The Home Depot

BU657Case Presentation

May 6, 2006

The Home Depot

Group Presenters

Anouska Harris Kevin Melo Kate Richard Rafael Torres

Agenda

Home Depot - Overview Business Strategy Analysis of Accounting Policies Evaluating Performance Is the Strategy Viable? Closing Remarks

Home Depot – Overview (1) Case Date: 1986 The Home Depot: Founded in 1978 Market: Do it yourself (DIY) market selling a large

selection of building materials and home improvement products

3 stores opened in Atlanta 1979 and grew rapidly in the “sunbelt” geography.

Sales in 1979: $7mm The Home Depot went public 1981

Initially traded over the counter Listed on NYSE (HD) in 1984

Home Depot – Overview (2)

1985 Sales: $700mm Assets: $380.2mm Earnings: $8.2mm Customers: 23.3mm Markets served:15 Stores: 50 Employees: 5,400

Business Strategy (1)

What is Home Depot’s Business Strategy?

Business Strategy (2)

What is Home Depot’s Business Strategy? Focused on DIY segment of market Keep costs low through low overhead,

purchase discounts, and high inventory turns Attracting customers through aggressive

advertising and competitive pricing Providing high quality service to customers

Business Strategy (3)

What is Home Depot’s Business Strategy? Provide high service to target customers

with well paid ee’s well trained ee’s well stocked stores Focus on the relationship (helping customers

choose the right product and provide assistance throughout the project)

Shopping convenience (7 days, evening hours)

Analysis of Accounting Policies

Revenue Recognition Cash-and-carry basis

Inventory Valuation Stated at lower of cost or market FIFO method

Overall Impression Nothing unusual for retail sales company

Dupont Ratio Analysis

Net Profit Margin = Measures how many cents of income is earned on each dollar of sales

Asset Turnover = Measures how efficiently assets are used to generate sales

Financial Leverage = Measures degree of indebtedness (risk) Return on Equity = Measures rate of return on Shareholder’s

investment

Evaluating Performance (1)

SENI

SEAssetsX

AssetsSalesX

SalesNI

Evaluating Performance (2)Net Profit Margin: 8,219,000

= 1.17%700,729,000

Asset Turnover: 700,729,000= 1.84

380,193,000

Financial Leverage: 380,193,000= 4.27

89,092,000

Return on Equity: 8,219,000= 9.23%

89,092,000

Evaluating Performance (3)Profitability   1986 1985 1984Net Profit Margin Home Depot 1.2% 3.3% 4.0%

Hechinger 4.8% 5.2% 5.3%

Return on Equity Home Depot 9.2% 17.6% 15.7%

Hechinger 15.8% 18.9% 19.1%

Asset Management        

Total Asset Turnover Home Depot 1.84 1.74 2.43

Hechinger 1.48 1.72 2.02

Debt Management        

Financial Leverage Home Depot 4.27 3.11 1.61

Hechinger 2.21 2.12 1.79

       

Dividend Payout Ratio Home Depot 0 0 0

Hechinger 0.93 0.95 0.95

       

Sustainable Growth Rate Home Depot 9.2% 17.6% 15.7%

Hechinger 14.7% 18.0% 18.1%

Evaluating Performance (4) Physical Analysis (from Exhibit 1)

Average Sale per customer is $30 Stores are getting bigger but not selling more

  1985 1984 1983 1982 1981

Sales per Store ($M) 14.0 14.0 13.5 11.8 6.4

Sales per Transaction $ 30.07 $ 30.27 $ 30.14 $ 28.00 $ 27.11

Sales Transactions per Store (K) 466.0 461.3 447.4 420.0 237.5

Sales per Square Footage $ 175.18 $ 180.33 $ 183.00 $ 168.00 $ 85.83

Evaluating Performance (5)

Time-Series vs. Cross-sectional approach

Exercise (15 minutes) Gross Profit Margin Inventory Turnover Debt to Asset Which company would you invest in?

Evaluating Performance (6)

Cash Flow Analysis (pg 5-56) Negative cash flow from operations for all 3

years Inventory increases Store expansions (property and equipment)

Most cash provided through LT Debt Hechinger had positive cash for all 3 years

Evaluating Performance (7)

Assessment: Home Depot is expanding fast Loosing control of costs Heavy reliance on debt financing

Is The Strategy Viable? (1)

Can they continue to provide low prices and offer high levels of service?

