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Home Depot's deep discount

From housing weakness to the subprime-led credit squeeze, Home Depot is being battered all-around by the U.S. economy's current  woes. Now the price tag of its supply unit, a target of leveraged buyout, now seems less optmistic when private equity firms feel the fade of easy money.
/ Source: Business Week

Home Depot appears to be caught in just about every treacherous undercurrent in the U.S. economy, from the meltdown in the subprime mortgage market to the crisis in the credit markets, where investors have avoided funding risky leveraged buyouts. One big worry concerns growth prospects at the nation's second-biggest retailer, whose fortunes are tied closely to the troubled U.S. housing market. And as if that weren't trouble enough, Home Depot faces brutal competition from rivals including Lowe's.

Now the Atlanta company finds itself at the vanguard of another troubling trend: The slowdown in the private equity boom. Home Depot said Aug. 9 that it plans to trim its $22.5 billion stock buyback by about 5 percent and that it may lower the price of its Home Depot Supply division. Private equity firms the Carlyle Group, Bain Capital, and Clayton, Dubilier & Rice agreed in June to buy the unit for $10.3 billion. At the time, Home Depot said it expected the transaction to close in the third quarter of 2007.

Unit sale in jeopardy
But as the subprime mortgage mess has spread to the broader global credit market, private equity firms have encountered trouble selling the high-yield debt they use to pay for some deals. That's one reason the buyers may have had second thoughts about the deal's original terms and are likely forcing Home Depot to accept less. All three private equity firms and Home Depot declined to comment Aug. 9.

Some investors believe that the sale of the Supply unit may not close at all. If that happens — or if management sells the unit at a fire-sale price — Chief Executive Frank Blake may have to fear for his job security in coming months. Trading in Home Depot's credit derivatives reflects fears that the deal will not close. Credit default swaps, a form of insurance that protects credit investors against defaults, were trading Aug. 9 at 49¢ on the dollar, according to Credit Derivatives Research. That level indicates that investors think there's a good probability that the deal won't close.

The dual dose of news sent shares of Home Depot down 5.3%, to $35.79, well off a 52-week high of $42.01 reached in February.

Home improvements?
Blake took over in January, following the contentious departure of former CEO Bob Nardelli, who angered investors and employees with a fat compensation package while the stock price languished. Nardelli has since been named CEO of Chrysler, which Cerberus Capital Management just acquired from DaimlerChrysler.

Since Blake assumed the top job, Home Depot shares have declined more than 10 percent — further torment for shareholders who felt Nardelli's deep cost-cutting and demand for centralized operations had destroyed customer service and harmed the company's long-term prospects. So while Blake is only eight months into his tenure, his honeymoon as a new CEO won't last long if he can't boost the lagging share price.

"There are a lot of unhappy campers out there. The stock has tanked during the last three weeks, and the community is not going to put up with this," says Marvin Roffman, chairman of Roffman Miller Associates. The Philadephia-based investment company, which manages $288 billion in assets, owns 172,000 shares of Home Depot.

No easy fix in sight
In the end, the winners in Home Depot's saga may well be the private equity firms. If they come to revised terms with Home Depot, they may wind up getting the Supply unit at a steal. Some investors such as Roffman Miller already opposed the deal because they thought the price was too low and compromised growth. "They were getting the business at a price of about one times sales. Now it looks like it might be lower," Roffman says.

There's no guarantee that a deal can be reached any time soon, though. Prices and fundamentals in the housing market are still falling, and as long as that's the case, Home Depot will see muted demand for its construction and improvement wares. The company also will find it difficult to resolve the always-tricky question of valuation as it tries to dispose of the Supply unit in a private equity sale. In other words, Home Depot may be stuck churning in the economy's cross currents for some time to come.