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Home Depot: Perverse Logic


Here, in a nutshell, is the perverse logic that drove the stock higher...

Home Depot (HD) reported earnings yesterday. In short, it missed earnings, missed revenues and CEO Bob Nardelli, a cheerleader if ever there was one, makes statements so bearish it would make Boo blush. What does the stock do? It rallies two bucks. Here, in a nutshell, is the perverse logic that drove the stock higher...

1) All the bad news is out:

Analysts, while optimistic in tone, are fairly bearish in their assumptions. Consensus estimates for the company are $3.10. This implies a forward P/E of 12x earnings, versus a five year average P/E of roughly 22x. Most analysts are incorporating severe margin declines (around 120bps) and comp declines of around 3 percent before some sort of stabilization in 2H '07. Anything better than this is upside. Let's forget that comp store sales came in at -5.1 percent this quarter. I will agree that the lack of a huge natural disaster this quarter did accelerate the deterioration in comps, but housing is still the driver. And, even Nardelli is saying the worst is not over.

2) Comparison-wise, next year should be easy:

The thinking on this is best summed up by Deutsche Bank's Mike Baker: "Even without a substantial improvement in the housing market next year, HD's comps should look better simply as comparisons ease…If we assume continued significant erosion in the three-year run rate of comps in 2007, then the reported quarterly comps next year will turn flat to positive by 3Q. Frankly, this could be overly bearish, as the three-year, comp run rate is actually improving in 4Q if HD can hit its MSD guidance in 4Q."

There is some validity to this, and the market will look kindly on HD, if it does cycle those comps positively. But it also reminds me a little of how I thought about my car in High School. I had a '77 Plymouth Gold Duster that broke down at least once a week. It was a crappy car, but it looked great compared to my buddy's '78 Ford Pinto.

While we do live in a relative world, the fact that HD's revenues, income and FCF-generation are on a downward trend is not made better by them improving from horrible to merely bad. The argument for HD was that it was no longer a cyclical stock, therefore it deserved an above-market P/E. Guess what, it is a cyclical stock.

3) And, my favorite, the Fed will cut rates and everything will be fine:

To give the devil his due, more so than for many industries, HD is interest rate sensitive. HD's relative performance does improve in a falling rate environment, showing a roughly 84 percent correlation to interest rate cuts, according to Baker. But it is not clear that the Fed is cutting rates. And, even if it does, the timing and consistency of the cuts are not clear. So to bet on HD as a bet on interest rates, my advice would be start playing fed fund futures, its correlation to interest rates moves is much higher.

Steve Zausner contributed to this article.
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