Home Depot: A Buyback on the Installment Plan

The retailer's $10.7 billion share repurchase should help boost its flagging EPS – but it still has yet to finance much of the buyback

For companies like Home Depot (HD) with exposure to the housing slump and whose shares have been beaten up accordingly, there's no time like the present to be aggressively buying back shares at discount prices.

On Sept. 10, the world's largest home improvement retailer announced the final results of its modified Dutch auction tender offer which expired at 5:00 p.m. on Aug. 31.

Home Depot said it will pay $10.7 billion to buy back 289,331,314 shares, or 14.6%, of its common stock at $37.00 per share. The price is the low end of a revised range of $37 to $42 share that the company announced on Aug. 9. The lower price enabled the company to repurchase an additional 39,331,314 shares beyond the 250 million shares it initially planned to buy back through the tender.

With help from the buyback, the Atlanta-based company said it now expects earnings from continuing operations for fiscal 2007 to fall by only 7% to 9%, instead of by 12% to 15% from fiscal 2006. The new forecast is based on a projected reduction in total outstanding shares by 165 million in the third quarter and 290 million shares in the fourth quarter.

Shares, which had fallen 16.4% at the market close on Sept. 7 from their recent high July 12, fell another 1.43% on Sept. 10.

The tender offer represents nearly half of the $22.5 billion recapitalization plan that Home Depot announced in June.

Last month, there was a risk the buyback program would be ruined when questions arose about whether or not Home Depot would be able to sell its struggling wholesale supply business, HD Supply, to a consortium of private equity firms. Part of the plan was that net proceeds from the sale would be used to fund the share buybacks.

Home Depot was forced to re-negotiate its deal (BusinessWeek, 9/17/07) with affiliates of Bain Capital Partners, the Carlyle Group and Clayton, Dubilier & Rice, in part because of a 22% drop in HD Supply's second-quarter earnings, excluding a one-time tax charge. The decline in profits was due to an accelerated downturn in the housing market amid growing subprime worries. On Aug. 28, Home Depot slashed the price tag on the supply business to $8.5 billion from the original $10.3 billion, agreed to pay $325 million for a 12.5% equity stake in the unit and consented to guarantee a $1 billion senior secured loan for the business. The sale closed on Aug. 30.

Given that net proceeds from the sale will now be only $7.9 billion, instead of $9.6 billion expected on the initial price, the question is what will Home Depot do to make up the shortfall?

The company will probably start issuing new debt next year in order to raise the cash it needs to complete the buyback program, Standard & Poor's said in a research note on Sept. 10. It saw little chance of the company's being able to complete its recapitalization plan before the end of 2007, given the uneasiness of the credit markets. (Standard & Poor's, like BusinessWeek, is a division of McGraw-Hill Companies (MHP))

At an investment conference last week, Home Depot's chairman and chief executive, Frank Blake, said he saw anemic conditions in the housing market extending into the latter part of 2008.

Gary Balter, an equities analyst who covers the company for Credit Suisse, said the real estate market isn't likely to improve much until 2009.

"If you look at historic housing patterns, especially given the crunch in mortgages, it's not unrealistic to expect home prices to drop another 15% to 25% next year," he said.

But that's not the end of the world for Home Depot, which had planned to spend the next two years re-investing in its infrastructure, he added. A weak economy in 2008 may hurt cash flow, but it won't deter the company from making the improvements it plans to make, he said. (Credit Suisse does investment banking with Home Depot.)

Analysts expect the company's profits to bottom in 2008. Standard & Poor's reaffirmed its earnings forecasts of $2.40 a share in 2008 and $2.93 in fiscal 2009. With the stock trading at 11.7 times its fiscal 2009 estimate, Standard & Poor's said the shares looked quite attractive.

As for the revised terms of the sales agreement for HD Supply, Balter isn't the only analyst who believes it's a good thing that Home Depot ended up keep a piece of the business.

Retaining an interest in the business means that Home Depot will share in any upside potential once there's a turnaround in the housing market, A.G. Edwards & Sons said in a research note on Sept. 4. That also means it "would likely be able to sell its remaining piece of Supply at a greater price tag than it currently commands in today's difficult macro environment," the note said. (A.G. Edwards, which has a buy rating on the stock, doesn't have an investment banking relationship with the company but owns a short position in its stock.)

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