Integrate or exit? (Corporate Dealmaker)

Integrate or exit?

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Home Depot Inc. spent 10 years hammering together a wholesale construction supply business to complement its retail operations. Now it's considering whether to pry the two apart.

The review comes as new CEO Frank Blake faces restive shareholders and skeptical analysts after a disappointing 2006 for the core retail business -- and with memories of the company's rocky ride under former CEO Bob Nardelli still fresh. The problem isn't that building HD Supply was such a bad idea; it's that the project is far from finished, and Blake and his team have other pressing tasks at hand. "They have a formidable task of improving their core business, implementing systems in retail and especially distribution. It's going to be a big effort for these guys," says Sanford C. Bernstein & Co. LLC analyst Colin McGranahan. "They were at risk of destroying one of the best retailers that's ever existed."

HD Supply is the product of no fewer than 39 acquisitions -- many of them executed by Blake himself, who had served as Home Depot's executive vice president of business development and corporate operations before taking over as CEO in January. Blake followed Nardelli, his former boss at General Electric Co.'s Power Systems division, to Home Depot in 2002. The wholesale strategy predates Nardelli's arrival, but the team of former GE executives -- which also includes Joe DeAngelo, who was promoted to become HD Supply chief in 2005 -- kicked it into high gear. At GE, Blake eventually rose to senior vice president of corporate business development before leaving for a 10-month stint as deputy energy secretary.

Since taking over at Home Depot, Blake has made turning around the retail business his priority. He launched a $2.2 billion initiative to invest in older stores, to bring in expert employees such as retired plumbers to work the plumbing aisles and to focus on customer service and store appearance. He also retained Lehman Brothers Inc. to conduct a review of Supply. The company declined an interview and has been tightlipped, maintaining it won't talk publicly until it reaches a decision on whether to keep, sell or spin out the business. In the meantime, financial buyers, and a few strategics, are circling.

The review comes at a pivotal time for the supply business. Home Depot only recently began rebranding the businesses acquired to build Supply under the HD Supply name, and it has yet to fully integrate the businesses with each other and with the retail division. "While the integration effort might not be a complete hairball," Blake told analysts on a recent earnings call, "it is sufficiently difficult to warrant checking -- before we begin -- on whether we can create more shareholder value through other alternatives, such as a sale."

	Hammering together Supply
	HD Supply was built on about 39 acquisitions that delivered new business linesand geographic reach, while taking out competitors. Here's a sampling:
Who		Acquired	Price ($bill.)	What they do	Significance
	Edson Electric Supply Inc. Phoenix	Aug. 2006¹	Undisclosed	Electricity distribution	Coupled with Hughes, gave Supply's electric business a Southwest presence
	Hughes Supply Inc. Orlando	Mar. 1, 2006	$3.51	Construction, repair and maintenance-related product distributor	Bulked up electric business, waterworks and distribution businesses (more than doubling Supply's business)
	National Waterworks Holdings Inc. Waco, Texas	Aug. 2005	1.35²	Water transmission equipment distribution	Platform for water transmission equipment business
	Brafasco Brampton, Ontario	July 2005¹	Undisclosed	Fastener supplier	Grounded fasteners and tools business
	Williams Bros. Lumber Co. Suwanee, Ga.	June 2005¹	Undisclosed	Commercial lumber supply	Helped insulate Supply against a housing downturn; platform for lumber business
	White Cap Construction Supply Inc. Costa Mesa, Calif.	June 2004	Undisclosed	Operates a contractor supply business and free standing stores	Platform for construction supply business
	Creative Touch Interiors San Diego	Jan. 2004¹	Undisclosed	Flooring, countertops, window treatments and design services	Anchored the interiors unit
	Apex Supply Co. Dallas	Dec. 1999¹	Undisclosed	Wholesale plumbing/HVAC distribution	Grounded plumbing business
	Contractors Warehouse North Highlands, Calif.	June 28, 1999	Undisclosed	Contractor building materials and equipment rental business	Anchored repair remodel business
	Maintenance Warehouse Corp. San Diego	Mar. 1, 1997	Undisclosed	Direct-mail marketing of maintenance and repair equipment	Provided marketing expertise
¹ Deal announced ² Corporate Dealmaker estimate Source: Corporate Dealmaker

