Home Depot's Supply Saga

We've all been hearing about how the slowdown in the housing industry -- fewer homes being constructed, a slower resale of homes at lower prices, and less equity extraction from existing homes -- was going to have an impact on home-improvement retailers such as Home Depot (NYSE: HD  ) and Lowe's (NYSE: LOW  ) . According to its third-quarter release, Home Depot did feel the squeeze. But that's not what's troubling me at the 800-pound orange gorilla of a retailer.

At first glance, sales growth of 11.3% and gross profit growth of 8.2% over the previous year's quarter don't seem like bad results during tough times. (Here's the breakdown of the full numbers.) This giant is obviously still growing, and the growth is coming from its commercial supply business.

The retail segment saw flat sales growth and a small decline in operating income, and for as bad as things are supposed to be, those results aren't unexpected. But the supply segment zoomed ahead with 159% sales growth and 117% operating income growth. Most of that growth was due to acquisitions.

I don't have a problem with Home Depot's "enhance the core, extend the business, expand the market" strategy. In fact, I think it's the right way to be thinking about generating future growth. But even with all of that growth in its commercial supply business, something's bothering me.

Have a look at the operating margins for the past three quarters at the supply business.

Q3 2006

Q2 2006

Q1 2006

Sales

$3,529

$3,492

$2,132

Operating Income

$245

$263

$149

Margin

6.9%

7.5%

7.0%

Data from quarterly financial statements.

On average, the retail business generated 12% operating margins over the same time period.

That comparison is what's bothering me. Home Depot is spending billions acquiring commercial supply businesses whose operating margins are significantly below those in the retail segment. And not only that, but they are also significantly below margins at competitors such as MSC Industrial Direct (NYSE: MSM  ) , Applied Industrial Technology (NYSE: AIT  ) , WW Grainger (NYSE: GWW  ) , and Fastenal (Nasdaq: FAST  ) .

MSM

AIT

GWW

FAST

TTM Operating Margin

18.0%

6.3%

10.3%

17.8%

Data from Capital IQ, a division of Standard & Poor's.

I know the commercial supply business is highly fragmented and that inefficiencies remain to be wrung out as time progresses. And those operating improvements should lead to increased margins and increased returns on invested capital. But I question whether it's enough to justify Home Depot's stock price today. Time will tell, but I'll be more than happy to watch things unfold from the sidelines.

For more on the orange big-box behemoth, check out:

Home Depot is aMotley Fool Inside Valuerecommendation, home of the market's best bargain stocks. See what other recommendations Philip Durell and company have made by checking out Inside Value free for 30 days.

Retail editor and Inside Value team member David Meier does not own shares in any of the companies mentioned. He is currently ranked 101st out of 12,984 investors in the Fool's CAPS rating service. You can view his TMF profile here. The Fool takes its disclosure policy very seriously.


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