the home depot inc
TRANSCRIPT
The Home Depot Inc.: Some Basic Facts-
Year of Inception : 1978 Market : Home Remodeling
Founded by : Bernard Mercus Market Segment : Do-It-Yourself (DIY)
Arthur Blank Selling Method : Cash-and-Carry
No.of Stores : 50 (end of 1985) Expansion Target : 9 Stores (1986)
Stock Listing : New York Stock Exchange (April, 1984).
QUESTIONS:
1. Evaluate Home Depot’s business strategy. Do you think it is a viable strategy in the long run?
Ans. Business strategy analysis gives the picture of key profit drivers, business risks as well
as profit potentials with qualitative judgments. Strategy Analysis is generally comprised of
industry, competitive strategy and corporate strategy analysis. Since, The Home Depot Inc.
has only one business, the corporate strategy analysis is not relevant for this case analysis.
Identifying key success factors and key risk through business strategy analysis helps the firm
to find out key accounting policies.
A. Industry Analysis:
Though The Home Depot Inc. is the leader in the industry, its market share is negligible (only
0.9% in 1985). However, its sales grew by 62% in 1985 which far above the industry
average. In terms of Porter’s five forces, the company has been facing challenges by the
existing firms and the competition is heating up. The Home Depot does not have much
challenge from new entrants, but it has possible threats from the suppliers since the rivals are
expected to be stronger and stronger. As a result it will also have high threat from the
bargaining power of buyers.
Fig-1: Industry Analysis
B. Competitive Strategy Analysis:
There are two types of strategies in competitive positioning: cost leadership and
differentiation. The Home depot Inc. is the leader in D-I-Y market and Hechinger’s is its
immediate rival. However, their market shares are very low compared to the whole industry.
Beneath here, Home Depot competitive strategy has been analyzed comparing with that of
Hechinger’s.
Rivalry among Firms
Industry Growth-14% CAGRivals-Hechinger Co. -55 stores (1985) -Sales Share-0.6% (1985) - Sales grew by-18%(1985)High Switching Cost
Competition based on cost
Threat of New Entrants
- Huge Inventory cost- Large Warehouse- Scale of Operations
Low Threats
Threats of Substitutes -Homogeneous Product-Low buyer’s willingness to switchLow Threats
Industry analysis
Home Depot -Sales Share-0.9% (1985)
-Sales grew by-62% (1985)
Bargaining Power of Suppliers
-Quality matters -quality assured by suppliers-Few retailers in the market
High Bargaining Power
Bargaining Power of Buyers
-Cost & quality matters-HD guaranteed quality
-No. of buyers increasing-Low substitutes
High Bargaining Power
Table-1: Competitive Strategy Analysis
The Home Depot Inc. Hechinger Company
Competitive
Strategy
Low & Competitive Price
Low margin, high turnover
-In 1985-ROS:1.2%; AT:2.2
Keeping cost by low overhead
Stocked right products-25000 items
Upscale stores
High margin, low turnover
- In 1985-ROS:4.8%; AT:1.5
Cost Leadership Strategy Differentiation Strategy
Key Success
Factors of Home
Depot.
Giving guarantee for both popular and less popular brands
Excellent sales assistance by its employees with technical know how
Best quality products and quality of service
Aggressive advertising and in store demonstration
Key Risk Factors
of Home Depot
Dropping of net earnings (42% in 1985) and stock prices(23.4% in
1985) made the financing difficult for expansion;
Already attracted some chain stores in the industry that challenges its
market dominant position.
Evaluation of Strategy: The Home Depot Inc. is pursuing a cost leadership business strategy
in the industry it operates (D-I-Y segment of home decoration). The core competencies of
Home Depot Inc. are selling brands with guarantee, quality products, excellent staffs and
assisting buyers. The company creates value chain by sharing cost savings with the
customers. However, the company’s net earnings has been decreased last three years and
failed to generate cash from its operating activities.
