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Home Depot was founded in 1978 in Atlanta, Georgia. The company went public in 1981. Their stocks were first traded in OTC (Over-The Counter) and were subsequently listed on the New York Stock Exchange in 1984. The Chain stores were warehouses that had huge amounts of building materials and home improvement products targeting customers that were individual home owners and small contractors.
Their aim was to bring the warehouse retailing concept to the home center industry. This was considered to be the first successful company in Do-It-Yourself (DIY) segment and was famous for providing high quality products with low prices. Beside providing best quality products, the company’s distinctive feature was that they provided knowledgeable customer services. All sales personnel were required to attend product knowledge training classes.
The home improvement industry in which Home Depot is part of was a large, rapidly growing and competitive industry during the 1980’s. With two wage earners in each household, families were willing to spend more money on home improvement projects and they rather do it themselves. Therefore the DIY segment grew rapidly. This growing industry attracted many competitors who had a dream of gaining a quick and easy profit.
The success of the first three stores in 1979 encouraged the company to expand its business rapidly and reach the 50th store opening by the end of fiscal 1985. Due to this rapid expansion, the sales grew from $7 million in 1979 to $700 million in 1985. A remarkable part of this expansion plan in 1985 was to acquire nine stores from a competitor store chain which was in financial difficulty, Bowater Home Centers. However, while gaining market shares in the industry, the company’s net earning declined. Furthermore, in 1985, the industry and retailing in general faced a difficult period in which the strongest and most capable companies survived from it but not without being affected. This downward situation also affected Home Depot stock prices.
For the purpose of this report which is considered to be conducted in 1986, we will review the company’s performance during the fiscal years 1983-1985.
Business StrategyThe company’s profitability is determined by its own strategic choices: industry choices, competitive positioning and corporate strategy.
The home improvement industry was growing rapidly with sales of around $80 billion in 1985 and a strong industry growth was expected to continue, especially in the DIY segment. This promising market condition attracted a lot of new entrants. However, not all of them were as successful as Home Depot who was a pioneer in the DIY segment. Home Depot had the first mover advantages such as having exclusive agreement with suppliers due to large scale purchases. The volume of their purchases gave Home Depot the bargaining power in dealing with their suppliers.
Home Depot’s competitive strategies have been a key success factor for the company.
The sources of competitive advantages were cost-leadership, rapid expansion and differentiation strategy with more emphasis on the first two.
To offer low cost products, the company undertook several steps. First, Home Depot stores were also the warehouses with inventory stacked over the merchandise displayed on the racks. This format kept the overhead low. Second, with emphasis on low prices (reduced margin) and higher volume sales, the company gained a high inventory turnover. Third, the managers were in favor of opening stores in existing markets to share advertising cost and operational expenses which resulted in a faster return than stores in new markets. Fourth, The company decided to lease second-use store spaces which would cost $1.7 million instead of acquiring new sites and having stores constructed for them that would cost $6.6 million per store. All these strategies allowed the company to pass these savings to customers by offering low and competitive prices.
Home Depot differentiated itself in the market by providing an exceptional customer service and sales personnel. The employees were trained about the company’s home improvement products and their basic applications, to aid the customers in their home improvement projects. This developed loyal customers who were willing to come back to the stores for their later projects. Also, by offering all sorts of products and materials needed for home improvement at low prices, Home Depot targeted variety of customers, from home owners with no experience in DIY to professional contractors.
Beside all the strategies that the company chose in accordance with its industry and its competitive positioning, Home Depot implemented several other tactics to improve its profitability. To ensure that the right products are stocked at all times, each Home Depot store had 25,000 separate SKU (Stock keeping units). All these items were kept on the sales floor of the stores to increase customer convenience and minimize out of stock occurrence. Moreover, Home Depot pursued an aggressive advertising program through media and direct mail catalogues. The advertising were focused on promotional pricing and helpful sales personnel. Finally, the acquisition of Bowater Home Centers, its competitors, was another step in becoming dominant in the market.
The strategies chosen by Home Depot seem to have worked effectively to this day. However, if the company continues to ignore the low profit that it is making and just expands the number of its stores, in the long run, the company might fail to achieve its business goals.
Stores ProductivityHome Depot’s expansion from 1983 to 1985 meant that the number of stores grew from 19 in 1983 to 50 in 1985. While sales in the stores were steadily increasing, a decrease in the average amount of sales per square foot was evident (see Table 1). This could be explained with an unchanged number of sales per transaction and also the steady number of transactions per store during the three fiscal years (Table 1). This also could be due to an increase in the average size of the stores.
However, the management was taking note of this decline. It was mentioned in the letters to the shareholders (1985) that the managements had installed computer systems in stores to increase efficiency and improve labor productivity at store level. The computer system was to facilitate the tracking of individual sales in each store to enhance inventory reorder and margin management.
This suggested that while the sales were steadily increasing in individual stores, the productivity of the stores were declining which resulted in lower profitability and hence the company’s profits were not keeping pace with its sales.
Capital ResourcesTo implement its expansion plan, Home Depot needed to generate fund both internally and externally.
Home Depot aims to generate cash internally from its assets. As mentioned in the letter to shareholders (1985), they plan to use the sale-and-leaseback approach to save approximately $50 million for 10 of their stores. Also, the disposition of certain properties and equipment located in Detroit, Houston and Tucson has already led to a net gain of $1,317,000. The company’s cash and carry policy and their strategy of using financing from vendor credit for their inventory meant that they were able to use the cash flow for their operations.
However, beside the internal cash generating efforts by Home Depot, the company needed to rely on the external financing both debt and equity, to further implement their expansion program.
