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