It seems that The Home Depot’s business strategy seems successful in the short run. But, the
company will not survive in the long run with its present strategy. As the industry is growing
rapidly, the company needs more expansion. Since, the operation activities could not succeed
to generate cash for its expansion; the company may face obstacles for financing even
through debt. So, the company has to have enough cash generating operations as well as net
earnings. Moreover, it is not difficult for the rivals to imitate Home Depot core competencies.
As a result, The Home Depot has to think of its business strategy for future success. May be,
the company may pursue a mixed strategy for their long run business prosperity.
2. Analyze Home Depot’s financial performance during the fiscal years 1983-1985.
Compare Home Depot’s performance in this period with Hechinger’s performance.
Ans:
(I). Financial Analysis: The Home Depot Inc.
Two major principle tools of financial analysis are employed for analyzing the financial
performance of The Home Depot Inc. for the year 1983-1985. These are Ratio Analysis and
Cash Flow Analysis. We begin by the ratio analysis first.
A. Ratio Analysis:
The financial performance i.e. the profitability ratios of The Home Depot Inc are not so
lucrative. The Home Depot Inc is experiencing a sharp decline in ROEs from 24.54% in 1983
to 9.71% in 1985. ROE shows how well managers are using the funds from the firm’s
shareholders. The decline in ROE is the result of decline in ROA, though the financial
leverage increased during the period 1983-85. And, ROA has decreased due to both decline
in ROS and Asset Turnover. During the period from 1983 to 1985 sales grows very rapidly,
but the average asset growth is higher than that. For instance, in 1985 sales grow by 62%,
wherein assets grow by 78%. As a result, the Asset Turnover (AT) falls; it is also happened
due to increase in days inventory held. The increase in assets for expanding business is
financed by debt; thereby increase in the financial leverage.
Table-2: Financial Ratios: The Home Depot Inc. 1983-1985
Ratios Jan 29,1984(1983)
Feb 3,1985(1984)
Feb 2,1986(1985)
Profitability Ratios
Return on Sales (ROS) 4.01% 3.26% 1.17%
X Asset Turnover (AT) 3.71 2.44 2.23
= Return on Assets (ROA) 14.84% 7.97% 2.61%
X Financial Leverage (FL) 1.65 2.44 3.72
= Return on Equity (ROE) 24.54% 19.41% 9.71%
X (1-Dividend Payout Ratio) 1.00 1.00 1.00
=Sustainable Growth Rate 24.54% 19.41% 9.71%
Short-Term Liquidity Ratios
Current Ratio (CR) 2.43 3.12 2.27
Quick Ratio (QR) 0.71 1.30 0.37
Cash Ratio 0.64 1.10 0.12
Operating Cash Flow Ratio -0.31 -0.06 -0.52
Days Inventories Held 75 82 83
Days Receivable Outstanding 2.01 4.95 8.04
Days Payable Outstanding 26.03 31.58 30.31
Long-Term Liquidity/ Solvency Ratios
Interest coverage ratio(Earnings) 183.56 7.37 2.14
Interest coverage ratio(Cash) -16.78 3.20 -2.89
Debt-to-Equity Ratio 0.37 0.68 0.77
Liabilities-to-Equity Ratio 0.61 2.11 3.27
Ref: Details of calculations are provided in “The Home Depot Inc.XLS” file
The decline in ROS is the result of continuous increase in COGS, SGA and net interest
expense as a percent of sales. It shows that The Home Depot Inc’s efficiency in creating
value chain has also been declined over time. The overall picture is depicted below in the
common size income statement of company.
Table-3: Common size Income Statement, 1983-85: The Home Depot Inc
Jan 29,1984(1983)
Feb 3,1985(1984)
Feb 2,1986(1985)
Sales 100.00% 100.00% 100.00%
COGS (% of Sales) 72.67% 73.58% 74.10%
Gross Margin (% of Sales) 27.33% 26.42% 25.90%
SGA (% of Sales) 20.82% 20.61% 23.18%
Net Interest Expense(% of Sales) 0.90% 0.26% -1.25%
Both short term liquidity ratios and long term solvency ratios are also not impressive.
