Watch for Downgrades of Home Depot

With interest rates on the rise and talk of a housing bubble not slowing down, I am anxiously awaiting some downgrades of Home Depot (HD). The stock is already fairly cheap, trading at $37 and change or 14.8x 2005 EPS estimates. However, in the current environment that multiple could contract further.

I wouldn’t be surprised to see analyst downgrades of the stock shortly. The argument they’ll make will be pretty straightforward and logical. As interest rates rise, the housing market will slow and existing homeowners will have less money to spend on home improvements. As a result, HD’s sales will slow and earnings will be at risk.

These types of comments, while mostly true, will present investors will an opportunity to buy the stock, not sell it. Worries about these things tend to be overly dramatic. And stocks tend to overreact to news as well, especially negative Wall Street comments. If HD shares drop into the low 30’s, the stock will trade at about 13x earnings. At that point, I think investors should use the doom-and-gloom scenario to step and buy the stock.

There is no guarantee the downgrades will come, but with 13 research departments rating Home Depot a “buy” and only 1 a “sell,” there are plenty of possibilities. We only need a couple of those analysts to pull their buy ratings to get a meaningful reaction.

Maytag Needs A Repair Man

Take a look at this chart of Maytag (MYG) stock. Talk about brutal. The analysts hate it. More sell recommendations than all other ratings combined. It’s the kind of situation that gets a contrarian’s attention. I’ve yet to buy the stock, but it will be something I plan to look at very closely in coming days, as the stock looks too cheap despite its problems. Anybody have any thoughts on MYG? Let me know!

Hottest Trend in Retailing: Department Stores?

Group 1: Best Buy, Walmart, Target, Home Depot, Lowes.

Group 2: Federated, May, Kmart, Sears, JC Penney.

Rewind the investment landscape a year and see which retailers Wall Street was talking about. It was the first group of companies listed above. However, nowadays it’s the second group that is getting all of the attention.

First it was Kmart buying Sears. That was supposed to be a unique situation. Kmart had come out of bankruptcy. Eddie Lambert already owned a chunk of Sears, so it made sense to buy the rest with the fortune he was making on his contrarian purchase of Kmart. Kmart owns most of its locations and has cheap lease agreements dating back decades for the rest of its attractive off-mall locations. However, once the real estate strategy was uncovered by Kmart, Wall Street analysts turned their attention to every other major retailer to try and quantify how much hidden value was there.

Federated recently announced they were buying fellow mall-based department store giant May. The stock have been on fire ever since. JC Penney has jumped 25% since rumors of that deal heated up. All of the sudden, department stores in malls across the country are the hottest investment idea in retail. But does this make any sense? Will every retail merger result in a Kmart-like jump in shareholder value?

Not likely. Merging two poorly-run retailers does not create a larger better-run, more profitable company. Shoppers have abandoned mall department stores over the years for good reason. And they’re not coming back. The attractiveness of the Kmart/Sears deal is less about improved operations as it is about creating shareholder value via other means. This will be done by selling real estate and other non-core assets. Sears can sell its stake in Sears Canada and its Lands End subsidiary. Kmart can sell more store locations since there is usually a Sears within a few miles of Kmart. The cash flow is not going to come from an influx of new customers beating down the doors of the recently renovated Kmart store that now is called Sears and carries Craftsman tools.

Why then, are the share prices of Federated, May, and Penney through the roof? It’s a valid question. A lot of people think every retailer can harness the Sears/Kmart model. If that was the case, wouldn’t they all have done it long ago? To show how speculative some investors have gotten, you only need to look at rumors that helped Circuit City stock rally. They were rumored to be looking at selling some of their real estate, given their dismal track record competing with Best Buy. Only one problem, though. Circuit City doesn’t own any real estate, they lease their stores.

I would be leary of the rallies in Federated/May and JC Penney. I hope they can get their acts together and increase profitability. It just seems unlikely that the people that have driven customers away and created an abundance of poorly-run and unappealing department stores would all of the sudden be able to turn their companies into gold, simply by merging and trying to duplicate someone else’s strategy.

Kmart Gets Another Nod from UBS

With hundreds of investment firms employing thousands of equity research analysts, you would think Wall Street would be paying a little more attention to Kmart (KMRT). How many analysts do you think cover the company? I bet very few people would say only one, but they’d be right. What sets UBS retail analyst Gary Balter apart, even moreso than his lack of fellow Kmart followers, is his track record.

