Home Depot,Inc-final - Grade: 93% PDF

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Case Study Assignment 2...

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Case Write-Up “The Home Depot, Inc.” Financial Statements Analysis

Student:

Christopher Pfaffinger

TA:

Jamil Hamdanieh

Lecture Time:

11:40AM – 12:55PM

Date:

February 24, 2016

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1. I believe Home Depot´s current expansionary business strategy is not a viable strategy for the long run. The company is pursuing a cost-leadership strategy with some differentiated elements. In order to thoroughly evaluate its strategy, I will focus on analyzing Home Depot´s industry and its competitive strategy. Home Depot primarily engages in the home improvement industry which had a total size of $80 billion in 1985 (Palepu & Healy, 2013). Factors, which drive the industry´s profitability can be explained through Porter's Five Forces. The rivalry among existing firms is low to moderate due to the fact that Home Depot was operating in the Do-It Yourself (DIY) niche with only a few strong competitors. Nevertheless, the industry had recently experienced a strong growth with a CAGR of 14% (Palepu & Healy, 2013). The threat of new entrants is low to medium. Incumbents in the industry benefit from a first mover advantage, distribution access and existing relationships. At the same time new entrants are subject to legal barriers and a capital intensive industry, however, they do get attracted by a growing and profitable niche. The threat of substitute products is low since Home Depot´s DIY-products are rather unique in the industry and it is hard to compete with Home Depot´s low prices. The bargaining power of buyers is low due to the lack of products and companies to choose from. Similarly, bargaining power of suppliers is low due to many existing suppliers and bulge orders placed by incumbents. Home Depot is creating value through passing on cost-savings to its customers. Its competitive advantage is based on costleadership through lower input costs, economies of scale and an efficient production which ultimately allows the company to supply its products at a lower cost than competitors. However, the firm also differentiates its products by selling unique DIY-products, by providing sales assistance through knowledgeable staff and through aggressive advertising (Palepu & Healy, 2013) . Since the firm partly engages in both strategies for creating competitive advantages, one could say the company is also “stuck in the middle” through its strategic choices (Palepu & Healy,

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2013). Those firms merely operate at a high level of profitability (Porter, 1980, p. 41). In fact, Home Depot´s net earnings have been decreasing for three consecutive years. In addition, according to Palepu and Healy (2013), the company runs “a risk of not being able to attract priceconscious customers, while at the same time being unable to provide sufficient differentiation to attract premium price customers ”. Besides, I believe that the current expansionary growth is not sustainable in the long run. 2. Home Depot´s financial performance during the fiscal years 1983 and 1985 is comparatively weak. My analysis will focus on some of the key aspects of Home Depot’s and Hechinger’s performance and is meant to be complemented by Exhibit I and II, where all of the following numbers come from. Firstly, the firm had three consecutive years of negative cash flows from operations with a decreasing trend. In 1983, its CF from operations amounted -$11 million and decreased to -$45 million in 1985, which forced them to rely on external financing. In the same time period, net income decreased from $10 million to $8 million. However, one major problem lies in the increasing negative cash flow from 1984 to 1985 that was partly caused by an inventory stock-up worth $69 million. Notably, Home Depot´s average days in inventory outstanding increased from 75 days in 1983 to 83 days only 2 years after. These inventory management problems clearly affect the company’s financial performance and also its level of profitability. For instance, ROE decreased from 24.5% to 9.7%. This stark decline is due to the increasing effect of financial leverage of 2.44 in 1984 and a declining performance in terms of ROA from 14.8% to 2.6% in 1983 and 1985, respectively. Therefore, the company decreased its efficiency in using its assets to generate operating profits. Which, again, was caused by a decreasing ROS and AT. The ROS showed a decline from 4.0% (1983) to 1.2% (1985) and can be explained through increasing COGS among other things. The gross margin decreased from 27.3% to 25.9%, which underlines