Though, Home Depot has a better position in collecting funds (receivables) than that of
payables; the trend of average collection period become worse. In terms of the cash basis, the
negative interest coverage ratio (-2.89 in 1985) depicts that Home Depot actually also
borrows money to pay the interest. The other ratios also (see table-2) reflect Home Depot’s
bad financial performance during the period 1983-85.
From the view of alternative decomposition method (Table-4), we see that The Home Depot
has positive spread for all the years: 1983-1985. However, the trend is alarming (though there
is some discrepancy in calculation)-it decreased from 11.89% in 1983 to 1.97% in 1985.
Table-4: Alternative Decomposition of ROE
Jan 29,1984(1983)
Feb 3,1985(1984)
Feb 2,1986(1985)
Operating ROA(OROA) 18.95% 9.24% 6.60%
(-)Effective Interest Rate after Tax 7.06% -0.91% 4.62%
=Spread 11.89% 10.14% 1.97%
Net Financial Leverage(NFL) -0.27 0.82 1.58
ROE=OROA+(Spread X NFL) 15.72% 17.61% 9.71%
Note: 1. Detail calculation are performed in Excel File (Ratio sheet)2.Due to data unavailability averages of some items are not used for the year 1983 and
1984. As a result ratios differ from that of traditional methods.
B. Cash Flow Analysis:
Table-5: The Home Depot Inc. Cash Flow Analysis: 1983-1985
(Figures in ,000)Jan 29,1984
(1983)Feb 3,1985
(1984)Feb 2,1986
(1985)Cash Flow (CF) from Operating Activities -10,574 -3,056 -43,120
Cash Flow (CF)from Investing Activities -16,330 -81,655 -92,026
Cash Flow(CF) from Financing Activities 40,821 114,605 92,755
Net Change in Cash or Equivalents 13,917 29,894 -42,391
Alternative Decomposition of Cash Flows
Net Profit 10,261 14,122 8,219
Operating CF before WC Investment 9,618 16,961 24,432
Op. CF before investment in non-current Assets -12,882 -3,937 -24,300
Free CF available to Debt & Equity -29,212 -85,592 -116,326
Free CF available to Equity -22,746 29,080 -43,050
Net Increase (Decrease) in Cash Balance 13,917 29,894 -42,391Note: Calculation of Cash Flow Statement in details are in Excel File-Cash Flow St.(1)&(2).
For each of the three years the company has a negative cash flow from operating activities.
The reason may be due to large inventory increase; purchase of PP&E. It may not be so
alarming since the company is growing. The number of stores has increased by 163% from
1983 to 1985 to sustain and gain the market share.
From alternative decomposition it is evident that Home Depot has positive cash flow before
working capital investment. But, after using working capital the company has huge negative
cash flow. The rapid negative growth of the free cash flow available to debt and equity is
very noticeable. Besides, cash needed for financing its growth the company is in danger of
default in paying interest and principal payment of debts. Most of the company’s financing
activities are met by using long-term debt; only the exception in 1983.
Summary: From the financial analysis it is evident that Home Depot if expanding fast with
heavy reliance on debt financing. This strategy seems not against the company’s growth
strategy since it still has positive spread-wherein debt is cheaper than equity financing.
However, this increase its probability of default since the company has been suffering in
managing cash and rising operating expenses share of sales. As a consequence, Home Depot
will face hardship in future for financing its business expansion.
(II). Comparison of Financial Performance: Home Depot Inc. vs. Hechinger.