Balter initiated coverage of Kmart with a “buy” rating on April 4, 2004. Back then, investors thought he was crazy. After emerging from bankruptcy, KMRT shares rose from $15 to $41 before Balter recommended them to investors. Baffled by such a move, given Kmart’s horrible track record as a money-losing retailer, people ignored Balter’s advice and many shorted the stock. That was a decision many would live to regret.

Balter was one of the few who realized that not only did Kmart rid itself of its massive debt load after its reorganization, but that its real estate was a hidden crown jewel. As the company began to sell off some valuable stores to the likes of Home Depot and Sears, investors began to realize that Kmart had potential for a monumental turnaround. Short sellers were forced to cover their positions, and investors who listened to Gary Balter and bought the stock in the low 40’s saw it soar to $109 per share by November of last year.

At that point, Balter pulled his buy rating on Kmart, reducing shares to “neutral” after the stock had jumped more than 150% since his initial recommendation and announced plans to acquire Sears. Concerns over merger integration and short selling by arbitrageurs proved the UBS downgrade to be very timely. The stock, after hitting nearly $120 when the merger was announced, fell to as low as $86 within several weeks.

In early January, I wrote a piece alerting readers that KMRT (then at $92 per share) was a smart buy amid the merger-related concerns. Once the deal closed in late March, shorts would be forced to cover and more value in the Kmart/Sears combination could be realized. Since then, the stock has risen to $112, with the deal expected to close within weeks. Tonight, sensing the deal will prove to be a success, Gary Balter is once again slapping a “buy” rating on Kmart stock, raising his price target to $160 per share. The stock is trading up $7 in after-hours trading as a result.

Investors can choose to continue to voice skepticism about the Kmart/Sears combination, but betting against Balter at this point seems risky. Eddie Lampert, the chairman and majority shareholder of the combined company, has a great track record in retail and should be able to improve operations and sell off more real estate to unlock value for all KMRT shareholders, himself included.

Below is a 1-year chart of KMRT stock. Balter’s initial recommendation, subsequent downgrade, and latest upgrade are labeled A, B, and C.

Post-Holiday Sale on Kmart Shares

What a difference a few months can make. The morning Kmart announced its $10+ billion dollar acquisition of Sears, its stock soared to nearly $120 per share. Since then, sellers have come in and arbitrageurs have opened short positions. In fact, more than 11 million KMRT shares were sold short in December, up from 8.9 million in November. The stock is down 7 points this year, to its current $92 price tag.

Investors who missed out on Kmart’s run from $15 to $120 are being given a second chance. Naysayers have been very vocal in dismissing the merger’s touted efficiencies and warning about integration risk as the retailers seek to transform their businesses as one cohesive unit, Sears Holdings.

Buyers of the stock in the low 90’s should be rewarded. Many of the shares sold short (21% of the float as of 12/8/04) will be bought back when the merger closes sometime around March of this year. Despite the claim that the combination will be little more than a larger version of a poorly run retailer, Chairman Eddie Lampert and Company will be able to improve operations meaningfully, just like they have done in the past with other retailers.

Also, don’t think real estate sales are over. There continues to be hundreds of millions of dollars in value embedded in Kmart/Sears land that will be harnessed. Post-holiday sales have brought shoppers many deals in recent days, and KMRT at $92 is a prime example of how investors can grab a great deal as well.

December Retail Sales Show Mixed Holiday Results

Today’s market was largely influenced by December same-store sales results released by America’s top retailers. While the holiday shopping season started off slowly, it appears that business overall wasn’t as bad as some thought earlier on. Thursday’s stock market action showed a clear divide between those that did well, and those that did not. Most retailers reported sales growth above consensus, but the stocks reacted violently in both directions.

As is always the case, Wall Street’s obsession with short-term results presented investors with many opportunities today, as retailers were among the day’s most active stocks. Ann Taylor (ANN) shares rallied after getting decimated late last year. Urban Outfitters (URBN) got hit after warning that 15 percent comp store sales gains could not be sustained (did anyone really think they could be?). Aeropostale (ARO) was one of the only teen retailers that did not do well, and a pair of analysts downgraded the shares based on a single lackluster month.

Most investors will sit tight, but they should really be stepping up to the plate. ARO trades at 13.5 times 2005 earnings with growth expected to be 20 percent. Makes no sense. URBN stock is reacting to less-than-expected momentum at existing stores, but their nationwide expansion plans are the reason to own the stock. I added to my position in the latter and initiated one in the former. Volatility like we saw today should make opportunistic investors salivate.