Home Depot's Higher but Fragile Hopes

Home Depot (HD) offered some encouragement to bullish investors on June 10 when the retailer raised its earnings estimates for the year. The home improvement giant also unveiled a variety of ways executives are trying to improve and cut costs in areas ranging from its supply chain to information technology and employee training.

But despite these efforts, Home Depot again demonstrated how closely its fate is tied to that of the broader economy, and especially to the housing market.

The good news: Executives were confident enough to increase their 2009 profit prediction. Rather than an earlier estimated drop of 7% in earnings per share, they say profits for 2009 could be flat or down as much as 7&. The company still expects 2009 sales to fall about 9%.

The news could be interpreted as a sign that the chain, along with many other retailers, is finding ways to widen profit margins during the recession—even as sales fall. "Home Depot is making the right moves to restructure themselves for a better environment," says Morgan Stanley (MS) analyst Gregory Melich.

" a very good may"

The near-term outlook for sales is improving, too, executives say. Chief Financial Officer Carol Tomé told analysts that "economic signals remain mixed," but added, "we had a very good May. May was better than the first quarter and it was better than April. Now it's June, and June is continuing to be very good relative to our plans."

She warned, however, that recent strength was driven by seasonal sales that could end by early July, prompting the company to remain cautious. "Our sense is a decent sales performance in May provided management with some comfort going ahead with the improved guidance," Robert W. Baird analyst Peter S. Benedict said.

Improvement in the economic environment is crucial for a retailer like Home Depot. Economists and many consumers have become more optimistic about the prospects for the economy later this year and in 2010. The stock market, represented by the Standard & Poor's 500-stock index, is up more than 30% in three months.

fears of rising mortgage rates

But there are signs of danger. Gas prices are on the rise, eating up more of Americans' stagnant incomes. The price of a barrel of crude oil, above $71 on June 10, is nearly double the price in January. The May jobs report, issued on June 5, showed wage growth slowing to a crawl, with average hourly earnings up 0.1%.

"The ongoing concern is that consumer spending is weakening anew, which could ultimately lead to a double-dip in activity for the economy as a whole," Deutsche Bank (DB) economist Joseph LaVorgna warned on June 9.

Home Depot's fortunes closely track those of the depressed housing market. America's housing bust is largely responsible for the home improvement chain facing its third consecutive year of declining earnings and sales. "The macro environment will remain the key driver of this stock in the near term," says Credit Suisse (CS) analyst Gary Balter. Of particular concern are rising mortgage rates, which make home buying more expensive. "Rising rates could quickly extinguish hopes for a steady recovery into next year," Balter wrote.

Home Depot's Tomé says the company is closely watching foreclosure rates across the country. (Although at least one analyst, Stephen Chick of FBR Capital Markets (FBR), believes foreclosures could actually spur sales at Home Depot, "as many of these foreclosed homes require renovations and updated maintenance.")

residential spending may have bottomed

Home Depot keeps an eye on private residential spending, too, saying the data point often closely tracks its own sales trajectory. Here, Tomé says residential spending, now at a 60-year-low, might have hit bottom. "Our belief [is] that the majority, if not all, of the contraction is behind us," she said.

Baird's Benedict agrees housing might finally be near the end of its long slide. "The lion's share of the correction in housing and housing-related spending has occurred," he wrote. And Citigroup (C) analyst Deborah Weinswig said in a June 10 report that "the housing market is showing early signs of recovery in markets that fell first."

The problem is that housing's early recovery—as well as any burgeoning optimism about Home Depot— could be stopped in its tracks. That's why the company's investors are watching the economic data carefully, wary of a negative swing in consumers' moods or a further rise in interest rates.

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