Can Home Depot Raise the Roof Again?

To their credit, Home Depot's executives didn't wallpaper over the giant retailer's results for the quarter that ended April 29. The Depot's bosses admitted that performance was awful and that the rest of the year won't be grand, either. First-quarter sales at U.S. stores open more than a year dropped 7.6% from the same period last year. Gross and net profit margins shrank. The average sales ticket -- that is, what every customer spent on a given trip to the store -- also went down. That's partly because the stuff that did sell briskly -- home appliances -- moved only because of deep discounts.

Shades of Wal-Mart? Looks that way. And there's more. Since 2002, Home Depot (symbol HD) has spent $16.5 billion to buy back shares, to little avail. The stock's annualized total return for the past five years is -2%. There's a lot more here than the failure of ousted CEO Bob Nardelli and the controversy over the $210 million he got to resign. What's a mere $210 million when a slug of corporate capital 80 times greater failed to give long-term stockholders even under-the-mattress returns?

With Nardelli history, Home Depot now blames the flagging housing market for the stock's tough going. That implies that once the nation's inventory of unsold houses shrinks and real estate sales prices firm, Home Depot shares will rise again.

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It's true that when homebuilding and remodeling are off, you don't see the contractors streaming into your local HD early in the morning. But the nexus between housing and the stock isn't that tight. In 2002, the median sales price of an existing single-family house (the slice of real estate in which buyers are most apt to undertake improvements) rose 7%, while HD shares fell 53%. In 2003, house values gained 8%, while HD stock went up 49%. In 2005, arguably the apex of the last housing boom, with home sales prices up 12% and a record 7 million existing residences changing hands, HD stock fell 4%. The stock closed at $38.37 on May 15, up 0.18%.

OK, we know, you can sell shares instantaneously, while a house is illiquid and immobile. But viewing HD shares as a kind of call option on real estate makes no sense. For that kind of leverage to residential real estate, you ought to load up on homebuilder stocks.

In less than a decade, HD has gone from a steady growth company that generates returns of at least 20% a year to a sometimes-reviled and chaotic retailer. The stock's price-earnings ratio has gone from the 35 to 45 that's associated with glamour stocks to a P/E of 15 (based on estimated earnings of $2.61 per share for the year ending January 2008) -- less than the 16 for Standard & Poor's 500-stock index.

HD won't go out of business or even close stores, but its growth prospects are not what they used to be. And, although it has a presence in Canada and Mexico, it's just starting in China and has no other significant source of foreign earnings. That's another echo of Wal-Mart, which is known for its international struggles.

A few friendly analysts find hope in one trend that should be apparent if you shop at HD this summer: better service. The management now sees the folly in Nardelli's decision to cut staff and hire more part-timers, undercutting Home Depot's reputation as a helpful merchant instead of just a place to buy nuts and bolts cheaply. Some of those millions that went into executive pay and share buybacks might find their way into the stores -- and maybe that will help. But there are no obvious reasons to think this will be one of the Dow's stronger stocks for the rest of the year. Sometimes, as the expression goes, let sleeping dogs lie.