Table-6: Financial Ratios
Home Depot Inc. Hechinger
1983 1984 1985 1983 1984 1985
ROS 4.01% 3.26% 1.17% 5.29% 5.17% 4.84%
X AT 3.71 2.44 2.23 2.02 1.72 1.48
= ROA 14.84% 7.97% 2.61% 10.69% 8.89% 7.16%
X FL 1.65 2.44 3.72 1.79 2.12 2.21
ROE 24.54% 19.41% 9.71% 19.13% 18.85% 15.82%
Gross Margin 27.33% 26.42% 25.90% 32.10% 30.10% 29.30%
SGA&E 20.82% 20.61% 23.18% 22.90% 21.10% 21.60%
Avg. Collection Period 2.01 4.95 8.04 35.00 33.00 32.00
Avg. A/P Period 26.03 31.58 30.31 63.00 61.00 58.00
Inventory Turnover 4.88 4.46 4.39 4.40 4.50 4.50
Both Home Depot and Hechinger’s profitability (ROA & ROE) has been declining from the
period of 1983-85; however, Hechinger’s declining trend is less than that of Home Depot
(Table-6). Hechinger’s has higher ROS and lower AT compared to Home Depot. This
difference is attributed due to the business strategy they have. Hechinger’s has been pursuing
differentiation business strategy while Home Depot is pursuing Cost leadership strategy.
Hechinger’s is better than Home Depot in managing operating expenses. While Hechinger
has the success in reducing SG&A expenses; Home Depot’s cost increased substantially
during the period 1983-85. This may be a reason of higher average profitability of
Hechinger’s than Home Depot.
On average both of the company has same inventory turnover. However, in case of managing
receivables Home Depot is performing well above than Hechinger’s. If average A/R
outstanding is increased further in size and amount for Hechinger’s, it may cause problem in
cash management and future scope of expansion.
Table-7: Cash Flow Analysis
(Fig in ‘000)Cash Flow From Home Depot Inc. Hechinger
1983 1984 1985 1983 1984 1985Operating Activities -10,574 -3,056 -43,120 3,138 19,007 12,190
Investing Activities -16,330 -81,655 -92,026 -16,346 -25,531 -36,037
Financing Activities 40,821 114,605 92,755 25,310 87,901 27,288
Net Change in Cash 13,917 29,894 -42,391 12,642 81,377 3,441
Alternative Decomposition of Cash Flows
Net Profit 10,261 14,122 8,219 16,243 20,923 23,111
Op.CF before WC Inv. 9,618 16,961 24,432 22,343 28,030 30,534
Op.CF before inv. in NCA -12,882 -3,937 -24,300 2,831 17,388 9,323
Free CF to D & E -29,212 -85,592 -116,326 -13,515 -8,143 -26,714
Free CF to Equity -22,746 29,080 -43,050 -7,160 -11,274 -23,847
Net +/- in Cash 13,917 29,894 -42,391 12,642 81,377 3,441
Note: Details of calculation are performed in Excel File
As of Table-7, in contrast with Home Depot’s negative cash generation from operation
Hechinger has success in generating positive cash. It is clear from the investing activities that
Hechinger’s is not following rapid expansion strategy like Home Depot. This is also
attributed by the slower growth of inventory and A/R of Hechinger. Since the Hechinger’s
has positive cash from operation, it does not have to borrow money for paying interest.
Moreover, Hechinger is continuously giving dividend to the shareholder, which will help the
firm for long-time existence.
Another notable difference is that unlike Home Depot, Hechinger relies heavily on equity
financing rather than debt. Finally, Hechinger's cash flow statement reveals a strategy of
slow and steady growth; while Home Depot’s cash flow reveals faster expansion.
3. How productive were Home Depot’s stores in the fiscal years 1983-1985?
Productivity is a measure of efficiency how proficiently a company can generate output by
using inputs. It is a ratio of output by input. In Home Depot case No. of Stores, Employees,
Square Footage are inputs and sales, earnings, transactions etc are outputs. Table-8 shows a
handful of productivity measures of the stores of Home Depot Inc. for the time span 1983-85.
