Boxed In: Why Wal-Mart, Home Depot Aren't Bouncing Back

A moment of silence, please, for the fallen retail giants: Wal-Mart (WMT) and Home Depot(HD).

The Mighty Fall Big-box retail stocks slip

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These stocks were once considered the safest havens of retailing: strong, powerhouse brands with predictable earnings growth. Both are now trading more than 25% off their highs. Yet even with the Fed apparently done raising interest rates for the time being, these shares have shown no sign of recovery. What went wrong? And when might they rebound? The answers won't please holders of these onetime highfliers

The Slowdown Slowdown

First, the postmortem. The entire retail sector has been carpet-bombed by the double whammy of a slower economy, on the one hand, and tough comparisons -- of sales, earnings and margins -- with previous years, on the other. The effects of the Fed's interest-rate hikes have been gently wafting through the economy, slowing consumer spending. What was initially blamed on bad weather and a lack of compelling fashion is now likely partly attributable to a somewhat more wary consumer, one who may have seen a mortgage payment go up or a stock portfolio decline in value during the spring Internet stock debacle. Goldman Sachs just iced the cake when it downgraded the entire retail sector back in May.

Add to this generally more sluggish consumer the tough job retailers had matching the gains they had racked up in the last few years. The trouble with investing in retailing stocks is that Wall Street rewards high rates of comparable sales and earnings growth with high multiples, but those multiples inevitably compress as growth slows.

Glory Days When retail giants walked tall

Source: BigCharts

"Basically, they had terrific runs from the middle of 1998 through the end of 1999," says David Brady, senior portfolio manager with the Liberty Stein Roe Young Investor fund, which doesn't hold either company's shares. Indeed, in that period, Wal-Mart and Home Depot shares each more than doubled. "The appreciation in the share price had gotten ahead of the growth," he says.

Wal-Mart, for example, beat beginning-of-the-quarter earnings guidance by an average of 9 percentage points in fiscal 1999. In the just-released second quarter of this year, it met the consensus estimate of 36 cents. (TheStreet.com explored Wal-Mart's slowing growth in a previous story.) And when it comes to comparable-store sales, the monthly statistic that tracks sales at stores open at least a year, Wal-Mart said this week that August is tracking at the low end of its 4%-6% growth target.

Big-Ticket Growth?

Home Depot also reported second-quarter earnings that were in line with analysts' expectations after beating estimates in three quarters during fiscal 1999. The company's earnings growth rate would likely have decelerated even if the economy had kept humming, says Brian Postol, retail analyst with A.G. Edwards & Sons. The company conducted extensive product-line reviews in order to take out costs, and the bulk of the improvements in gross margins have been achieved. (He has a maintain rating on both Home Depot and Wal-Mart, and his firm hasn't done underwriting for either.)

Against the Grain Kohl's rolls

The few companies that survived the retail malaise are, for the most part, still expanding furiously. Take Kohl's (KSS), the discount department store whose stock has appreciated 61% this year. "It's in a very different phase of its growth," says Brady. "Its growth opportunities are so open-ended, and it's not as heavily reliant on comp sales at older stores. Increasing comps at newer stores is a much easier job." (His fund doesn't hold Kohl's shares.)

Costly Error Costco pays the price

And not everyone can blame the economy and tough comps alone -- there were a few individual errors, too. Costco (COST) was also considered a safe haven -- until it said in May that it fell short of first-quarter earnings expectations and wouldn't meet those for the second quarter, either. The culprit: higher-than-expected costs involved with expansion and distribution.

Harder

So on to the harder question: When will Wal-Mart and Home Depot and the rest of the big-box posse recover? Not for a while, it seems. In the case of Wal-Mart and other general merchandise retailers, early signs from the back-to-school season aren't stellar. And anxiety about the holiday season, which usually kicks in around the early fall, is already rearing its head. Home Depot, meantime, is tied more to the housing cycle. With the Fed seemingly done raising rates for now, its top-line, or revenue, growth may pick up.

Promising? Gilmartin's picks

Of course, these are high-quality names, and even critics say they're good for the long term. But there may be some more pain to be had. "Is Home Depot still a great name? Absolutely. Are they a little bit vulnerable? Sure," says Brian Gilmartin, a portfolio manager with Trinity Asset Management, which owns shares in Home Depot and Wal-Mart. "Would I be a buyer of Wal-Mart and Home Depot now? No," he says. (Among retailers, he prefers Starbucks (SBUX) and Walgreen (WAG), both of which he also owns.)

It may be well into the first quarter before the economy is humming and investors start to take into account the less-difficult comparisons the retailers will face in 2001 and start buying these stocks again. "If you're looking to make consistent money over the next year, you're going to have to get it by going in and out of the stocks," says Postol.

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