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Case Home Depot

THE HOME DEPOT 1. 2. Questions Home Depot’s Stock Price Dropped 23% between January 1985 and February 1986. What Were the Reasons for this Decline? Should the Company Change its Strategy? THE HOME DEPOT Strategic Analysis The Home Depot Pioneered the Concept of Warehouse Retailing in the Home Centre Industry. The Company’s Strategy Consists of: Focusing on the Do-It-Yourself Segment of the Market; 1. Keeping Costs through Low Overhead, Purchase Discounts, and High Turnover; 2. Attracting Customers through Aggressive Advertising and Competitive Pricing; 3.

Providing High Service to the Target Customer Group through Well-Trained Employees 4. and Well-Stocked Stores; THE HOME DEPOT Financial Analysis (1) 1. The Home Depot Is Experiencing Declining ROEs (AVG): 45. 5% in 1982; 24. 5% in 1983; 19. 4% in 1984; 9. 7% in 1985; This Decline in ROEs Is Explained by Declining ROAs and Obtains in Spite of Increasing Financial Leverage: ROA (AVG) 1983 1984 1985 3. 14. 8% 8. 0% 2. 6% FL (AVG) 1. 7 2. 4 3. 7 2. The Decline in ROAs Is Explained by Both Declines in ROSs and Declines in ATs: ROS 1983 1984 1985 4. 0% 3. % 1. 2% AT (AVG) 3. 7 2. 4 2. 2 THE HOME DEPOT Financial Analysis (2) 1983 Sales Growth (%) Earnings Growth (%) Assets Growth (AVG %) Asset Growth (%) BY AVG EY F F F F 1983 +218. 7 +176. 9 +137. 0 +117. 8 +93. 1 +176. 9 1984 +137. 0 +156. 5 +218. 7 1984 +68. 9 +37. 6 +156. 5 1985 +61. 9 (41. 8) +77. 5 1985 +52. 5 +77. 5 +137. 0 The Company Has Been Increasing its Asset Base by Adding New Stores; This Expansion Is Financed to a Large Extent through Debt Leading to Increased Leverage; Sales Growth Is However Not Keeping Up with the Rate of Increase n the Asset Base; The Lower Asset Turnover Coupled with the Reduced Profitability of Sales Has Led to a Substantial Decline in the Company’s ROE; 4. The Decrease in ROSs (Sales Profitability) Results from Higher COGS, SGA, and NIE as a Percent of Sales; 1983 1984 1985 Fiscal Year Return on Sales Return on Sales (%) = Gross Margin (%) – SGA/Sales (%) – NIE/Sales (%) – Tax Expense/Sales (%) 4. 0 27. 3 20. 8 3. 4 3. 3 26. 4 20. 6 (0. 3) 2. 8 1. 2 25. 9 23. 2 1. 2 0. 5 THE HOME DEPOT Financial Analysis (3) 5.

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The Decrease in Asset Turnover Can Be Explained by: An Increase in Inventory: ­ 75 Days in 1983> 83 Days in 1985; A Decreasing Average Amount of Sales per Square Foot Explained by: ­ A Fairly Steady Number of Transactions per Store; ­ A Fairly Steady Amount of Sales per Transaction; ­ An Increase in the Average Size of Stores; ­ 1983 1984 1985 Fiscal Year Working Capital Ratios Days’ Inventory (365*AVG Inventory/Cost of Sales) Days’ Receivables (365*Accounts Receivables/Sales) Days’ Payable (365*Accounts Receivables/Purchases) 5 3 35 82 8 34 83 4 33 Stores Productivity Sales/Store ($ million) Transactions/Store (000) Sales/Transaction ($) Square Feet/Store (000) Sales/Square Foot 13. 5 446 30 74 183 13. 9 460 30 77 180 14. 0 467 30 80 175 ­ ­ F Summary of Financial Analysis The Home Depot Has Been Able to Increase Sales through an Increase in the Number of Stores; The Productivity of these Stores is However Declining, Resulting in Lower Turnover and Profitability; The Company’s Profits Are Not Keeping Pace with its Sales! THE HOME DEPOT

Performance Relative to Hechinger Co (1) While Hechinger Appears to Be Experiencing a Decline in Performance, the Decline Is Relatively Small Compared to that of the Home Depot. In General: Hechinger’s Ratios Are Strong Relative to The Home Depot’s; • Hechinger’s ROSs Are Significantly Better than the Home Depot’s Margins; • Hechinger’s Gross Profit Margins Are Higher and Selling Costs Are Lower; • The Home Depot Has a Higher Turnover; • THE HOME DEPOT The Home Depot vs Hechinger Home Depot Fiscal Year ROE (%) ROA (%) 83 24. 5 14. 8 84 19. 4 8. 0 85 9. 7 2. 6 Heching er 83 19. 1 10. 84 18. 9 8. 9 85 15. 8 7. 1 ROS (%) AT FL • 4. 0 3. 7 1. 7 3. 3 2. 4 2. 4 1. 2 2. 2 3. 7 5. 3 2. 0 1. 8 5. 2 1. 7 2. 1 4. 8 1. 5 2. 2 • These Differences Could Be Attributed to the Differences in the Two Companies’ Strategies: The Home Depot Follows a Low Margin and High Volume Strategy; ­ Hechinger Seems to Pursue a High Margin Strategy; ­ Hechinger Is Financially Much Stronger than The Home Depot as Indicated by the Differences in the Two Companies’ Financial Leverage. This Could Become a Competitive Liability for The Home Depot if There Is a Price War in the Industry; THE HOME DEPOT

