Can Home Depot Keep Building if the Economy Shrinks?

Fund managers like the stock, despite fears of overexpansion.
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In this corner:

Home Depot

(HD) - Get Report

, one of the great growth retail stocks of the past decade.

The Home Depot File

Business: Home improvement retailer.

Fiscal 2000 Revenue:
$38.4 billion

Fiscal 2000 Earnings
Per Share: $1.

Estimated Fiscal 2001 EPS: $1.15

Estimated Earnings for the Year Ending Jan. 01: +15%

Stock Snapshot

Current P/E: 39.4

Stock Price: $45.69

52-Week Range: $70- $34.69

Percentage Change from
52-Week High: -34%

Shares Outstanding:
2.315 billion

Source: Thomson Financial/Baseline, Morningstar

And in the opposing corner: A contracting economy and construction market that have plastered the company's stock price, and a home-improvement industry that is creeping perilously close to saturation.

Will Home Depot, with the help of a new president from the ranks of

General Electric

(GE) - Get Report

, emerge victorious once again? That's the question this week's

Gut Check

put to fund managers and industry analysts. The answer: Despite the bugbears, Depot watchers are cautiously optimistic that the Atlanta-based retailer will be able to deliver the 23% to 25% earnings it has promised for 2001.

The Depot opened Jan. 2 at $45.69, down 34% from its 52-week high of $70. The stock has recovered a bit from the beating it took Oct. 12, when the company warned it would miss third-quarter earnings expectations; the stock plunged 29% to a 52-week low of $34.69. Home Depot did, in fact, post earnings growth of 13%, half of the 25% it had earlier announced.

Nevertheless, the company expects earnings to return to the 23% to 25% range in 2001. The consensus of

I/B/E/S

analysts is that the stock will move to $61.26 within the next 12 months. Also, the stock's

price-to-earnings ratio is 37.9, down from its five-year average of 44.2, according to

Morningstar

.

Most portfolio managers are cautiously optimistic that Home Depot's long-term outlook and growth plans will outweigh current challenges. Eric Morrison of the

(RMGPX)

Wilmington Large Cap Growth Institutional fund is one such manager. Morrison has invested 2.5% of his fund in Home Depot and currently ranks it as one of the fund's top-10 stock picks.

"Home Depot is one of the premier growth retailers and their management is among the best in the country. Even though the market is very fragmented, they have been able to grab market share from competitors and are always looking several years ahead for future growth," Morrison says.

"What you've got to like about Home Depot is that it

provides visible growth two, three years out," says Frank Sands Jr., director of research at

Sands Capital Management

. Sands subadvises the

(PTSGX) - Get Report

Pitcairn Select Growth fund, which has a 4% weighting in Home Depot.

Of the various expansion strategies that Home Depot has in place, the most striking is a phenomenal number of new store openings, in line with Home Depot's new store growth rate of 21% to 22% of the past five years. Home Depot plans to increase its current 1,087 stores to a more-than-doubled 2,300 by the end of 2004.

Some analysts wonder whether 2,300 of the colossal, 50,000-square-foot orange warehouses may be too many. After researching the home-improvement industry,

Prudential Securities

analyst Wayne Hood concludes the U.S. could support a total of 2,738 home-improvement superstores by 2004. However, Home Depot isn't the only drill sergeant in town. Competitor

Lowe's

(LOW) - Get Report

, a chain of 620 stores, also has aggressive expansion plans, and between the two companies, the market is in danger of becoming saturated in 2003, Hood says. (Prudential Securities has done no underwriting for Home Depot.)

For Home Depot to double the size it has achieved over the past 22 years in the next four years will mean doubling its current work force to 460,000, says John Caulfield, executive editor of

National Home Center News

. This will be no easy feat, given the current unemployment rate of 4%, Caulfield says.

"The question is, can they

continue to expand without an acquisition and can they do this in the U.S.? The answer to both is no," Caulfield says. "To grow this fast, some of that growth will have to be outside of the U.S."

Bill Batcheller, senior portfolio manager of the

(AMTMX)

Armada Tax Managed Equity fund, believes international markets could become more important to Home Depot as it finds it increasingly difficult to beat previous strong year-over-year comp store sales and earnings in the U.S.

Home Depot has said it plans to expand beyond its current international footholds in Canada and Latin America. The company also plans to expand its primarily retail customer base to include more professional contractors and builders. Home Depot services professional customers in 18 markets and plans to have this service in 500 stores by the end of 2001 and in 80% of all their stores by 2003, Caulfield says.

Home Depot is also expanding in other ways. It has broadened its merchandise mix to include appliances, flooring, cabinets and tools for rent. It also has big plans for two new store lines, the Expo design stores and Villager's Hardware, a scaled-down, more personalized version of the Home Depot warehouses.

Home Depot recently extended sales and product training to bolster the average annual $200,000 sales per salesperson, says Roselia St. Louis, assistant portfolio manager of the

(LALCX)

Lord Abbett Large Cap Growth fund, which has 1% of its assets invested in Home Depot.

Now led by Robert Nardelli, Home Depot's new president as of Dec. 5, the company is expected by analysts to do an even better job of managing inventory, distribution and costs. Nardelli was renowned for his cost cutting and merger-and-acquisition activity as CEO of

GE Power Systems

. He had been a leading contender to take over Jack Welch's job as CEO of the overall company.

"Mr. Nardelli is reputed to be a strong manager, and his skills in running and growing a large, multinational organization are increasingly paramount for a company of Home Depot's massive size and global aspirations," says Matthew Fassler, an analyst with

Goldman Sachs

, in a report. (Goldman Sachs has done no underwriting for Home Depot.) Budd Bugatch, senior vice president with

Raymond James

, calls Nardelli "a very accomplished senior executive who comes with the highest leadership credentials of almost anybody in American business." (Raymond James has not done any underwriting for Home Depot.)

Another catalyst some fund managers and analysts are counting on to improve Home Depot sales is a lowering of interest rates, which could boost home sales. Citing data from the

Mortgage Bankers Association of America

, Goldman's Fassler says that mortgage applications in December were up 20% from a year earlier, whereas they had declined 3% in November. This is a key catalyst for Home Depot sales because "housing turnover leads Home Depot's same-store sales," Fassler says.

St. Louis of Lord Abbett believes it's likely that the

Federal Reserve will cut interest rates further when it meets Jan. 31, because of the softening economy and the lack of inflationary pressures. Even if that does not happen, "If we go past the slowdown in 2001 and look to 2002,

Home Depot has quite a few catalysts

in place to drive growth," she says.

Still, there are some other long-term figures that have some managers and analysts concerned. Home Depot expects to post same-store sales growth of 4% for the fourth quarter, whereas it was 9% last year, Caulfield says. Also, the

Home Improvement Research Institute

expects home-improvement product sales to grow 6.2% in 2000 but for that growth to slow to 4.9% in the 2001-2005 period.

This might prompt Home Depot to focus more on the professional market, Caulfield says. He points out that three acquisitions that Home Depot recently made --

Maintenance Warehouse

,

Georgia Lighting

and

Apex Supply

-- are all distribution companies. "Over the next few years, Home Depot's earnings growth drivers will change. Eventually, all of their stores won't be retail," Caulfield predicts.