Home Depot Turnaround Progresses

The home improvement giant scores an impressive third quarter and tweaks up its full-year guidance.
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Updated from 7:54 a.m. EST

Home Depot's

(HD) - Get Report

turnaround took another step forward on Tuesday, but the company still has a long way to go.

The home improvement company posted record earnings and revenue in its recently completed third quarter. But the performance was likely boosted by strong macroeconomic factors, including the improving economy and the continuing refinancing boom, as well as easy comparisons with last year.

Despite those factors, Home Depot again struggled to keep pace with chief rival

Lowe's

(LOW) - Get Report

. Meanwhile, Home Depot saw an apparent decline in new store productivity in the quarter. And the company's outlook for the fourth quarter remains unchanged.

"It was a solid quarter," said Fran Radano, who covers the company as a buy-side analyst with Gartmore Global Investments. "It sounds like they're starting to do some of the right things, but it's clearly not a perfect story."

(Gartmore is overweight both Home Depot and Lowe's.)

Other investors seemed to have a similarly mixed reaction to Home Depot's report. Although the company's shares traded up immediately following its report, they were down 6 cents, or 0.2%, to $35.41 in recent trading.

To be sure, Home Depot's third quarter was impressive. The company boosted its per share earnings 25% from the year-ago period on a nearly 15% increase in overall sales.

For the quarter, the home improvement retailer earned $1.15 billion, or 50 cents a share, on revenue of $16.6 billion. In the year-ago period, the company earned $940 million, or 40 cents a share, on sales of $14.48 billion.

Analysts surveyed by Thomson First Call were looking for earnings of 46 cents a share on $16.26 billion in sales.

The sales increase was driven largely by a strong performance in same-store sales, which measure the results of outlets open more than one year. Comparable-store sales increased 7.8% in the quarter, which marked Home Depot's best quarterly performance since the fourth quarter of 1999, according to the company.

In addition to the strong sales, Home Depot's bottom line also benefited from cost controls in the quarter.

The company's gross margin, which represents the difference between what a company charges for its goods and what it pays for them, increased by 35 basis points in the quarter to 31.29% of sales.

Last year, Home Depot got lower prices from suppliers as it bought large quantities of merchandise to rebuild its inventories, said company CFO Carol Tome. The company did not get as many discounts this year, Tome said.

But this increase in product costs was offset by a larger decline in operating costs as a portion of sales. Such costs, which include marketing, store opening, general and administrative expenses, declined 1 percentage point to 20.3% of sales.

The strong same-store sales, coupled with higher productivity, helped keep operating costs in line, Tome said.

While impressive compared to its past performance, Home Depot's report left several doubts for investors.

The company's same-store sales gain, for instance, was made easier to achieve by the fact that Home Depot's comparable-store sales declined 2% in the year-ago period. And while the company's sales per square foot increased 4.2% over the third quarter last year, they were again up against an easy comparison. Until this quarter, sales per square foot at the home improvement chain had declined in 13 straight quarters.

Meanwhile, the company's new stores apparently aren't performing as well as those it operated in the past. In the year-ago quarter, new store productivity was about 81% of the company's existing store base, according to a buy-side analyst who covers the firm. But in the just-completed quarter, new-store productivity dropped to 69% of the company's older stores, according to the analyst, who asked not to be named.

"That's a telling sign that their new stores aren't doing so well," said the analyst, whose fund has no position in Home Depot, but is long Lowe's.

And despite Home Depot's performance, the company couldn't match rival Lowe's. In its third-quarter report on Monday, Lowe's

posted a 30% gain in per-share earnings on a 24% jump in sales.

"Home Depot is losing share left and right," said the analyst.

Home Depot may have added to those worries by forecasting limited upside for the fourth quarter. Although the company upped its full year guidance, that increase merely incorporated its 4-cent-per share outperformance in the third quarter.

The company now expects to post its earnings per share to grow 15% to 17% over last year's profits of $1.56 a share. That puts its estimate at about $1.79 to $1.83 a share for the full year, or about 33 cents to 37 cents a share in the fourth quarter.

Prior to today's report, analysts polled by Thomson First Call had projected that Home Depot would earn 35 cents a share in the fourth quarter and $1.77 for the year.

Despite Home Depot's strong third quarter, Gartmore's Radano and others believe that the retailer's stock may not be the best one to buy for the short term. Home Depot shares have already risen nearly 50% this year, outpacing the S&P 500.

While other retailers typically record the bulk of their sales in the holiday quarter, that's typically not the case for home improvement chains. So, while companies such as the

Gap

(GPS) - Get Report

and

Best Buy

(BBY) - Get Report

could see their stocks soar on booming holiday sales, Home Depot and Lowe's shares may see little benefit, said Radano.

"If you're looking for a 60-day trade, these are not the names to be in," he said.

As for the longer haul, Home Depot may be a good investment, but its still got issues to work through, Radano and others say.

"You've got a maturing company. How well can they continue to improve their merchandise and smartly cannibalize their stores?" said Tom Goetzinger, who covers the company for Morningstar.

(Morningstar does not do investment banking and Goetzinger does not hold Home Depot shares.)