Cash Flow Analysis (1) • The Company Has a Negative Cash Flow from Operations in Each of the Three Years: This Need Not Necessarily Be Alarming as the Home Depot Is a Growth ­ Company; However What Is Potentially Alarming Is the Huge Increase in the Negative ­ Cash Flow from Operations between 1984 and 1985, Primarily Due to a Large Inventory Increase; The Negative Cash Flow from Operations Is Exacerbated by the Decline in ­ Margins; The Significant Investment in Property and Equipment Was a Second Reason for the Company’s Cash Deficit: In 1985, the Company’s Expansion Required an Investment of $90m; ­ Since the Company’s Operations Generated Negative Cash Flow, this Investment ­ Had to Be Funded through External Sources; Most of the Company’s Cash Needs Are Financed through Long-Term Debt: In 1984, the Company Borrowed $120m, and an Additional $92m Was Borrowed ­ in 1985; The Company Used Convertible Debt in Both Years, which Is Unlikely to Get ­ Converted into Equity Any Time Soon; In Contrast to the Home Depot, Hechinger Had a Positive Cash Flow from Operations in Each of the Three Years; Hechinger Did Not Rely on Debt Financing but Used Equity Financing to Fund its Capital Expansion; Hence Hechinger’s Debt-Equity Ratio in 1985 Was only 1. while the Home Depot Has a Debt-Equity Ratio of 2. 7; • • • • • THE HOME DEPOT Total Cash Flow Analysis (1) ($000) Net Earnings Depreciation and Amortization Deferred Income Taxes Goodwill Amortization Net Gain in Disposals Other 1983 10261 903 713 1984 14122 2275 1508 93 1985 8219 4376 3612 637 (1317) 180 Increase in Receivables Increase in Inventories Increase in Prepaid Expenses Increase in Accounts Payable Increase in Accrued Expenses Increase/(Decrease) in Income Taxes Payable Cash from Operations (1567) (41137) (227) 17150 2865 406 (10574) (7170) (25334) (1206) 10505 2731 (657) (3056) (15799) (68654) (587) 21525 5314 (626) (43120) THE HOME DEPOT

Total Cash Flow Analysis (2) ($000) Cash from Operations Addition to Property and Equipment Disposals of Property and Equipment Other Cash before Investments, Dividends, and External Financing Acquisition of Bowater Cash before Dividends and External Financing Dividends Cash before External Financing ($000) Cash before External Financing Increase in Current Portion of Long-Term Debt Repayment of Long-Term Debt Proceeds from Long-Term Borrowings Proceeds from Sale of Common Stocks Cash from External Financing (26904) 1983 (26904) 10 (52) 4200 36663 40821 (84711) 1984 (84711) 233 (6792) 120350 814 114605 (135146) 1985 (135146) 10095 (10399) 92400 659 92755 (26904) 1983 (10574) (16081) 3 (252) (26904) 1984 (3056) (50769) 861 (2554) (55518) (29193) (84711) (135146) 1985 (43120) (99767) 9469 (1728) (135146) Net Change in Cash 13917 29894 (42391)

THE HOME DEPOT Summary of Financial Analysis • • • • The Home Depot Is Expanding Fast; In Doing So, It Is Losing Control of its Costs; Furthermore, the Company Is Relying Heavily on Debt Financing; The Above Analysis Raises the Following Questions: Is the Company on the Verge of Trouble? ­ Can It Continue to Implement its Growth Plans without Making Modifications to ­ its Operating and Financial Strategies? THE HOME DEPOT The Story So Far • From January 2nd 1985 to February 3rd 1986, the Home Depot’s stock price fell by 23. 4% while the S&P 500 composite index increased by 29. 4%; In the financial year ending February 2nd 1986, EPS fell by 41%.

As of February 1985, managers confidently predicted an increase of 30% in EPS; In the same financial year, bottom-line performance, as measured by ROE, fell to 9. 7% from 19. 4% in the previous year. ROEs have been declining for at least the past three years (45. 5% in 1982); This decline reflects a strong decline in business profitability, as measured by ROA, to 2. 6% from 8. 0% in the previous year, attenuated by an increase in financial leverage from 2. 4 to 3. 7; The decline in business profitability comes in the form of: An increase in operating expenses relative to sales from 20. 6% to 23. 2%; ­ A decrease in gross margin from 26. 4% to 25. 9%; ­ A decrease in asset turnover from 2. 4 to 2. 2; ­ The decline in business profitability comes in a period of rapid expansion.

