Home Depot, Seeking Growth, Knocks on Contractors' Doors

Home Depot, Seeking Growth, Knocks on Contractors' Doors
By CHAD TERHUNE
The Wall Street Journal, August 7, 2006

On a recent Monday morning, Home Depot Inc. salesman Allen Perry pulled his pickup truck into a subdivision of two-story brick homes in Atlanta's booming suburbs. Dressed in jeans and a yellow polo shirt, he grinned widely as he gazed upon one of his biggest sales this year: a $170,000 set of aluminum panels used to form concrete walls.

Mr. Perry doesn't wear the retailer's trademark orange attire. And he never mentions Home Depot to customers like Jason Hewatt, a contractor whose workers were busy preparing the aluminum panels for a concrete pour. As the two men spoke, it was obvious that little from their jargon-filled banter would be familiar to the typical Home Depot customer -- a do-it-yourself home tinkerer buying a gallon of latex paint.

But Mr. Perry, and hundreds of other salespeople like him, are part of the company's crucial next wave: conquering the lucrative building-supply market.

In the 1990s, Home Depot was a megagrowth machine, churning out new stores, strong sales and big profits. The company's shares soared. But after blanketing North America with more than 2,000 "big boxes," Home Depot -- with its core business of selling to homeowners and small-fry carpenters, electricians and plumbers -- seemed to have few places to grow. In its biggest markets, it also faced formidable competition from rival Lowe's Cos.

Such problems have weighed heavily on Chairman and Chief Executive Bob Nardelli. Home Depot posted $81.5 billion in revenue last fiscal year. Among retailers, its annual sales are exceeded only by Wal-Mart Stores Inc. and Carrefour SA of France. But since Mr. Nardelli arrived in late 2000, overall sales growth has slowed to about 12% a year, down from 19%. The company's shares have slid by 20%.

Despite still-healthy profits, shareholders have griped about the CEO's compensation -- an estimated $240 million over a five-year period. In May, they were further roiled when no directors, other than Mr. Nardelli, showed up at the annual meeting and the company refused to immediately disclose the results of shareholder votes. (Mr. Nardelli says the meeting format "didn't work" and that all directors will attend next year. He also points out that about $100 million of his compensation is in stock options that have no value at the current share price of nearly $35.)

Today, the CEO is on a mission to retool the company's image and improve his own standing with shareholders. Just as Wal-Mart used grocery sales to trigger a massive growth surge in the 1990s, Home Depot is pushing outside the orange box to redefine itself as more than a retail chain.

In 2005, Home Depot started sending out high-end catalogs such as "10 Crescent Lane," featuring baroque-style headboards and other items not sold in its stores. This year, the company began selling automotive parts in Florida and opened its first two convenience stores in Tennessee.

To reduce the cannibalization of sales from existing stores, Mr. Nardelli said earlier this year that Home Depot would slash store openings by nearly half over the next five years.

Mr. Nardelli's biggest gamble, however, is his expensive plan to dominate the building-supply market. The idea: buy up companies that sell building products, tools and other industrial supplies to contractors and municipalities. The plan is reminiscent of Home Depot's consolidation of the retail hardware industry more than a decade ago.

The wholesale building-supply business is a highly fragmented $400-billion-a-year market in the U.S., spread across more than 22,000 distributors.

"We have reached a defining moment in the history of this company as we broaden our market view from the traditional $200 billion retail market," says the CEO. "What we really are doing here is repositioning our company so we can continue to have sustainable, predictable growth."

Over the past two years, Mr. Nardelli has quietly spent $6 billion to acquire more than 25 wholesale suppliers. They serve a range of customers, from utilities needing poles and cables to builders ordering truckloads of lumber. He bought White Cap Construction Supply Inc. in 2004 for about $450 million and last year acquired National Waterworks Inc., a leading provider of water and sewer-system materials, for $1.35 billion. Home Depot retained most of the management and rolled them into a new unit called Home Depot Supply.

Biggest Acquisition

In March, Home Depot closed on its biggest acquisition yet: $3.2 billion for Hughes Supply Inc., a leading distributor of building, electrical and plumbing supplies. Two months later, the company announced plans to acquire EnerBank USA, a small company providing home-improvement loans. Some analysts think the deal, if granted government approval, could be the foundation of a bigger finance arm -- like General Electric Co.'s GE Finance -- offering loans to the construction industry.

So far, the deals have given Home Depot more than 900 supply branches across the U.S. and quickly made it one of the leading distributors nationwide -- on par with the biggest established players, such as Wolseley PLC and W.W. Grainger Inc. By 2010 Home Depot Supply expects to have 1,500 supply houses with revenue of about $25 billion annually. That would represent nearly 20% of the company's overall sales -- up from 5% in 2005.

But selling to the construction trades is far different from hawking basic tools, appliances and paint. Large-scale contractors rely on longstanding relationships with specific suppliers who offer highly trained sales staffs and specialized services. Handshake deals with trusted associates often trump rock-bottom prices from a stranger.

Many contractors, who often associate the brand with amateurs, won't darken the door of a regular Home Depot. A few years ago, they shunned the company's efforts to roll out Home Depot Supply stores. The stores looked and worked too much like the standard warehouse format.

