Home Depot Chooses Profits Over Empire Building

By Stephen D. Simpson, CFA | September 18, 2012 AAA

Although not everything that home improvement superstore operator Home Depot (NYSE:HD) has tried worked, management deserves credit for being ready with a quick hook when it seems clear that an idea just isn't going to live up to expectations. That seems to be the case with the company's plans for China, as management has announced that it will be closing its remaining big box stores in China and shifting to a strategy of specialty stores and e-commerce.

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Home Depot Says "Zai Jian" to Chinese Stores
Home Depot announced Thursday after the close that it will shut down its remaining seven big box stores in China. This marks the end of a relatively unimpressive attempt to expand into one of the largest and fastest-growing retail markets in the world. While Home Depot entered China in 2006 with a 12-store acquisition and was all too willing to bask in the analyst/investor love for the Chinese expansion angle, it just never really worked out as a concept.

In retrospect, it's perhaps not all that surprising that this strategy didn't work. Maybe it's true that China is a "do it for me" culture where a home improvement store appealing to consumers (as opposed to contractors) just isn't going to work. Or maybe the major cities of China aren't necessarily conducive to the model Home Depot has established in the United States where people drive their pick-up trucks and SUVs to a Home Depot on the weekend, load up and then drive back to the suburbs to work on their various remodeling/improvement projects.

Preserving Returns at the Cost of Empire
Whatever the reason for the lack of success, this is another example of Home Depot pulling the plug on a growth venture that didn't live up to management's return expectations. Home Depot entered South America (Argentina and Chile) around the turn of the century, only to pull out a few years later. Likewise, the company was relatively quick to sell off HD Supply when it was clear that the companies like Grainger (NYSE:GWW) and WESCO (NYSE:WCC) were no pushovers.

Some may decry this as a lack of patience, and I can see their point - Cummins (NYSE:CMI) started investing and establishing relationships in China decades ago, and only started seeing a major return over the last five or so years. That said, I applaud a company that is unwilling to throw good money after bad and double down on an idea that just doesn't appear to be working. Many companies have ruined themselves by frittering away capital on low-return "growth" projects and investors should appreciate the virtues of a slightly smaller company with better returns and cash flow.

Can the West Figure out Chinese Retailing?
It's interesting to me to see the hit-or-miss results of Western retailers expanding into China, and the excuses they use to explain it. In the case of Home Depot and home improvement, maybe it really is true that the Chinese just don't do small projects - after all, British company Kingfisher (OTC:KGFHY) has likewise been forced to pull back from big box store formats in favor of a "design center" approach.

And then there's the example of Best Buy (NYSE:BBY), which has in the past blamed its problems in China on cultural factors like a preference for haggling. While that seems to be a widely-accepted notion, domestic electronics and appliance retailers like Gome and Suning seem to have managed to migrate away from it.

Maybe the bigger issue is flexibility. Walmart (NYSE:WMT) and French retailer Carrefour (OTC:CRRFY) both seem to get along with the Chinese consumer, while other companies such as IKEA and Yum! Brands (NYSE:YUM) have tweaked their operating models and offerings to appeal more to local tastes and prospered for it.

The Bottom Line
Turning back to Home Depot, while the company will be taking a 10 cent hit as it exits China, the impact on the bottom line really isn't even a rounding error at this point. While some investors may be disappointed that this retrenchment reduces the company's long-term revenue growth potential, there's no rule that says the company can't try again later, perhaps with a different model. In the meantime, there's still growth potential in markets like Mexico, to say nothing of driving even more efficiencies from the existing operations in North America.

All in all, while Home Depot is still not all that cheap as a stock, this is a responsible move for a management team that seems to be able to distinguish the quality of a business from its size.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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