With strategic missteps, an outsized compensation contract and a knack for alienating employees and shareholders, Home Depot’s Robert Nardelli turned out to be a star-crossed leader.

Wharton faculty members and other experts say Nardelli, a talented former executive at General Electric who came within a hair’s breadth of replacing Jack Welch as head of the giant conglomerate, brought the wrong toolbox to the job after he was recruited for Home Depot’s top spot in December 2000. He did not know the retailing business and mistakenly thought that what had worked at GE could be readily transplanted to Home Depot’s more freewheeling, entrepreneurial culture. After years of a declining stock price — and a now-legendary 2006 shareholders meeting where an imperious Nardelli refused to answer questions — Home Depot announced the CEO’s resignation on January 3. He walked away with a package worth $210 million.

Nardelli was immediately succeeded as CEO, chairman and president by Frank Blake, who had served as Home Depot’s executive vice president since 2002. Before joining the Atlanta-based company, Blake also held senior positions at GE.

“While GE is a great source of management talent, the style of leadership that works at GE doesn’t necessarily readily carry over into a company that does not have GE’s traditions or GE’s riveting focus on performance,” says management professor Michael Useem, director of Wharton’s Center for Leadership and Change Management. “GE has a deeply held, corporate cultural value around the idea of performance. If you don’t get results, you just won’t hold your position long. An executive leaving GE will attempt to bring what worked in the past, but at Home Depot the way of operating was decentralized. Managers had a lot of discretion and there was a free-flowing, exciting feel to working there. Nardelli tried to streamline some 2,000 stores to get control over them, which might have worked at GE, with its focus on performance. But at Home Depot, that approach to leading did not work well, given the history of the company.”

According to Barry Henderson, an equities analyst at T. Rowe Price, the Baltimore, Md.-based mutual fund company, Nardelli made “two big mistakes” at Home Depot: He alienated employees and angered stockholders. Henderson says the alienation of the rank-and-file at the home improvement retailer has been largely overlooked by the business press in analyses of Nardelli’s departure.

“The Home Depot culture is distinct in retail,” Henderson explains, describing it as having been “extremely entrepreneurial and very customer focused” when Nardelli arrived. Nardelli concentrated on overhauling Home Depot’s business processes, which did need to be addressed, but he “overfocused” on the processes and swept aside the elements that made Home Depot special.

For one thing, Nardelli angered people by firing long-time Home Depot executives and bringing in GE alumni, according to Henderson. He also increased the number of less knowledgeable part-time workers at Home Depot’s stores, which left full-time employees fuming and led to a diminishment of customer service, one of the company’s strengths. From the very beginning of his tenure, Nardelli, now 58, “damaged morale, and he was seen as a real threat to the Home Depot culture,” Henderson says.

As an example of how a high level of commitment to customers made Home Depot a success, Henderson recounts a vignette from the book Built from Scratch: How A Couple of Regular Guys Grew The Home Depot from Nothing to $30 Billion, by company founders Bernie Marcus and Arthur Blank. In the 1990s, a man entered a Home Depot store to return a set of tires and obtain a refund — even though Home Depot did not sell tires. The employee at the service desk called corporate headquarters for guidance. The employee was told to ask the customer how much he had paid for the tires and to give him a cash refund from the register drawer.

“The tires,” says Henderson, “were hung near the service desk as a reminder that the customer is always right — the ‘lifetime value of the customer’ is how you would say it in business-school terms. [Home Depot] didn’t care about shrink [the percentage of products lost through theft or error]. Nardelli was exactly the opposite. Shrink was one of the first things he attacked when he got there.”

Looking for Growth

In fairness to Nardelli, he had his work cut out for him when he joined Home Depot, according to Wharton management professor Lawrence Hrebiniak. “Nardelli came into a very tough situation. The original entrepreneurs had built an amazing business” that had shown tremendous growth. Nardelli was under intense pressure “to continue that growth.”