Over the last financial year: Sales grew by 62%; ­ Assets grew by 78%; ­ Expansion in new markets requires aggressive pricing and promotions, adversely affecting gross margins, heavy spending on advertising, adversely affecting operating expenses, and time to achieve critical mass, adversely affecting asset turnover; As management did not achieve (and fell way short of) its earnings target, the cost of expanding in new markets may have been much higher than expected; Rapid expansion may also have led the Home Depot to lose control of its costs; Cash Required for Expansion • • The company plans to open 9 stores during the next year; The financing requirement per store is estimated to be $8. 4m: $6. 6m for PPE; ­ $1. 8m for inventories; ­ The cash required for expansion in 1986 is $75. 6m; • • • • • • • • F

Assumptions Related To The Projected Income Statement Let us assume no changes in operating performance: • F F F • • • F Sales to grow to $943m in 1986: $17. 3m of sales for AVG number of stores in use during the year; The projected growth rate Is 35% compared to 62% in 1985; This lower growth rate is justified by the opening of fewer stores; EBIT are to remain at 2. 7% of sales; NIE is to remain at $8. 7m; The tax rate is to increase to its “normal” level of 46%; The tax rate in 1985 was reduced by one-time tax credits; Projected Income Statement ($m) Net Sales EBIT Net Interest Expense Profit Before Taxes Taxes Net Income 943. 0 25. 5 (8. 7) 16. 8 (7. 7) 9. 1 Assumptions Related To The Projected Cash From Operations • Depreciation and amortization expense is assumed to be $6. m: Depreciation of $108,000 per warehouse in use in 1985 (40. 5 warehouses): ­ F Depreciation expense of $5. 9m; Amortization expense of cost in excess of the fair value of net assets required ­ equal to prior year expense: $0. 6m; Deferred taxes are assumed to remain at the 1985 level; Days of Inventories (83), Receivables (11), and Payables (34) Are Assumed to Remain at the 1985 Level; Cost of Sales as a Percentage of Sales Is Assumed to Remain at the 1985 Level (74. 1%); • • • Workings Related To The Projected Change in Inventories • F F • • Projected sales of $943m; Projected COGS of $699m; Projected average inventory: $699*83/365= $159. 3m; With a beginning inventory of $152. m, the projected ending inventory has thus to be $165. 9m, leading to an increase of $13. 2m; As $13. 2m < $1. 8 * 9 = $16. 2m, the projected increase in inventory is $16. 2m; Workings Related To The Projected Change in Accounts Receivable Beginning receivables are: $21. 5m; F F Since ending receivables are estimated to remain at 11 days of sales, expected ending receivables are: $943*11/365 = $28. 9m; The expected increase in receivables is $7. 4m; Workings Related To The Projected Change in Accounts Payable • • F F F Expected COGS: $699m; Expected increase in inventory: $16. 2m; Expected purchases: $715. 2m; Since ending payables are estimated to remain at 33. days of purchases, expected ending payables are: $715. 2*33. 5/365 = $65. 6m Since beginning payables are $53. 9m, the expected increase in payables is $11. 7m; Projected Cash From Operations ($m) Net Income Depreciation Deferred Taxes Increase in Inventory Increase in Receivables Increase in Payables Net Cash from Operations 9. 1 6. 5 3. 6 (16. 2) (7. 4) 11. 7 7. 3 The Financing Story So Far Assuming no change in business performance, the Home Depot is unlikely to be able to fund the planned expansion via internally generated funds: • The cash flow generated by the operations is expected to be positive in the forthcoming financial year, $7. m, but not large enough to fund the CAPEX requirements for the 9 incremental warehouses amounting to $59. 4m; Can the planned expansion be funded from issues of debt? F Debt Capacity • • • • • • Under the current revolving credit agreement, the company has $112m in unused debt; However, the agreement’s interest coverage is likely to limit the total additional borrowing to strictly less than this amount: Total net interest expense cannot exceed 50% of EBIT; Since the projected EBIT are $25. 5m, the maximum allowed net interest is $12. 8m; Assuming interest on current debt of $8. 7m, the maximum incremental net interest is $4. 1m; If the interest rate on the new borrowing is 9%, this implies maximum possible borrowings of $45. 6m ;

Conclusion • Given the level of current performance, the previous analysis shows that it is difficult to rely exclusively on debt financing to fund its planned expansion; Another option worth considering is to sell and lease back some of the Home Depot’s fixed assets: – Management states in its letter to shareholders that it is considering this option to raise $50m; – While this is a possible solution, it is likely to be a temporary one; A third option is to issue equity: – As February 1986, the company’s stock price was $13. 125; – To raise $59. 4m, the company has to issue approximately 4. 5m new shares, severely diluting the ownership interests of current shareholders; A fourth option is to improve the company’s cash flow from operations. Can this be accomplished soon enough to avoid adversely affecting the firm’s growth plans? • • •

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