It's also a critical time for the corporation. After years of explosive growth, year-over-year sales at Home Depot declined in 2006 for the first time. In retail, comparable store sales dropped 2.8%, while net sales grew just 2.6%, to $79 billion, and return on invested capital fell to 20.5%, compared to 22.4% for fiscal 2005. The company also admitted losing share in the home improvement and professional supply market, some of that presumably to its smaller, agile competitor Lowe's Cos. Nardelli was forced out in January after a turbulent year in which he faced intense criticism over his $38.1 million compensation package, an annual meeting that some board members didn't attend and cost-cutting measures perceived to have a negative impact on retail. A stock option backdating scandal -- which predated Nardelli -- also erupted in 2006, and a proxy contest followed. It has since been dropped.

Today, shares are trading in the upper $30s, down significantly from their record high of near $70 in December 1999 -- the same month Nardelli moved in. And Home Depot's aggressive expansion has slowed. The company operates 1,872 retail stores in the U.S., 155 in Canada, 61 in Mexico and with its December 2006 deal for Beijing-based The Home Way, 12 in China. Back in 1997, the company was planning to expand to more than 1,000 stores internationally by 2000 and grew to 2,100 outlets, mostly retail, by 2007.

No matter what Home Depot ultimately decides to do with its supply business, Blake faces some serious challenges. The residential construction market is down for the sixth consecutive quarter, and analysts don't expect a recovery before 2008. Lowe's is continuing its drive for market share in the U.S. and abroad. And shareholders seem split on the way forward, with some preferring to hang onto HD Supply in the highly fragmented, $410 billion construction supply industry, and others, according to analyst speculation, preferring to cut ties to something Nardelli created.

Home Depot's construction supply business traces its roots to 1997, when the company purchased equipment and repair direct-mail marketer Maintenance Warehouse Corp. for an undisclosed amount. The business didn't really get its legs, though, until Nardelli came over from GE in 1999, bringing the GE growth-by-acquisition playbook with him.

"This is GE," Jeffries & Co. analyst Donald Trott, a Home Depot shareholder, says of HD Supply. "The way GE has been built is continually acquiring and trying to build best-of-breed position in adjacent industries. ... This is really the same kind of thing that they're doing here."

All told, Home Depot has spent about $8 billion buying the companies that make up HD Supply. The idea was to create a division that would cater to homebuilders, contractors and maintenance professionals working on everything from large-scale infrastructure projects to remodeling jobs while leveraging Home Depot's $69 billion supply chain.

The ramp-up of HD Supply continued when Blake came over in 2002, but the majority of tack-ons came in 2005, the year DeAngelo was elevated from head of pro business and tool rental to chief executive of Home Depot Supply.

While the terms for most of Home Depot's supply business acquisitions weren't disclosed, the unit doubled in size with the $3.51 billion deal for Hughes Supply Inc. in January 2006. With its winning bid, Home Depot reportedly beat out Clayton, Dubilier & Rice Inc., a private equity firm, which has also bid for HD Supply. In a few other deals, Home Depot would run into buyout shops it would see again down the road.

In 2004, Home Depot acquired tools and supply seller White Cap Construction Supply Inc. from Leonard Green & Partners LP for undisclosed terms. At the time, a Leonard Green managing partner said the firm stood to gain 2.5 times the $88 million it had paid for a 60% stake.

The following year, Home Depot bought water transmission equipment distributor National Waterworks Holdings Inc. from Thomas H. Lee Partners LP and J.P. Morgan Partners LLC for what sources at the time pegged to be $1.35 billion including debt. These larger deals augmented a series of smaller ones.

"What they were doing is making little acquisitions in key areas geographically of smaller companies -- real small companies -- and piecing together this entity," says David Stepherson, a vice president with Hardesty Capital Management, whose firm owns Home Depot shares.