These are discussed below:
(a) Sales per Store: Net Sales/ Average Number of Stores.
The sales per store remain almost stable for Home Depot for all of the years ($17.3 million on
average). However, the incremental sales for the newly opened stores decline by 32% from
$25 million in 1983 to $17 million in 1985.
(b) Transaction Per Store: No. of Customer Transaction/Average Number of Store
The transaction per store declines from 586,000(in 1983) to 575,000(in 1985). This may not
be so concerned because the newly opened at least need some time to be well known to the
customers.
(c) Net Earnings per Store: Net Earnings/Average Number of Stores
Net Earnings per store drastically decline from $710,000 to $202,000 from FY 1983 to FY
1985. Moreover, in 1984 and 1985 the newly opened stores contributed negatively (-64% in
1985) in net earnings of Home Depot. It reveals that the new stores take more than 1 year to
be in the break-even.
(d) Net Sales per square Feet: Net Sales/ Avg. Square Feet
It is evident from Table-8 that efficiency of using store space also decreases by 10% over the
period 1983 to 1985.
Table-8: The Home Inc: Store Productivity: 1983-1985
1983 1984 1985
Avg. Net Sales/ Stores(in millions) 17.67 17.31 17.30
Avg. Sales growth/new stores (%) -33.26% 2.76%
Transaction per store(in thousands) 586 572 575
Net Sales/Transactions($) 30 30 30
Net Sales/Square Feet($) 244 228 219
Net Sales/Employee($) 146,400 135,250 149,085
Incremental Sales growth/ new Employee (%) -35.48% 3.53% 73.37%
Net Earnings per Employee($) 5,886 4,406 1,745
Incremental Earnings growth/Employee (%) -0.05% -25.14% -60.40%
Net Earnings/Store(in thousands) 710 564 202
Earnings Growth/new Store (%) 20.62% -20.60% -64.10%
Note: 1.Detail calculation are conducted in Excel Files (Store Productivity)2. Assume that Home Depot did not open all new stores and employ new employees during a period continuous basis. Hence, averages are used in some measures.
(e) Employee Productivity
Employee productivity is measured by Net sales per employee, Net Earnings per employee.
From Table-8, we see that sales per employee actually increase by negligibly by 0.18% to
$149085 in 1985 from 1983. And, Net earnings per employee drastically fall from $ 5,886 in
1983 to $ 1,745 in 1985.The negative earnings growth per employee shows that Home Depot
expenses more to its employees than the actual net worth addition by them.
Conclusion: It can be concluded that Home Depot Inc. stores are remain as same as
productive during the time span of 1983 to 1985, though it is expanding very fast.
4. Home Depot’s stock price was dropped by 23% between January 1985 and February 1986,
making it difficult for the company to rely on equity capital to finance its growth. Covenants
on existing debt restrict the magnitude of the company’s future borrowing. Given these
constraints, what specific actions should Home Depot take with respect to its current
operations and growth strategy? How can the company improve its operating performance?
Should the company change its strategy? If so, how?
Ans.
The Home Depot’s financing needed for Expansion
Construct Stores Capital needed Second-use Stores Capital needed
Acquire sites & construction $6,600,000 Leasing $1,700,000
Inventories $1,800,000 Inventories $1,800,000
Total per store $8,400,000 Total per store $3,500,000
Total for 9 new stores $75,600,000 Total for 9 new stores $31,500,000
Covenants of the credit facilities
a. Tangible Net Worth : $168,600,000(1986)
b. Debt to Tangible Net Worth : Not more than 2 to 1
c. EBIT to Intt. Expense : Not less than 2 to 1
d. Current Ration : Not Less than 1.5 to 1.
Funds available from credit line=$200,000,000-$88,000,000=$112,000,000
Proceeds from sale and lease back (10 stores) =$50,000,000
213,165,000=150,000,000(1+r)3
So, r=12.4%
And, 150,000,000(1+12.4%)
=168,600,000