Mending relations with shareholders is a more difficult proposition than helping homeowners fix up their houses. Home Depot (NYSE: HD), however, seems earnestly trying to do both -- perhaps at the ultimate cost of greater profits.
New CEO Frank Blake is extending the olive branch to big activist investor Ralph Whitworth, whose Relational Investors owns a 1.3% stake in the do-it-yourself home-improvement retailer. He's agreed to name a Whitworth colleague to the board of directors, and he's gone to personally meet with Whitworth regarding other measures that might improve the retailer's performance. That meeting led Blake to consider selling off the company's wholesale supply business.
Supply-side rollup
The HD Supply business has been a much-maligned part of previous CEO Bob Nardelli's attempt to roll up the fragmented commercial supply business under Home Depot's orange roof. In the first nine months of 2006, the company spent about $8 billion for a dozen or so acquisitions, with roughly 27 purchases over the past two years. Whitworth charged that HD Supply not only distracted management from the company's core retail operations, but also diluted margins.
Where those core retail operations generated operating income equal to about 12% of their $61.6 billion in sales, the supply line contributed only 7% in operating margins on $9 billion in sales. Furthermore, the supply business was making about half of its sales to homebuilders. Rather than providing a balance to the home-improvement business, HD Supply was walking in lockstep with it, dragging down performance.
Whitworth's solution: Either sell it or spin it off. With Lehman Brothers (NYSE: LEH) brought on to consider these "strategic alternatives," the company would be free to focus on retail-store performance and deteriorating customer service.
In the third quarter of 2006, same-store sales decreased 5.1%, compared to a 2.7% increase the year before. New stores, which are deliberately opened near existing ones to theoretically enhance customer service and gain incremental sales, cannibalized 16% of existing stores' sales. Anecdotal evidence doesn't suggest, however, that customer service has improved.
Reconstructing the housing market
Despite all these problems, this could be precisely the wrong time to get rid of HD Supply.
With $12 billion in sales, Home Depot's supply business is healthy. Sales grew 7% in the first nine months, compared to anemic 4% growth in the retail business. HD Supply accounted for 15% of Home Depot's sales in the third quarter. By comparison, Wesco International (NYSE: WCC) saw sales rise 20% for the year, while WW Grainger (NYSE: GWW) had 7% annual sales growth.
While it might be good to offer HD Supply up while it's still a vibrant part of the business, and thus attract a higher premium, it seems unlikely that Home Depot will be able to fetch the 11 times EBITDA that it paid to acquire Hughes Supply. And if half of its sales truly are to the homebuilders, selling the line right before the sector turns around could cost the company the substantial upside of a resurgence in homebuilding.
Service with a smile -- not!
There's also a little too much fuss being made over management "distraction," which supposedly prevents them from "concentrating" on customer service. Service has been in decline for a number of years, well before Home Depot bought Hughes, and it's endemic to businesses everywhere, including Lowe's (NYSE: LOW). There's nothing magical about spinning off HD Supply that will make employees less surly.
Focusing on doing one thing well is certainly one way to improve a company, though it's not the only way. Plenty of success stories involve branching out into related lines of business that don't "distract" and don't fall into investing legend Peter Lynch's category of "deworsification."
Foolish final thoughts
Certainly, there are differences in supplying do-it-yourselfers who want to remodel their homes and do-it-for-me professionals in the commercial businesses. The latter tends to be built upon relationships developed over time, which are not easily replicated in a corporate structure like Home Depot's. Still, that customer segment isn't so far removed, either.
If selling off HD Supply brings back Home Depot from its trek in the wilderness, it will indeed be hailed as a great success for Ralph Whitworth. But if Home Depot bails out too soon, it might leave a lot of potential profit on the table.
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Fool contributor Rich Duprey does not own any of the stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.
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