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the negative trend. In terms of short term liquidity it needs to be noted that the current ratio was 2.4 in 1983 and stayed fairly stable until 1985. The quick ratio was 0.7 in 1984, meaning that Home Depot had problems to meet current liabilities with its liquid assets. The long term solvency ratios indicate that Home Depot decided to finance its expansion mainly with debt. In fact, Home Depot issued $217 million in debt in order to finance their expansion. The total debt to equity ratio increased from 0.07 to 2.4. A higher D/E ratio generally increases the risk of doing business. In addition, Home Depot had to borrow money in order to meet interest expenses, which is indicated by the company’s negative interest coverage in 1985 (-2.9). While Home Depot failed to manage inventory properly, Hechinger performed better in many regards, which resulted in stronger financial ratios including ROE, ROA, ROS, inventory turnover and higher margins. Is has to be stated though that Hechinger was pursuing a competitive strategy based on differentiation, which provides, on average, higher margins than a cost leadership advantage. Anyways, Hechinger also faced problems through a declining ROE, for instance, as it decreased from 19.1% to 15.8%. And also its gross profit margin showed a declining trend and its asset turnover (1.5) was worse than Home Depot’s (2.2). Nevertheless, Hechinger was able to generate a positive cash flow from operations for three consecutive years. Besides, Hechinger expanded its business through equity capital instead of debt capital. Hechinger’s debt-to-equity ratio was 1.2, while Home Depot had a debt-to-equity ratio of 2.7. Hechinger was also more efficient in terms of its inventory turnover (4.5); something, which proves to be key in managing a company’s expenses. 3. Home Depot’s stores became less productive between the fiscal years 1983 and 1985. All of the following numbers refer to Exhibit III. The firm’s aggressive growth including the opening of 31 new stores, 10 new markets and the doubling of the amount of employees to 5,400 in 1985 did not positively affect the bottom line per store. However, it needs to be taken into account that it is

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normal in times of expansion to suffer from less productivity for the sake of gaining market share in order capitalize from it later. This is due to the high fixed costs in the initial phase of a newly operating store. While Home Depot’s revenues per store were increasing during that period, net income per store decreased sharply from $540,053 in 1983 to $164,380 in 1985. Similarly, sales per employee increased by approximately $23,000, but net income per employee experienced a sharp decline from $4,275 to $1,522 within the same time period. Besides that, revenues per transaction stayed at the same level ($30.1), but net income per transaction decreased by 75%. That being said net income per market also declined by almost 30%. 4. I believe that Home Depot should improve its inventory management system and adapt its growth strategy to the current market situation, thus slowing it down in pace. In addition, the company should make use of a sale-leaseback option. One of Home Depot’s major problems is its negative cash flow from operations. A new management information system would allow “a more concise method of inventory reorder and margin management” (Palepu & Healy, 2013, p. 711) as the management team stated. Eventually, this would decrease the average days’ inventory and help the company to improve its cash flow from operations. Issuing equity does not seem feasible given the current financial situation: In order to raise a sufficient amount, Home Depot would dilute the stakeholders’ interests. However, a sale-leaseback would be a better option in order to better utilize Home Depot’s fixed assets as it is stated in the management’s letter to its shareholders. This would provide more funds and help to finance the company’s growth. Given the company's constraints through debt covenants, Home Depot also has to slow down its expansionary growth. Only by harmonizing its growth, Home Depot will be able to start generating positive cash flows from operations. Once the company has managed to do so, it might consider to vertically integrate after a careful analysis, thus to take control over more steps along the value chain.

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Works Cited Capital IQ (by Standard & Poor's). (n.d.). The Home Depot, Inc. Financial Data. Retrieved February 21, 2016, from https://www.capitaliq.com/ Palepu, K. G., & Healy, P. M. (2013). Business Analysis Valuation: Using Financial Statements. Mason, OH: Thomson South-Western. Porter, M. (1980). Competitive strategy: techniques for analyzing industries and competitors. New York: Free Press.

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Exhibit I: Financial Ratios for Home Depot, Inc.

Key Financial Ratios ROE ROA ROS Profit Before Taxes/Sales Gross profit margin Gross margin EBITDA Margin Financial Leverage

1983 24.5% 14.8% 4.1%

1984 19.4% 8.0% 3.3%

1985 9.7% 2.6% 1.2%

7.4% 28.8% 27.3% 6.9% 1.65

6.1% 30.7% 26.4% 6.4% 2.44

1.5% 28.6% 25.9% 3.5% 3.72

3.7x 181.5x 4.9x

2.4x 74.9x 4.5x

2.2x 45.4x 4.4x

Short Term Liquidity Days inventory Days accounts payable Current ratio Quick ratio

74.6 32.3 2.4x 0.7x

83.2 33.0 3.1x 1.3x

83.0 26.7 2.3x 0.4x

Debt, Long Term Solvency Debt to equity ratio Debt to capital ratio

6.8% 6.4%

147.4% 59.6%

236.1% 70.2%

Asset Turnover Total Asset Turnover Accounts receivable turnover Inventory turnover

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Exhibit II: Cash Flow Statement for Home Depot, Inc. (Capital IQ (by Standard & Poor's), 2016)

The Home Depot, Inc. (NYSE:HD) > Financials > Cash Flow In Millions of the reported currency, except per share items.

