The Home Depot, Inc. Case Analysis.
The Home Depot, Inc
Case Analysis
FINA 273
Professor Krishna R. Kumar
By Anastasia Nasyrova
Master of Science in Finance
George Washington University
. The Home Depot's competitive strategy is based on merchandise strategy. The company offers low prices by exploring the concept of the warehouse retailing. The warehouse stores located in the suburban places, the high volume of inventory displayed on the industrial racks and the simple facility design, allowing the company to pass savings on the customers. In order to increase convenience and out-of stock issues all inventory presented on the sales floor of the store. The Home Depot assures that the quality of the product offered is best and satisfied customers of different test, experience and knowledge of home improvement projects.
The Home Depot practices decentralized management, especially for its buying function. Regional buyers and merchandisers from six regions make product mix and inventory decisions. Consequently, while product categories are similar from store to store, suppliers can differ. The sheer sales volume of the Home Depot stores enables them to exert considerable influence on suppliers, even dictating such important aspects of the buyer-suppliers relationship as delivery terms and product labeling. The company's power over suppliers, though, is tempered by the need to maintain adequate inventory in so large a distribution channel.
Finally, the company provides training for their employees that help to have excellent sales assistance on the store floor. Also the company offered competitive salary and wage level. The Home Depot pursued an aggressive advertising program in order to attract more customers.
By concentrating on the merchandise strategy the company can meet different challenges.
Home Depot has long prided itself on hiring former plumbers, carpenters, and housepainters to man its aisles and advise customers. But that has turned into an expensive endeavor in an era of nearly full employment. The company keeps all merchandises on the store floor using the industrial racks and shelves. It is also can be dangerous and carry injuries caused by overloaded shelves in the aisles and running forklifts.
The Home Depot buys its products in orders in advance of shipment with arrangements similar to futures contracts. That keeps a stable supply coming onto store shelves. It also locks Home Depot into paying prices that might be months out of date. Because of the huge amount of the warehouse store that company has it makes difficult and inflexible to manage such orders by buying the products in cash market at spot prices.
2. The Home Depot profit margin decrease sharply in year ending February 1986. The decrease in profit margin results from of increasing cost of goods sold to sales percentage, and increasing selling and administrative expenses to sales percentage. The increasing in the selling, administrative expenses, store operating and pre-opening expenses as percentage of sales may result from increasing advertising expenses, and also due to opening large percentage of new store with lower sales, and the related cost of building market share.
The Home Depot profit margin and operating asset turnover both steadily decreased that reflect in following ...
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2. The Home Depot profit margin decrease sharply in year ending February 1986. The decrease in profit margin results from of increasing cost of goods sold to sales percentage, and increasing selling and administrative expenses to sales percentage. The increasing in the selling, administrative expenses, store operating and pre-opening expenses as percentage of sales may result from increasing advertising expenses, and also due to opening large percentage of new store with lower sales, and the related cost of building market share.
The Home Depot profit margin and operating asset turnover both steadily decreased that reflect in following decrease in RNOA for year-ends in February 1986.
Operating asset turnover ration increased between January 1985 and February 1986. It follows that average number of days that accounts receivable were outstanding almost doubled for this period. In the same time account receivables were increased more that double. Even so, The Home Depot doesn't appear to have a major problem with collecting its accounts receivable. Many firms transact business with terms of 30 days.
Inventory Turnover decreased and average number of days in Inventory increased but very slightly and sufficient. However, the significant numbers of days in Inventory (>80 days) were cause The Home Depot merchandise strategy is to keep all inventories in stock and on shelves.
Fixed Assets Turnover decrease between year-end January 1985 and 1986 results from rapid expansion and continued growth of the Home Depot. Decreasing in the fixed assets turnover may also indicate problem in operating efficiency. However, the company made significant investments in fixed assets in anticipation of higher sales in the future. The Home Depot expansion includes acquiring more land, buildings, furniture and equipment for the opening of 20 new stores, and also leasehold improvements.
The rate of return on common shareholders' equity (ROCE) measures the return on common shareholders after subtracting from revenues operating assets, cost of financing debt and preferred stock. The income from operations that is not allocated to creditors or preferred shareholders belongs to the common shareholders as the residuals claimants. ROCE incorporates the results of a firm's operating, investing, and financial decisions. ROCE can be disaggregating on its components as follows:
ROCE = RNOA + Wd/We (RNOA - NBC)
The Home Depot had decreasing trend on ROCE. It also had down trend of RNOA in years ending Feb. 1986, 1985, 1984. NBC had jump up in year ending February 1985 and came back to even lower position in the end of the same fiscal year. The net borrowing cost depends on risk-free rate, the risk of debt and the corporate income tax rate.
In year-ends Feb.1986 the inflation didn't have an effect on sales or results of operations.
But effective income tax rate declined from 46.2% to 29.3% resulting from an increase in investment and other tax credits.
ROCE was below RNOA whenever RNOA below the cost of capital provided by creditors and preferred shareholders. For fiscal year 1985 the cost of capital appears to exceed RNOA slightly (6.15 against 6.14) and reduced the return to the common shareholders (6.13).
Wd/We is measure of leverage or capital structure leverage. However, leverage was stable prior 1985 fiscal year, when it went up. Leverage increased the variance of ROCE.
Financial leverage had disadvantage for the Home Depot shareholders in fiscal year 1985, and year 1984 because its ROCE lies below its RNOA.