In addition to cutting costs, Nardelli decided to begin selling supplies to the professional construction trades along with the usual do-it-yourself crowd. “He wanted to do something different; the problem was he didn’t do good strategic analysis,” says Hrebiniak. “The building-supplies area is a difficult business. You have a different type of relationship with contractors because it’s a wholesale operation. [Nardelli] went into a low-margin business looking for growth,” but he didn’t find it.

Hrebiniak also suggests that Nardelli “took his eyes off” his chief competitor, Lowe’s, which was investing a ton of money in new stores that were more attractive than the older stores operated by Home Depot. “Lowe’s said, ‘We’re going to come in and start stealing your business,'” Hrebiniak says.

As the competitive situation grew more difficult, Nardelli made another mistake: cutting costs in an attempt to shore up the bottom line. Hrebiniak agrees with T. Rowe Price’s Henderson that Nardelli’s cost-cutting moves crippled customer service. Hrebiniak says this misstep occurred because Nardelli reverted to the kind of approach he was accustomed to as the successful head of GE’s power-turbine manufacturing business. “He started cutting costs at Home Depot to make his numbers look better,” says Hrebiniak. “When things get tough, that often makes sense, but not at Home Depot. Cutting costs meant cutting service.”

On top of this, Nardelli alienated shareholders. He was being paid enormous sums of money over a period of years when the performance of Home Depot’s stock was lackluster. During his tenure, Home Depot’s stock value dropped 8%, while Lowe’s shares soared some 180%.

“The pay package had a lot to do with it,” Henderson says of the shareholders’ unhappiness, noting that Nardelli’s cash salary, plus cash bonuses, totaled over $65 million from the time he joined Home Depot in December 2000 through 2005. “That is far in excess of any of his peers.” At the same time, Nardelli was given stock options, but they were not structured in a way that would link them with the company’s share price. “It didn’t appear he had great incentive to get the stock price higher,” Henderson notes. “The stock was down 8% between the time he joined and the time he left. People were just disgusted by that.”

In terms of raw numbers, Nardelli did what appeared to be a commendable job. Henderson estimates that for Home Depot’s 2006 fiscal year, which ends January 31, 2007, the company will post sales of $90.4 billion, almost twice the sales figure of $45.7 billion recorded for fiscal 2000. During that same period, net income rose 130%, from $2.5 billion to $5.9 billion, according to Henderson’s estimates. Home Depot’s return on average invested capital was also noteworthy during Nardelli’s tenure: It stood at 16.8% for fiscal 2000, peaked at 19.5% in 2005, and will be 17.4% for fiscal 2006, Henderson says.

Still, investors did not bid up the stock. The reason, according to Henderson, was that investors always questioned whether the company’s top-line growth was sustainable. They also were concerned that the good numbers came at the expense of customer service. “What he appeared to do was cut SG&A [sales, general and administration] to make his numbers for the year, to hit his earnings-per-share growth targets,” says Henderson. But Nardelli hurt morale in the stores. “That, combined with a pay package that was not linked to the stock price, really angered investors. Those were the two reasons he had to go.”

Much attention has been focused on Nardelli’s $210 million payout. How, many ask, can such an enormous sum be given to someone who failed as a CEO? Wayne Guay, a Wharton accounting professor whose research focuses on issues related to executive compensation and corporate governance, says such big figures are sometimes misunderstood. The $210 million was not given to Nardelli to make him leave; rather, that amount was negotiated by him and the Home Depot board in 2000 to lure him away from his lucrative position at GE.

A Kind of Insurance

The severance pay, says Guay, served as a kind of insurance policy for Nardelli. If things did not work out at Home Depot, he wanted to walk away with enough money to make him “whole” for having left GE and running the risk that he would fail at his new position and be replaced. He adds that if Nardelli had succeeded at boosting Home Depot’s stock price to some significant degree, which would be worth billions of dollars to shareholders, it is likely that few people would now be complaining about the package.

