market, a tough competitor gaining market share and slowing growth issues related to store saturation in the US market, investors should expect Home Depot shares to come under pressure.

Given the economic condition investors should expect a further deteriorating housing market over the next few quarters or more, alongside HD's issues of store saturation and intense competition. That being said, at a multiple of 11 for 08 EPS estimate, the shares trade at a discount to Lowe's (LOW) and a significant discount to the S&P 500.

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