The Home Depot Inc. Mark Breen Greg Callow Marv Franz Mary Mumcuoglu Tracey Weiler

Agenda 1) Case Background 2) Industry and Strategy Analysis 3) Accounting Analysis 4) Evaluating Performance 5) Cash Flow Analysis 6) Financing 7) Subsequent Developments 8) Summary

Case Background Warehouse concept hardware stores Increasing competition in the industry Experiencing rapid growth Faces common problems like many growth companies, i.e. financing growth Runs up against debt covenants and dropping stock price

Industry Rivalry: Moderate Industry Analysis Industry Rivalry: Moderate High market growth Low product differentiation – more on service/selling side Economies of scale in purchasing, advertising Exit barriers are low

Threats of Substitute Product: Low Industry Analysis Barriers to Entry: Low Some difficulties in achieving economies of scale Channels are easily accessible Some capital requirements Threats of Substitute Product: Low Contractors are more expensive High growth in industry shows people enjoy doing work themselves

Power of suppliers: Low Power of customers: High Industry Analysis Power of suppliers: Low Low switching cost Power of customers: High Switching cost are low Importance of price Repeat business at Home Depot may be small Once people learn from Home Depot’s sales people they may then go to the competitor offering the lowest prices

Strategy Analysis Value Proposition: Low cost, high service, full stock Product Market Focus: Full selection of product for Do-It-Yourself home renovations Core Activities: Merchandising, purchasing, customer service Goals: Growth, market share

Strategy Analysis Low cost strategy but differentiates themselves on service Keep costs low through minimal overhead, volume purchase discounts & inventory turnover Much higher S&G expenses – advertising & customer service Often dangerous to position in between low cost and differentiation

Major Questions about Strategy Strategy Analysis Major Questions about Strategy Do they have a sustainable competitive advantage? How much of success is driven by market growth? Growth by itself can be a problem: Profitable growing markets attract competitive responses driving margins down As business dynamics change companies can end up over-leveraged

Accounting Analysis Nothing looks unusual Major Accounting Policies Revenue Recognition: Business is cash and carry, revenue is recognized at time of sale COGS- Booked at time of sale to match with revenues Inventory Valuation: Inventory is valued using FIFO

Evaluating Performance - Time Series Comparison Dupont Framework: NI/SALES X - Profitability SALES/ASSETS X - Asset Management ASSETS/SE - Financial Leverage = ROE 1986 1.17 1.84 4.27 9.19 1985 3.26 1.74 3.11 17.64 1984 4.01 2.43 1.61 15.69

Evaluating Performance - Time Series Comparison Conclusions: ROE has decreased dramatically because margins and asset turnover are decreasing This is offset by an increase in leverage.

Evaluating Performance - Further Investigation - NI/SALES 1986 - Dollars (Millions) 1986 - Percent of Sales 1985 - Dollars (Millions) 1985 - Percent of Sales 1984 - Dollars (Millions) 1984 - Percent of Sales SALES 700.729 100% 432.779 256.184 COGS 519.272 74.10% 318.460 73.60% 186.170 72.70% SELLING 134.354 19.20% 74.447 17.20% 43.514 17.00% PRE-OPENING 7.521 1.07% 1.917 .44% 2.456 .96% ADMIN 20.555 2.93% 12.817 2.96% 7.376 2.88% INTEREST EXPENSE 8.725 1.20% (1.114) (.26%) (2.318) (.90) MARGIN 1.50% 5.80% 6.46%

Evaluating Performance - Further Investigation - NI/SALES Conclusions: Overall MARGINS ARE DECREASING Most costs increased steadily over the three years COGS increased from 72.7% to 74.1% of sales Selling costs increased from 17.0% to 19.2% of sales Pre-opening costs decreased from 0.96% to 0.44% and then increased dramatically to 1.07% of sales Net interest expense has decreased dramatically from (2.38%) to 1.2% of sales They had interest revenue during 1984 and 1985 and an interest expense during 1986

Evaluating Performance- Further Investigation- SALES/ASSETS Key Business Drivers: 1986 1985 1984 Inventory Turns 3.4 3.79 3.17 Sales per Store (M) 14.0 13.9 13.5 AVG Size of Store 80 77.4 73.7 Sales per SQR/FT 175.2 180.3 183.0 Transactions per Store 466.5 459.9 446.3 Sales per Transaction 30.04 30.36 30.21