“It’s almost inevitable these payouts will draw angst from shareholders for poor performing CEOs, but that’s why the CEOs negotiate these contracts,” Guay says. If Home Depot stock had gone up just a few points each year during his tenure, Nardelli “more than makes up for this compensation package. At the time this contact was signed, presumably people thought it was a reasonable thing to do.”

Hrebiniak agrees. “I think Nardelli’s personal style, his gruffness, the board-meeting fiasco — all of that was important. But if he hadn’t made strategic mistakes, his personal style wouldn’t have come into play as much. Even his compensation, which is obnoxious, would not have been as big a deal.”

According to Home Depot, the $210 million package included a cash severance payment of $20 million; acceleration of unvested deferred stock awards valued at about $77 million; unvested options worth about $7 million; bonuses and long-term incentive awards of some $9 million; a $2 million 401(k); previously earned and vested deferred shares worth approximately $44 million; retirement benefits worth about $32 million; and some $18 million in “other entitlements.”

The Board’s Responsibility

Ultimately, of course, Home Depot’s board was responsible for hiring Nardelli and giving him a lucrative package. Such huge amounts of money, on their face, continue to strike many people as exorbitant. Some management experts believe that boards remain insular and too beholden to the chief executives they hire, and that over-the-top compensation for CEOs will not be reined in until boards begin to assert their independence.

“I think the big lesson from this situation is a reminder about how far removed governance of firms is from criticism from the outside community,” says Wharton management professor Peter Cappelli. “There is a host of arrangements that companies use — especially compensation consultants, groups of peer companies and other defenders of the status quo — that tell the companies that what they are doing for their executives is appropriate. Of course, the executives themselves have a huge interest in believing this, and that carries over to their roles on boards of other companies. So the complaints of shareholder groups don’t really matter enough to drown out the support system that says these arrangements are fine.”

Cappelli adds: “There is no ‘market’ driving executive compensation. None of these deals is set by the market. Every one is negotiated by the CEO with the people who will ultimately report to him. So, guess how those negotiations are likely to go.”

Wharton’s Useem says the Nardelli case is a reminder that “outsized pay packages raise many questions about the judgment of boards of directors.” In Useem’s view, there are two criteria for determining whether compensation packages are too generous. First is the sticker shock: It “just seems crazy on the face of it that somebody can be deemed to be worth $210 million” for six years of work, Useem notes. Second is whether large sums are paid to a CEO as the price of the company’s shares declines.

In general, says Useem, “When compensation levels go north of $10 million a year, as so many of them do now — and Nardelli’s was more than that — there is doubt in the minds of employees that the CEO they are working for is indeed a person who puts the company’s interests ahead of his or her own. The argument that [author] Jim Collins powerfully makes in Good to Great is that effective leading in the companies he studied was defined by, one, an unrelenting focus on getting results by the CEO and the top management team and, two, an abiding humbleness in everything they did. Not in being meek, but in putting self-interest last and the company’s interests first. Very high levels of pay, just on the face of it, seem to tell the average employee that the CEO — and Nardelli in particular — does not.”

Nardelli’s actions cemented that idea with employees and shareholders alike. Although Nardelli later apologized for his behavior at Home Depot’s 2006 annual meeting, Useem says his performance at that session will forever serve as a symbol of the “tone deaf” chief executive who ignores shareholders and displays an “arrogance of style.”

He adds that it is too early to judge whether Home Depot’s board, in appointing Blake, chose the right person to replace Nardelli. But the board did take an important step concerning governance in a decision that was made on January 4, the day after Nardelli’s departure, but not disclosed until a regulatory filing on January 8. According to the Associated Press, the company said it would begin requiring that two-thirds of its independent directors approve any compensation to the CEO. Previously, only a majority of independent directors was needed to approve CEO compensation.

What is the ultimate answer to fairly compensating a CEO? According to Guay, boards should tie his or her compensation to the firm’s stock price — not to annual sales, net income, market share or any other metric.