3. The Home Depot generates negative cash flow from operations of $41,803, $2,143 and $10,574 in 1985, 1984, and 1983 fiscal year respectively.
The company experienced positive working capital from operations in all three years $16,398, $18331 and $12,342 in years 1985, 1984 and 1983. Investing activities consumed $93,343, $82,568 and $16,330 in fiscal years 1985, 1984 and 1983 respectively. The negative cash flow from operations coupled with negative cash flow from investing required the Home Depot to obtain the cash from financing sources. The company primary relied on long-term borrowing in 1984 and 1985 fiscal years and on issuing common stocks in 1983 fiscal year.
It used long-term debt to finance the acquisitions. The Home Depot made a significant corporate acquisition on Bowater Home Center, Inc. in 1984 fiscal year for which it needed external financing. Debt is less expensive source of capital that equity. Also the Home Depot used debt because of collateral value of its stores and store equipment, and predictability of cash flows of large retailer.
4. During the 1985 year the Home Depot entered into the unsecured revolving line of credit agreement. This agreement put interest coverage restrictions that company has to meet. Among other things, the company is required to maintain a minimum tangible net worth of $150,000, a debt to tangible net worth ratio of no more that 2:1, a current ratio of not less than 1.5:1, and a ratio of earning before interest expenses and income taxes to interest expenses of not less that 2:1.
Interest Coverage Ratio:
The Home Depot debt level increased while profitability decreased in 1985 year, resulting in a decreasing interest coverage ratio. This ratio is 2.1 and viewed by analyst close to be a risky situation. So the Home Depot can exhibits some solvency risk by this measure.
The constraints on the credit agreement wasn't high restrictive and required to maintain the appropriate level of risk. Even so, for period of time between 1983 and 1985 years company didn't have problems to keep interest coverage level exceeding 2.0.
5. The debt covenant agreement had a requirements to maintain the ratio of earnings before interest expenses and income taxes to interest expenses not less that 2.0. The EBIT can be express as:
EBIT = 2.0 * Interest Expenses =
= 2.0*(Interest expenses 85' + Interest Expenses added in 86' (50 mln. debt under 10%))
= 2.0 *(10,206 + 50,000*0.1)
= $30,410
The Home Depot needed at least $30,410 before interest and income taxes to cover the total interest in 1986 under the debt covenant.
If taxes stays on the same level equal to 29.26% then company need to make
$30,410 * (1-0.2926) = $21,512 before interest.
6. If the company maintained NOPAT profit margin ratio in 1986 (profit before interest to sales) at the 1985 level its mean next:
NOPAT/Sales (1985) = NOPAT/Sales(1986) =>
Sales 1986 =
Sales 1986 needed to cover the total interest under the debt covenant have to be at least
Sales 1986 >= *700,729 = $1,120,000
The Home Depot had 50 stores in year 1985. If it build the 10 additional stores in 1986, the Sales per store = $1120,000/60 = $18,667
7. Sales per store in 1985 = $700,729/50 = $14,014.
In order to move from the level of the 1985 year to the level of the 1986 the Home Depot have to increase sales per store by more that 4 millions. The best way for the Home Depot to achieve it and to invest in its growth on sustainable basis company would need to generate more cash from its own operations. The successful marketing strategy and promotional activity, decreasing time of opening the new stores, the more effective operation strategy can have a positive effect on growth rate of sales. New training program for store managers, department heads and sales personnel would help to increase the sales. Also, introduction of the new product lines, improving quality of the existing product lines, improving the store operation system would give the competitive advantage and as following the positive effect on the performance of the company and increase of sales.
8. Successful management of the company and choosing the right strategies can revolve the declining stock price, improve profitability and growth prospects of the Home Depot, which makes shareholders clearly worry about the company in the year 1985.
The specific recommendation in respect overall strategy would be include: marketing strategy as promotion of brand name products, introduction of new marketing approaches to meet specific customer needs in the changing markets environment; strategic planning; innovative technology development; business strategy as determining product differential mix and developing competitive pricing strategy; implementing non-interest expenses controls.
The Home Depot's profit margin, operating assets turnover, inventory turnover and fixed assets turnover steadily was decreased in the period 1983-1985 fiscal years. It may indicate the problems in operating efficiency. Management needs to pay attention to the operating activities. Also areas of attention would be return on common shareholders' equity that sharply decreased during the same period and interest coverage ratio that dropped 21% in 1985 fiscal year. In respect to operation management, company could be improved in several directions:
- Distribution: effective use of logistics management techniques;
- Management information systems: innovative merchandising, efficient control of inventories, adjusting the store's hours of operation;
- Human resources: knowledgeable sales staff, train and re-train employees;
- Production: introduction of new merchandise, timely reviewing current merchandise list, improving quality standards.
The Home Depots' cash flow from operations was not sufficient to finance their investing activities. Cost of acquisition of the Bowater Home Center and opening numbers of new stores was significant. The Home Depot engaged in long-term borrowing to make up the shortfall. Per shareholders concern of declining profitability, company needs to improve financial conditions by maintaining successful financial policies. It's could developed liquidity policy that based on maintaining the level of liquid assets needed to ensure it can meet its obligations, in terms of debt. Asset/liability management could govern by explicit guidelines for comprehensive management and control of risk exposures resulting from fluctuations in interest rate and level of inflation. As a matter of internal policy, the Home Depot could maintaining capitalization policy and set an adequate level of capital that will inspire confidence in the investor community.
