Reading Home Depot's Fuzzy Blueprint


By Amy Tsao Home Depot (HD) is discovering that staying No. 1 can be tough when your biggest profit booster -- which in Home Depot's case has been adding locations -- runs out of gas. Over the last decade, as it opened scores of stores in attractive suburban markets and grew profits handily, Home Depot was one of Wall Street's most beloved stocks. Now, the nation's top home-improvement retailer, which operates 1,386 stores, is wading through a tough period in which investors are demanding proof that the company's growth is not restricted by the limited scope for opening fresh megastores.

In many ways, Atlanta-based Home Depot is trying to pull off what Wal-Mart (WMT) did in the mid-1990s, says Colin McGranahan, an analyst at Bernstein Research. For several years, Wal-Mart, which has 1,133 standard discount stores, saw its stock take a breather as investors waited to see whether new strategies like warehouse store Sam's Club and the Superstore would take off. McGranahan says that Wal-Mart's price-to-earnings ratio was well below its long-term average valuation between August, 1995, and August, 1998, as the company gradually proved that various new strategies would pay off.

ADDED PRESSURES. McGranahan thinks Home Depot's stock could behave similarly. "Home Depot's valuation could meander for several years before it expands back toward its mean again," he says. And Home Depot faces several tough challenges that Wal-Mart didn't. When Wal-Mart's new-store growth was reaching a peak, it didn't have to contend with the competition and rattling management changes that will make Home Depot's job of carving out successful new businesses that much more difficult.

The retailing environment now "is much more difficult than 10 years ago," says Carl Steidtmann, chief economist of Deloitte Research. "A lot of these guys [in the retail industry] had weaker competitors that could not take share from them. Now, the remaining players are all pretty strong companies."

At least for the moment, with the housing sector continuing to surge, the home-improvement business is by no means shabby. Home Depot is predicting annual revenue growth in the range of 15% to 18% and annual earnings-per-share growth of 18% to 20% over the next three years. But investors are antsy about how it will fulfill that forecast. Home Depot reported a 35% increase in profits, to $856 million, on a 17% rise in sales to $14.3 billion for the first quarter. These results met analysts' expectations, but the stock was punished in the week that followed. Its shares lost about 15%, trading around $40 per share as Wall Street focused on the fact that the company didn't raise earnings guidance and offered few details on new strategies. On June 3, the stock closed at $40.52.

LOOKING SOUTH. Home Depot couldn't be reached for comment on this story. But the company has said it is on track with its growth plans. In its recent earnings release, CEO Robert Nardelli noted the solid reception for its first "urban" store -- a smaller facility than the typical location -- which opened in the first quarter in Brooklyn, New York (See BW Online, 4/6/02, "Tapping the Urban Goldmine"). He he also pointed to Home Depot's expanding presence in Mexico through a planned acquisition of Del Norte stores. The deal would make Home Depot the second-largest home-improvement retailer in the Mexican market.

Clearly, Home Depot is trying to make the transition from the free-wheeling days of co-founders Bernie Marcus and Arthur Blank to the more disciplined management of Nardelli, a former General Electric executive. Since his arrival in January, 2001, Nardelli has introduced money-saving strategies in stocking and logistics management. And many top Home Depot managers have been replaced. Although UBS Warburg analyst Aram Rubinson believes Nardelli's tighter grip on the reins is a plus, he also fears the outfit is "changing too much too fast." Rubinson recently downgraded the stock.

Home Depot has said that it has long recognized the need for other avenues of growth and has been trying out new ideas like design stores, professional services, and smaller stores in urban markets like Brooklyn. A push to supply bigger contractors is perhaps the most promising effort underway. Already, a third of the outfit's business comes from building-trade professionals. Now, it plans to expand on that and open some stores aimed exclusively at that market. This strategy would pit Home Depot against smaller companies that traditionally specialize in specific areas of home-building supply. "There's some real growth potential there," says George Whalen, president of Retail Management consultants.

TRANSATLANTIC AMBITIONS? Analysts also like the idea of Home Depot buying growth with the $5.2 billion in cash it has on its balance sheet. Acquisitions, most likely in Europe, could be a way to reinvigorate expansion, analysts say. "It's the most obvious move for them," notes Geoff Whissman, vice-president of Retail Forward, a retail consulting company. He believes Home Depot could become a significant player in Europe within the next three years. Most of Home Depot's stores are in the U.S., but it has some operations in Mexico and Canada.

Meanwhile, the company is trying to expand the definition of home improvement by having a hand in anything related to home and garden. Many of its efforts are getting mixed reviews. Whissman worries that the company is shrinking the box with its move into smaller markets. The smaller, urban-store format in Brooklyn is getting "strong response," the company says, but analysts worry about the economics of expanding in dense cities, where operating costs tend to be higher. Other new initiatives have gotten tepid response from Wall Street. The Expo Design stores, which offer home-design products and services, have underperformed since the concept was rolled out throughout the '90s.

And Home Depot has a tough competitor in Lowe's (LOW), based in Wilkesboro, N.C. Though it operates fewer than half the number of Home Depot stores, analysts expect Lowe's will keep stealing market share as it increases its store base. McGranahan expects investors will continue to reward the stock of the No. 2 competitor as long as Lowe's maintains a higher rate of growth than Home Depot. Lowe's has promised earnings-per-share growth in the range of 28% to 30% for 2002. Its shares are trading at around $45, off its 52-week high of $49.99.

BOXED IN. Though Home Depot reinvented the home-improvement business, its ability to remodel itself appears limited. "There's no obvious concept that will allow them to expand the box," says Whissman. Experts expect that some of Home Depot's new strategies will prove successful, but not spectacularly so. "This isn't going to be like Wal-Mart and food," says Whalen, who notes that Wal-Mart will likely be No. 1 in the $400 billion groceries business soon.

Management changes at Home Depot aren't the root of its troubles -- and neither is the increasing pressure from Lowe's. But these factors make it even more challenging to convince Wall Street that new ways to grow the company are working. In the meantime, the stock could stay under pressure for some time, just as Wal-Mart's did when it was introducing new avenues of growth. Tsao covers financial markets for BusinessWeek Online in New York


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