Is their growth strategy sustainable?

1987 Projected Income Statement1986 Net Sales (5-54) $700,729,000 Assume 1987 Net Sales $1,000,000,000

EBIT = Earnings Before Interest and Taxes

1986 1985 1984EBIT/Sales 0.0311 0.0702 0.0745

Average Annual Decline = 0.02171987 EBIT/Sales = 0.0311 - 0.0217 = 0.0095

Assume 1987 EBIT = $9,500,000

1987 Projected Income Statement

EBIT $9,500,000 (Previous Slide)

Interest (Exp-Inc) (8,725,000) (Same as 1986/5-54)

Profit Before Tax 775,000Taxes (0.461) (357,275)Net Income $417,725

1987 Projected Cash From Operations

Net Income $417,725 (Previous Slide)

Add Back Non-Cash Expenses (5-56)Depreciation 4,376,000 (Same as 1986)Deferred Income Tax 3,612,000 (Same as 1986)Working Capital 8,405,725

Changes in Working Capital (5-57)Inventory (46,994,000) (Avg. 1985 and 1986)Receivables (11,484,500) (Avg. 1985 and 1986)Payables 24,560,000 (Avg. 1985 and 1986)

Net Cash From Operations $(25,512,775)

Cash Required for Expansion(5-47)Site Acquisition and Construction $6,600,000

Inventory (Net of Vendor Financing) 1,800,000    8,400,000  

x 9 Stores Cash Required for Expansion $75,600,000  

Total Cash Needed

Net Cash From Operations$(25,512,775)

Cash Required for Expansion (75,600,000)

Total Cash Needed in 1987 $(101,112,775)

Line of Credit

Line of Credit = $200,000,000$88,000,000 Outstanding, $112,000,000 Available ???

(5-64) Note 3 – Restrictions1. Minimum tangible net worth of $150,000,000 (1985),

increasing annually to $213,165,000 by Jan 1989

Tangible Net Worth = Total Assets - Goodwill - Current Liabilities - Long-Term Debt - Other Liabilities

Tangible Net Worth = $71,218,000 (Default)

Line of Credit Restrictions

2. Debt to tangible net worth ratio of no more than 2 to 1

= Total Liabilities/ (Assets – Goodwill)

=0.8

3. Current ratio of not less than 1.5 to 1

=Current Assets/ Current Liabilities=2.3

Line of Credit Restrictions

4. Ratio of EBIT to Interest Expense, net, of not less than 2 to 1

1987 EBIT (Previous Slide) $9,500,000 x 50% Max. Net Interest Expense $4,750,000

Current Interest (Previous Slide) $8,725,000 Default

The Home Depot –Update 1987Dramatic increase in profitability in 1986 and 1987

Sales continue to grow = 1986: $1.001 billion 1987: $1.454 billion

Net Earnings = 1986: $23.8 million1987: $54.1 million

Return on Sales = 1986: 2.4% increase 1987: 3.7% increase

Number of transactions per store = 38% increase from 1985 to 1987 (466,000 - 641,000)

Positive Cash flow of: 1986: $66.8 million 1987: $56.2 million

The Home Depot –Update 1987Dramatic increase in profitability in 1986 and 1987

Company Stock Price = 2/3/1986: $13.125 2/2/1987: $22.375 (increase of 70%)

Debt to Equity = 1985: 2.7 1987: 0.91

Home depot took steps to reduce operating costs which led to an increase in profitability without sacrificing growth.

Markets rewarded these developments, enabling the company to issue equity and reduce debt.

The Home Depot –Update 2006

Revenues: $81.5 billion Net Earnings: $5.8 billion Assets: $44.5 billion Stores: 2042 Stock Price: (4/28/06) $39.93

52 Week

High Low

43.98 34.56

20 Jul 2005 29 Apr 2005

*2005 Annual Report Data

Hechinger –Update 2006 Was a Home Improvement Retail Industry “giant” with

200 stores. 1996 Revenues: $2,199,067 (3 consecutive years

with declining sales and million dollar losses. Could not handle competitive market pressures

(Home Depot & Lowe’s). Files CHAPTER 11 in 1999. Liquidated assets Home Décor sell “Hechinger brand” through e-tailing

network.

Closing Remarks

What value is there in Ratio Analysis? Pros / Cons

How do analysts assess a company?