Template: Period Type: Currency:

Standard Annual Reported Currency S&P Capital IQ (Default)

Units:

Cash Flow Restated 12 months Jan-29-1984 USD

For the Fiscal Period Ending Currency Net Income

Restated 12 months Feb-03-1985 USD

12 months Feb-02-1986 USD

14.1 10.3

Depreciation & Amort.

8.2 2.3

0.9 -

Amort. of Goodwill and Intangibles Depreciation & Amort., Total

0.1 2.4

0.9 (Gain) Loss From Sale Of Assets Other Operating Activities

0.5 (1.6) (41.1)

Change in Acc. Receivable Change In Inventories Change in Acc. Payable

5.2 1.6 (7.2) (25.3) 10.5

17.2 Change in Inc. Taxes

5.2 -

(1.3) 3.6 (15.8) (68.7)

(0.7)

26.8 (0.6)

(0.8)

(2.3)

(5.4)

(44.8)

(50.8) 0.9

(99.8)

0.4 Change in Other Net Operating Assets 2.6 (10.8)

Cash from Ops. Capital Expenditure Sale of Property, Plant, and Equipment

(16.1)

Cash Acquisitions Divestitures Invest. in Marketable & Equity Securt. Net (Inc.) Dec. in Loans Originated/Sold Other Investing Activities Cash from Investing Short Term Debt Issued Long-Term Debt Issued

0.0 -

(29.2) -

(16.1)

(79.1)

-

120.4

4.2

8

9.5 0.0 (90.3) 92.4

Total Debt Issued

120.4 4.2 (0.1) (0.1)

Short Term Debt Repaid Long-Term Debt Repaid Total Debt Repaid Issuance of Common Stock

(6.8) (6.8)

92.4 (0.3) (0.3)

0.8 36.6

Repurchase of Common Stock

-

0.4 -

0 Common Dividends Paid Total Dividends Paid

-

-

-

Special Dividend Paid Other Financing Activities

-

0.0

-

0.1 Cash from Financing

0.2 114.4

40.8 Misc. Cash Flow Adj.

-

Net Change in Cash

92.8 29.9

0 (42.4)

13.9 Supplemental Items Cash Interest Paid

NA

NA

Cash Taxes Paid

NA

NA

(27.3) (27.3)

(56.4) (53.8) 21.1

9.3

Levered Free Cash Flow Unlevered Free Cash Flow Change in Net Working Capital

22.5 Net Debt Issued

3.8 (147.9) (141.5) 58.8

113.6 4.2 Apr-03-1986 RS RUP

Filing Date Restatement Type Calculation Type

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Apr-02-1987 RS REP

92.1 Mar-31-1988 NC REP

Exhibit III: Store Productivity for Home Depot, Inc.

Data Table Sales Net Income Customer Count Square Footage Number of Markets Number of Stores Number of Employees

1984 $256,184,000 $10,261,000 8,500,000 1,400,000 7 19 2,400

1985 $432,779,000 $14,122,000 14,300,000 2,400,000 11 31 4,000

1986 $700,729,000 $8,219,000 23,300,000 4,000,000 15 50 5,400

Productivity Sales per Store Net Income per Store Sales per Square Foot Net Income per Square Foot Sales per Employee Net Income per Employee Sales per Customer Net Income per Customer Sales per Market Net Income per Market Transactions per Store (#) Revenue per Transaction Net Income per Transaction

1984 $13,483,368 $540,053 $183

1985 $13,960,613 $455,548 $180

1986 $14,014,580 $164,380 $175

$7.3 $106,743 $4,275 $30.1 $1.2 $36,597,714 $1,465,857 447,368 $30.1

$5.9 $108,195 $3,531 $30.3 $1.0 $39,343,545 $1,283,818 461,290 $30.3

$2.1 $129,765 $1,522 $30.1 $0.4 $46,715,267 $547,933 466,000 $30.1

$1.2

$1.0

$0.4

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