Evaluating Performance- Further Investigation- SALES/ASSETS Conclusions: Inventory turns have decreased Average size of store has increased Average sales per store has been steady Average amount of sales per square foot of store space has declined Overall, efficiencies are decreasing

Evaluating Performance - Cross Sectional Comparison HOME DEPOT HECHINGER 1986 1985 1984 ROE = 9.19 17.64 15.69 15.80 18.90 19.10 PROFITABILITY (Driver 1) * 1.17 3.26 4.01 4.84 5.17 5.292 ASSET MANAGEMENT (Driver 2) * 1.84 1.74 2.43 1.48 1.72 2.02 DEBT MANAGEMENT (Driver 3) * 4.27 3.11 1.61 2.21 2.12 1.79 NOTE: Home Depot has lower profit margins, less asset turnover, better debt management

Evaluating Performance - Cross Sectional Comparison Do these findings align with strategy? Home Depot: Low Prices High Volume Good Customer Service Hechinger: Upscale stores Higher Prices Low Volume

Evaluating Performance - Cross Sectional Comparison Further Questions: What markets does each company operate in? Why does Hechinger has better inventory turns (4.5 vs. 3.4 in 1986)? Both have declining ROE, does this imply increased competition or expansion?

Cash Flow Analysis Cash 1986 1985 1984 By Operations (43,120) (3,056) (10,574) Before External Financing (135,146) (84,711) (26,904) From External Financing 92,755 114,605 40,821 Net Change (42,391) (29,894) 13,917

Cash Flow Analysis – Further Investigation 1986 1985 1984 Increase in Inventories (68,654) (25,334) (41,137) Addition to Property and Equipment (99,767) (50,769) (16,081)

Cash Flow Analysis Conclusions: Problem: Home Depot is expanding rapidly Costs are soaring out of control (inventory and equipment) Heavy reliance on debt financing Problem: How will Home Depot finance their planned expansion?

Financing Costs for Expansion Inventories 1.8 M Property, Plant and Equipment 6.6 M Cost per Store 8.4 M Cost for 9 Stores 75.6 M

Projected Income Statement Financing   Projected Income Statement Sales 1000 M EBIT 27 M Interest (8.7) M EBT 18.3 M Taxes (.461 avg of 1983 + 1984) 8.4 M Net Income 9.9 M

Projected Cash From Operations (M) Financing   Projected Cash From Operations (M) Net Income 9.9 Depreciation 4.4 Deferred Tax 3.6 Working Capital (Op’s) 17.9 Change in Inventory (46.9) Change in Receivables (11.5) Change in Payables 24.6 Net Cash From Op’s (15.9)

Financing Financing Required Line of Credit 200 M – 88 M = 112 M   Financing Required Line of Credit 200 M – 88 M = 112 M Restrictions EBIT/Interest < 2:1 Maximum Interest Allowed 27 X 0.5 = 13.5 M Current Interest 10.2 -1.5 = 8.7 Amount Interest Cost Allowed 13.5 – 8.7 = 4.8 Max Borrowing All’d 4.8 / 0.8 = 60 M

Cash Flow Analysis Is It Enough? Question: Needed – 91.5 M 75.6 M for new stores 15.9 M for operations Able to Borrow – 60 M Question: Where will Home Depot get their additional financing?

Cash Flow Analysis Can Home Depot generate greater cash flows? Yes. If capacity utilization is increased then sales growth will occur as fixed costs spread over a larger sales base.

Cash Flow Analysis Can Home Depot generate greater cash flows? Sales / Store = Sales / Transaction x Sales Transactions / Store 1985 = 14 M = 466.5 x 30.04 1984 = 13.9 M = 459.9 x 30.36 1983 = 13.5 M = 446.3 x 30.21 Can increase sales per store by increasing customer traffic but probably not sales per transaction

Conclusions Subsequent Developments: Performance in future years was a dramatic turn around in the company’s profitability Sales continued to grow at a slightly lower, but still impressive rate Return on sales, return on equity, pre-tax margins and asset turnover all increased through better inventory control, and better cost control Most important improvement was in the number of transactions per store Financial position improved dramatically, operations provided a positive cash flow Stock price increased Company’s leverage dropped to a debt-equity ratio of 0.91

Conclusions Summary: Management of The Home Depot took key steps to improve the productivity of their assets Led to an increase in profitability without sacrificing growth Financial markets rewarded the developments Enabled the company to issue equity and reduce debt Company left with considerable financial flexibility to implement its growth plans

Questions?