Home Depot: Clean Break

The giant home-improvement retailer is considering shedding its wholesale business. Whether the move will boost the stock is unclear.

Looks like Home Depot may do some remodeling. The Atlanta-based retailer announced February 12 that it is considering a sale, spin-off or initial public offering for its wholesale business, which sells supplies and services to contractors.

Such a move would wipe clean the fingerprints left by former CEO Bob Nardelli. He led the retailer on an $8 billion shopping spree that created the division. Nardelli once hoped the wholesale-supply unit, which sells lumber and other materials to professional builders and furniture to hotels, would make up 20% of revenue by 2010. The division now generates about $12 billion in annual sales, or 12% of the company’s revenue. But Nardelli was ousted in January over his plush pay package and the company’s mediocre financial performance.

Frank Blake, Home Depot’s new boss, has plenty of reasons to bid farewell to Nardelli’s creation. Blake is feeling the heat from activist investor Ralph Whitworth. His company, Relational Investors, won a seat on Home Depot’s board on February 5 as a peace offering to avoid a proxy battle. Whitworth has called the wholesale division “strategic adventurism” and advocates that the company exist the business soon.

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Whitworth may have a point. Selling to building pros has lower operating profit margins than Home Depot’s traditional retail operations. For the first nine months of 2006, the wholesale-supply business generated 7% operating margins, while its chain of big-box stores sported 12% margins.

Catering to professionals has distracted Home Depot from its core retail business, says Morningstar analyst Anthony Chukumba. Prime example: At last year’s annual meeting, Home Depot executives said the company would slow new-store growth over the next few years to focus on the wholesale-supply unit. A spin-off would put the focus back on Home Depot’s more profitable business. “Although there is no assurance a transaction will occur, we view the announcement as a significant shift in strategy,” Chukumba says.

Generally, analysts support the spin-off but are unsure of how it will affect the company and its shares. Robert W. Baird & Co. analyst David Manthey favors a spin-off or sale because it would “create a large pure-play distributor.” The wholesale unit might fetch as much as $13 billion, estimates Colin McGranahan, an analyst with Sanford Bernstein & Co.

The possible deal has one noteworthy critic: Mad Money’s Jim Cramer. Nardelli cobbled together building suppliers to create Home Depot’s wholesale division at the height of the housing bubble. The company paid top dollar for its acquisitions. Now, Home Depot may sell at the low point, Cramer says, which is “pathetic corporate America idiocy at its worst.”

The dust has yet to settle on Blake’s makeover of Home Depot. Regardless of what happens with the wholesale division, the worst of the housing market slowdown is behind us, says A.G. Edwards analyst Brian Postol, and that will cause sales and profits at Home Depot to improve. “As fundamentals begin to show gradual acceleration, we believe investors will start to take notice.” The stock (symbol HD) gained 33 cents, or 0.77%, on February 13 to close at $41.76. It trades at 15 times the average analyst earnings estimate of $2.84 per share for the fiscal year that ends January 2008. Postol thinks the stock is worth $46.

Contributing Editor, Kiplinger's Personal Finance