"I think at the time they had every intention of trying to create this monolithic Home Depot Supply business," adds Sanford C. Bernstein's McGranahan. Calling it HD Supply, he adds, was the first step to leveraging the brand. "They planned for this to be a very large and significant part of Home Depot Inc. down the road. I think that what Home Depot built, by buying things at very high multiples, is a fairly unique construction supply platform with tentacles in basically every important market."

(The exception, says McGranahan, is maintenance, repair and operations, but buying a company such as Chicago-based MRO supplier W. W. Grainger Inc. would fill that gap.)

As Nardelli, Blake and DeAngelo focused on cobbling together the supply business throughout the early 2000s, Lowe's was moving into key U.S. markets; it has also recently unveiled plans to head into Mexico and Canada. In that environment, it made sense for Home Depot to seek out an alternative growth strategy, says Piper Jaffray & Co. analyst Michael Cox.

"We were thinking it's a tremendous growth opportunity for them to consolidate a fragmented industry that in many respects looked like the hardware industry that they consolidated through the big orange boxes. They had the capital to make acquisitions. They had the management know-how of making acquisitions from their prior days at GE, and the market opportunity was there."

Beginning in 2006, the first year Home Depot broke out financials for the supply business, sales at HD Supply rose 162%, from $4.6 billion to $12.1 billion between fiscal 2005 and 2006, and operating profit rose 151%, from $319 million to $800 million, thanks largely to the Hughes Supply acquisition. But for 2007, the company forecast just 17% growth in Supply sales and 25% in operating profit.

Though it's a lower-margin business, the supply division is a point of differentiation for the retailer. And along with international expansion, it remains a potential alternative growth strategy. Despite the recent downturn, Home Depot continues to dominate the home improvement industry, with fiscal 2006 sales of $90.8 billion and earnings of $5.8 billion. But Lowe's is now in second place, with 2006 sales of $46.9 billion and $3.1 billion in income, and unlike Home Depot, it still has room to expand domestically.

On the retail front, "[Home Depot] is seeing all of the things that Lowe's is doing right and has done right, and they're essentially trying to replicate it," says Hardesty's Stepherson. That list includes cleaner stores with brighter lights and better service. Softening sales at Home Depot in early 2003, which contributed to its stock dropping to the low $20s from the upper $40s a year earlier, were attributed in part to a decline in customer service.

Should Blake ultimately decide to sell HD Supply, there won't be a lot of systems and procedures to untangle because the business hasn't been integrated into core operations. Analysts estimate the business could command between $10 billion and $12 billion -- equating to 10 times Ebitda and about 1 times sales, in line with its diversified specialty distributing peers. It's an area where private equity has gone before, and several shops are in the running should Supply go on the block.

While the consortium breakdown isn't clear, T.H. Lee, Bain Capital LLC, CDR, Carlyle Group and Leonard Green are among the sponsors who submitted bids to Home Depot's bankers, sources have told The Deal. On the strategic side, the European building material distributors France's Cie. de Saint-Gobain SA and the U.K.'s Wolseley plc are also thought to be looking at the unit.

If a buyout consortium wins Supply, the participants may well decide to split it up. Conglomerates, Cox notes, historically haven't made for particularly good stocks, a natural reason for a carve-up. But the buyout scenario carries a cruel irony, Jeffries & Co.'s Trott points out. "Cyclically, this is the time, if anything, to be a buyer, not a seller. You have a depressed sector backdrop."

There was some speculation about Home Depot itself being a take-private target as it came off a difficult 2006 and buyout firms were teaming up to do ever-larger deals. But according to an analysis in The Deal (Feb. 9, 2007) the company is likely too big for a buyout in its current form. And while selling off Home Depot Supply would make it a smaller company, it would also make it a less desirable buyout target.

"I think part of the attractiveness of Home Depot as a takeover target was you could break it up," McGranahan says. "As you just get down to the core retail business, I think it actually decreases the attractiveness as a takeover target."

Blake has given no indication of when a decision to keep, sell or spin HD Supply will come. But whatever course he choose, there's a big remodeling job on the horizon for Home Depot. - Carolyn Murphy

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