That is why veterans such as Mr. Perry are so crucial to the new effort. The 34-year-old got his start in this business after graduating from college in 1994 loading trucks at a Hughes supply branch in Atlanta. Now the White Cap salesman roams the metro Atlanta area on his own, visiting work sites and selling concrete-related supplies to contractors. Last year he booked roughly $10 million in sales for Home Depot and won a "Top Gun" sales award inside the company. For his success, he is richly rewarded. Although he won't divulge his pay, Home Depot says its best supply salesmen can earn $200,000 to $800,000 annually, primarily in commissions. Store employees, by contrast, start out at $7 an hour, or less than $15,000 a year.

It is a departure from the company's roots. Home Depot founders Bernard Marcus and Arthur Blank passed out dollar bills in the parking lot to attract customers into the first store in 1979 and encouraged store managers to tear up edicts from headquarters. The rank-and-file store employees were lionized by the company and often received direct coaching from Messrs. Marcus and Blank on customer service.

That free-wheeling attitude helped Home Depot become one of the hottest growth stocks ever, doubling its store count nearly every four years. Hundreds of early employees became millionaires.

But Home Depot failed repeatedly at finding its next great idea. Rural stores called Crossroads in the mid-1990s flopped. Many of its 54 upscale Expo Design Centers were closed last year amid poor sales. By 2000, the company was struggling to maintain its typical 25% annual earnings growth. The company shocked investors in October 2000 with a profit warning that sent the stock tumbling 28% in one day.

Meanwhile, the performance of Lowe's, which has 1,250 U.S. stores versus more than 2,000 for Home Depot, has surged. It has outpaced Home Depot in same-store sales -- or sales at stores open at least a year -- for 19 of the past 20 quarters.

Mr. Nardelli, a manufacturing veteran at GE who had never run a retailer, arrived at Home Depot in December 2000 two months after the profit warning. He made it a priority to stamp out the decentralized "cowboy culture" of Messrs. Blank and Marcus. He reined in Home Depot's costs, centralized purchasing and boosted the company's profit margins. The result: Home Depot posted earnings-per-share growth in excess of 20% for four consecutive years, one of only two companies in the Dow Jones Industrial Average to do so.

Faced with fewer store-expansion opportunities, Mr. Nardelli began buying the new lines of business. He had been a serial acquirer during his GE career, stringing together roughly 50 global deals in 1999 and 2000 while leading the company's power-generation unit.

Mr. Perry's old employer, Concrete Foundations Supply, was one of the earliest purchases. In the spring of 2004, during a round of golf, Mr. Perry's boss at the time broke the news that he was selling his 30-employee company to Home Depot's newly acquired White Cap division. Mr. Perry considered leaving. "I was a big fish in a small pond. Now I'm thinking I'm employee No. 2,749,000," he said.

'We Are Not Barbarians'

Mr. Nardelli pledged to keep the top management, salespeople and internal cultures of the companies he acquired, usually maintaining their corporate name and colors on stores and delivery trucks. "We are not barbarians at the door," Mr. Nardelli says.

At White Cap, Hooters waitresses still cater branch openings, and a buxom brunette in a tight-fitting White Cap T-shirt was recently featured on the company Web site.

Cultural continuity is important because large contractors often base their buying decisions as much on relationships as price points. Mr. Perry, for one, was relieved Home Depot largely left him alone to service his clients. He soon saw that the company's clout also made it easier to get manufacturers to demonstrate new products in front of his customers. The acquisitions gave Mr. Perry more products to sell, as well as a broader geographic selling turf.

Mr. Perry spends much of his day monitoring deliveries and quality control. Nothing inflames the ire of a contractor like a late or missed delivery. He uses a Nextel walkie-talkie to keep in touch with a dispatcher and truck drivers -- passing on directions to construction sites where streets are rarely labeled. A global-positioning-system device perched on Mr. Perry's dashboard guides him across the Atlanta suburbs.

Some analysts and investors believe that the money being spent on supply could be better used elsewhere. Specifically, they would like to see more renovations of Home Depot's aging stores and more seasoned, higher-paid employees with home-improvement know-how.

Customer service at Home Depot has suffered in recent years as the retailer relies increasingly on novice, part-time help. Another concern is that the supply businesses have lower profit margins than Home Depot's existing stores. In the most recent quarter, Home Depot stores had an operating profit margin of 11.8% compared with 7% for the supply side.

Home Depot concedes the supply business will drag down overall operating margins this year but expects to expand its margins by 2010. And Mr. Nardelli points out that Home Depot's strong balance sheet enables it to invest in both store renovations and supply acquisitions.

It clearly frustrates the CEO and other top executives and directors that some investors and analysts haven't embraced his vision.

"We are going through an enormous transformation," says Mr. Nardelli. "Sometimes transformation is unsettling not only internally but also externally to Wall Street. We pose a real challenge for traditional retail analysts to understand our business model."

Walter Todd, a principal at Greenwood Capital Associates in Greenwood, S.C., sold his firm's 189,000 shares in Home Depot in May, after he became dissatisfied with the company's direction under Mr. Nardelli. Although he says the CEO "has done a lot of good things at Home Depot," he says he "comes across as arrogant and overconfident."

But Home Depot director Bonnie Hill, who heads the company's compensation committee, says Home Depot's board remains fully committed to Mr. Nardelli.

"Bob has done a great job with the company," says Ms. Hill, who runs a corporate-governance consulting firm. "The place was maturing and we were reaching the point of saturation. A new direction was needed."