Top Line Stings Home Depot

The retailer's soft sales signal that its business is maturing.
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Home Depot's

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first-quarter earnings rose 19% from a year ago as the company's recent acquisition of Hughes Supply roughly doubled the size of its supply business. Still, weaker-than-expected sales on the retail side sent shares lower Tuesday.

The Atlanta-based home-improvement retail chain said it earned $1.48 billion, or 70 cents a share, in the first quarter, up from $1.25 billion, or 57 cents a share, a year ago. Analysts surveyed by Thomson First Call were expecting earnings of 67 cents a share for the latest quarter.

Despite its better-than-expected profitability, Home Depot's revenue fell short of expectations. Its CEO, Bob Nardelli, said on a conference call that he saw weakness in sales at the retailer's flooring business, which has been a key driver for the company.

Shares of Home Depot were recently down $1.47, or 3.6%, to $39.03.

The selloff comes amid widening concerns among market watchers that the slowing housing market could hurt the home-improvement retail business and weigh on stocks like Home Depot and its chief competitor,

Lowe's

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.

"Some people will view the relative weakness in sales on the retail side of their business as being tied to the slowing housing market, but that's really not the case," says Craig Johnson, president of Customer Growth Partners. "This is a company in transition as its growth slows in the U.S. and it starts to focus on international markets and acquisitions on the service side of the business."

Johnson says Lowe's now has more room to grow in the U.S., which might make its stock a more attractive investment. Lowe's will report its earnings next Monday, and analysts expect the company to post earnings of 94 cents a share, up from the 74 cents a share it reported for the same quarter last year.

Home Depot's first-quarter sales rose 13% from a year ago to $21.46 billion, just short of the $21.63 billion Wall Street projected. The latest period included about a month of results from Hughes Supply, which Home Depot acquired March 30. The purchase helped sales at its supply division jump to $2.13 billion from $657 million.

Home Depot said its retail-segment sales rose 5.7% from a year ago to $19.38 billion, which was viewed as a soft number. Still, it benefited from a rise in the average size of each purchase, as its "average ticket" rose 4.3% to an all-time high of $60.75 in the quarter. The gain occurred across all merchandise categories, the company said.

Its retail services business saw revenue rise by 8.5% to $844 million in the first quarter, thanks to solid growth in categories including countertops, windows, solar and exterior patios and doors.

"Our stores are well prepared for spring and summer with an unprecedented number of new and exclusive products," the company said. "Throughout 2006, we will continue our focus on providing distinctive, one-of-a-kind merchandise and creating excitement in our stores. Beginning this quarter, we are accelerating the reset activity in 500 of our highest volume stores and will reset over 100 bays in each of those stores by year-end."

Changes Afoot

In a sign that fundamental changes are taking place at the company, Home Depot stopped reporting quarterly same-store sales, a widely used retail metric that factors out sales growth from newly opened stores.

"This is a company in transformation from a traditional retail model to a cash flow and returns driven model," says Credit Suisse First Boston analyst Gary Balter. "That was most evident in the retail segment, where top line grew a surprisingly low 5.7% on a 6.4% square-footage increase, implying about a 1% comp, while still delivering a healthy 15.3% income increase in that division."

Balter said Home Depot is acting like a mature business by slowing investments into its core business, maximizing cash flow and reinvesting that in stock or in more opportune market-share businesses. He compared the strategy to

Sears Holdings

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and

AutoZone

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, two companies under the control of hedge fund guru Ed Lampert, who is known for sacrificing top-line growth in return for cash, profitability and higher returns for shareholders.

"We like those stories, but recognize that not everyone will," says Balter. "In that regard, we may still see more growth-oriented investors -- if any are left in this stock -- sell today as the true realization of where this company is heading became clearer. Value- or return-oriented investors, on the other hand, should react with joy and, given the depressed valuation, should be very supportive of the stock around these levels."

The company expects 2006 sales will grow 14% to 17% and earnings will rise 10% to 14%. Analysts expect Home Depot to earn $3.07 a share for the year, which would mark a 15% increase over the $2.67 a share it logged for all of last year.

Meanwhile, Balter says that Home Depot's results could bode well for Lowe's, since he attributes the weakness in retail sales to a combination of lower investments in labor, poor weather in California and cannibalization of stores.

"Lowe's continues to invest in retail infrastructure and has much lower exposure to the west coast," Balter said. "We continue to look for a 7% comp from the blue box."