One of the major financing strategies that Home Depot chose was to enter into a new credit agreement for a $200 million revolving credit facility with a group of banks during fiscal 1985. Home Depot invested $88 million dollars of the banks credit in 1985 to open twenty new stores in eight new markets. Further debt financing included the industrial revenue bond of $4.4 million. In addition, a large portion of the firm’s long term debt consisted of convertible subordinated debenture worth of $100,250,000 which is unlikely to be converted to the equity any time soon.
As part of the expansion plan in 1986, if Home Depot wants to acquire new space for its stores made with its own specification, an approximate cost of $6.6 million per store would be required. However, if the company decides to lease second-use-store space, the cost of acquiring the lease would be $1.7 million. The company chose to lease stores in order to save money for future operations. Moreover, for each new store, the company would require approximately $1.8 million of inventory, through vendor credit.
As mentioned above, the company funded majority of its growth in 1985 through debt financing, and intended to finance the growth in 1986 in the same way. However, a drop in their stock price’s in 1985-1986 and having to comply with their debt covenant restrictions, created a difficult situation in their borrowing and expansion capability. The company still has a $112 million unused debt under the revolving credit agreement. However, the interest coverage is likely to inhibit the company from making full use of the credit agreement available funds.
Financial PerformanceHome Depot has had an impressive growth during 1984 and 1985. As the company engaged more in major expansion (opening 20 new stores) in 1985, its revenue rose 62% from $432 million in fiscal 1984 to $700 million in 1985. However, this increase was just a small part of the company’s financial performance.
In 1985, Home Depot experienced a decline in ROE (Return On Equity) which was due to the decline in return on assets (Table 2). The company was increasing its asset base by opening new stores and this would mean that by having more assets and consequently more sales, the company’s profit would rise. However, since the company had low-cost strategy and the costs of expansion were high, the number of sales increased but the profit declined. This resulted in decline both in profit margin (return on sales) and asset turnover which led to a substantial decline in the company’s ROE. On the other hand, the company was using debt financing to support its expansion so the financial leverage increased from 2.4 in 1984 to 3.7 in 1985 (Table 2). Also, the sales profitability (return on sales) declined in 1985. This was due to the increase in the cost of goods sold; selling, general and administrative (SGA) expenses and interest expenses as a percentage of sales (Table 2).
In order to analyze the company’s performance, we compared the financial ratios of Home Depot with one of its major competitors, Hechinger, during fiscal 1983-1985 (Table 3). Hechinger was new in the DIY segment of the industry and had a quite different strategy from Home Depot. Hechinger targeted upscale customers and aimed at high profit margins. Hechinger ROS was significantly better than Home Depot’s margins (Table 3). Their Gross profit margins were higher and their selling costs seemed to be lower than Home Depot. However, Home Depot has a higher asset turnover. Overall, although Hechinger was experiencing a decline in performance, in comparison to Home depot, the decline was relatively small. Hechinger was financially stronger than Home Depot as shown by the difference in their financial leverage (Table 3).
Furthermore, by analyzing the statement of cash flow for both companies, it became evident that Home Depot had an alarmingly negative cash flow from operations between 1984 and 1985 due to a large inventory increase and a high investment in property and equipment. In contrast, Hechinger had a positive cash flow from operations in all three years. Unlike Home Depot, Hechinger relied on equity financing to fund its expansion.
Evaluation & RecommendationsThe company has undermined the profitability of its stores and has mainly focused on the expansion plan and opening new stores. While the sales of the company have been steadily increasing, the profitability has been decreasing and the share prices have dropped by 23%. This suggests that the company is unlikely to be able to rely extensively on equity and debt financing. There are a number of options that the company is able to take in order to stay in the current expansion track. The company is able to further use the method of sale-and-leaseback mentioned in their letters to shareholders to raise funds internally.
However, while this is a possibility, the fixed assets of Home Depot are limited and hence this can be considered as a short term, temporary solution. Another option would be to issue further equity to raise funds. However, this will severally reduce the interests gained by the current shareholders. A further option would be to improve the company’s cash flow from operation. As mentioned earlier, the company works on the basis of cash and carry and their inventory are covered by vendor credit which would allow the company to make excellent use of their cash flows.
By correcting some of the steps that the company has taken and by wisely choosing the right strategies mentioned above, Home Depot can improve its future performance and profitability and be dominant in the market in the years coming.
K. Palepu, ‘The Home Depot, Inc.’, the case, Harvard Business School, 1996Palepu, Healy and Bernard. ‘Business analysis and valuation’, Third edition, 2004Table 1: Stores Productivity198319841985Sales/Store ($million)Transaction/Store (000)Sales/TransactionSquare Foot/Store (000)Sales/Square Foot13.5446307418313.9460307718014.04673080175Table 2: Financial ratios of Home DepotFinancial RatioFiscal Year198319841985Return on SalesAsset TurnoverReturn on AssetsFinancial LeverageReturn on Equity (%)Gross Margin (%)SGA Expense/Sales (%)Net Interest Expense/Sales (%)Tax Expense/Sales (%)4.03.714.81.724.527.320.8-220.127.116.11.02.419.426.420.6(0.3)18.104.22.168.63.79.725.922.214.171.124Table 3: Comparison of Home Depot to HechingerHome DepotHechingerFiscal Year198319841985198319841985ROE (%)24.519.49.719.118.915.8ROA (%)14.88.02.610.78.97.1ROS (%)4.03.31.25.35.24.8AT126.96.36.199.01.71.5FL188.8.131.52.82.12.2AT: Asset Turnover, FL: Financial Leverage