Home Depot's Headache: HD Supply

Lower profits at the retailer's wholesale business -- and tightening credit markets -- could scuttle its sale to private equity firms

For Home Depot (HD), tt wasn't the lower profits that made investors unhappy. As expected, the leading home improvement retailer reported on Aug. 14 that second-quarter earnings declined from the year-earlier period. But investors may have been even more concerned about the possibility that the company won't be able to sell its supply business.

The 6.1% decline in earnings from continuing operations to 77 cents a share, from 82 cents a share a year ago didn't come as a surprise to anyone who's been following news of the deepening slump in the housing market. Revenue fell 1.8% to $22.2 billion on a 5.2% drop in sales for stores open at least one year, which was partly offset by sales from new stores.

The Atlanta-based company also reaffirmed expectations of a 12% to 15% drop in earnings from continued operations and a 15% to 18% drop in consolidated earnings for fiscal 2007 from last year. The housing and home improvement markets will remain soft in 2008, CEO Frank Blake said in an earnings release.

Shares were down 3.5% at $34.06 in afternoon trading Aug. 14.

Most of the pressure on the stock stemmed from the company's warning that it might have trouble selling its HD Supply unit to private equity players due to tightening in the debt markets, said David Schick, a retail analyst at Stifel, Nicolaus & Co. (SF) (Stifel Nicolaus does investment banking with Home Depot.)

In its earnings release, Home Depot said that discussions with affiliates of Bain Capital Partners, Carlyle Group, and Clayton, Dubilier & Rice about restructuring a previous agreement for the sale of HD Supply could end up lowering the purchase price from $10.3 billion.

A hiccup in the HDF Supply sale would put the company's $22.5 stock repurchase plan at risk, as proceeds from the sale were to be used to fund the buybacks.

Last week, Home Depot cut the price range for a tender of 250 million shares to between $37 and $42 a share from an earlier range of $39 to $44 a share and extended the expiration of the offer by 15 days to Aug. 31. At the original price, the tender offer, if fully subscribed, would have comprised about 44% to 49% of the initial $22.5 billion share repurchase authorization, according to a research note by A.G. Edwards & Sons on Aug. 9. (A.G. Edwards, which has a buy rating on the stock, doesn't an investment banking relationship with the company.)

Renegotiation of the selling price has been prompted in part by a 22% decline in HD Supply's earnings, excluding a one-time tax charge, Credit Suisse said in a research note on Aug. 14. Those results are now being reflected as discontinued operations on Home Depot's income statement. (Credit Suisse does investment banking with Home Depot.)

But another reason for renegotiation appears to be the current crunch is credit markets, which makes it harder and more costly to fund buyouts.

Stifel Nicolaus believes the selling price could drop to $8 billion and Schick said he wouldn't be surprised if it turns out to be lower than that. Home Depot paid roughly $8.4 billion to acquire the components of that business over the past three or four years.

While the sale of HD Supply is important for its short-term impact on the company's recapitalization plan, it wouldn't have a significant on an operating basis, Schick said.

The fact that Home Depot may have to alter its $22.5 billion recapitalization strategy isn't surprising, as the plan depended on generating $10.3 billion from the sale, Credit Suisse said in its note. It's even possible the company would cancel the sale if it can't negotiate a high enough price, the note said.

Some analysts viewed Home Depot's reiteration of its gloomy earnings outlook for this year as a positive surprise, however.

"If you look at existing home sales on a two-year basis, the business is worsening, but sequentially Home Depot's business is not worsening. That suggests that Home Depot is incrementally doing something better," said Schick.

He said he's basing his positive view on the stock on what the company is able to control, such as improving its stores, not the factors it can't control such as problems in the housing and debt markets.

And Stifel Nicolaus's latest bi-monthly survey of consumer spending sentiment shows that since the late spring Home Depot has no longer been losing mindshare, or mention among consumers as to where they plan to shop, Schick said. Changes in mindshare typically precede changes in actual market share, he added.

"If we isolate what Home Depot is doing – it's putting money back into stores, putting tools back into stores – we find it's improving," he said.

That seems to be underscored by a narrowing in the year-over-year decline in comparable store sales to 5.2% in the latest quarter from 7.6% in the first quarter, he pointed out.

In an Aug. 9 research note, A.G. Edwards & Sons (AGE) said it was more optimistic about the home improvement segment of the retail market over the next few quarters, as it thinks the housing correction is approaching a bottom and that the Federal Reserve policy bias is shifting toward rate cuts, which could come by the end of the year. The firm also said that valuations are low compared with historical levels.

Same-store sales should grow at a more consistent 3% to 4% rate over the next few years, A.G. Edwards said. That will stem from less cannibalization of same-store sales by new Home Depot stores, as the company plans to slow square footage growth over the next five years to an annualized rate of 4% to5% from the 8% to 10% rate seen in the last several years. Additional support for sales will come from efforts to modernize stores, differentiate products, improve signage and offer lower prices, A.G. Edwards said.

Before it's here, it's on the Bloomberg Terminal.