Question 1

Home Depot (“HD”)Strategy

The home improvement industry was a large one with industry sales approximated at $80bn dollars in 1985 and had grown at a compounded annual growth of 14% over the last 15 years.

HD’s strategy was to bring the warehouse retailing concept to the home center industry, a DIY concept in a warehouse which sold an array of building materials and home improvement products on a cash and carry basis. The company targeted individual homeowners and small contractors as it customers. The strategy had important elements which included offering low and competitive prices, were situated in suburbs and stores were also the warehouse which allowed HD to keep overheads low and pass savings to customers. They also serviced mainly “sunny” areas which would be more conducive and aligned to their family driven DIY concept.

HD carried approximately 25000 stock keeping units thus increasing convenience and minimising out of stock occurrences. They offered customers the nationally advertised brands as well as lesser known brands accompanied by guarantees from either HD or the manufacturer.

The biggest value add to their strategy was the sales assistance, whereby they employed largely on a full time basis, skilled, technically apt employees who were also trained further at HD, to enhance their sales offering. To complement the above HD embarked on aggressive advertising programs to attract customers.

The last part of the strategy was to grow the business aggressively over time, using a mix of equity and debt financing.

Is this a viable strategy

The wholesale industry is one which emphasises high volume and low margins with high inventory turnover. Typically this can be conceived as sacrificing quality for price. Clearly this was not the case at HD which provided the customer with the ability to choose products of similar nature, across different brands and which included guarantees of some sort. The working capital management has to be extremely efficient in this type of business and in order to maximise cash flow. Pricing and margins too have to be managed efficiently. Overstocking or mispricing on large number of inventories can lead to reduced margins or loss of inventory.
HD has through their profitability and growth shown that they have the expertise to manage this and the move to systems which may enhance efficiencies is positive. Notwithstanding this, the change of systems if not properly managed and integrated can have an adverse impact.

The DIY concept clearly found favour amongst HD’s customers given its growth to 1985 and in particular, we view the skilled sales assistance as a leading contributor to this growth success. Not only were the staff skilled and competent, they were largely full time employees who were paid better than the average. Whilst this component cannot be quantified, it is our view that it played a pivotal role in the sales growth.

With their being a move towards two household incomes and increasing disposable income, the DIY concept gained traction amongst families as a both a cost saving but also opportune for families to spend time together doing something different. HD may have had this as part of their vision and strategy. Advertising seems to be key to the success the business has had especially when opening new stores.
The consumer at the higher end of the market is more concerned with quality and limited/specific choices than the price differentials between goods. As such, HD continues to operate an end customer based advertising and marketing campaign that is not focused upon the intermediaries but rather upon the end user. Middle to lower end customers are more often than not concerned with prices, and have a wider range of goods requirements. By offering different brands, the consumer can be moved towards the lower cost section by trading down concerns in a tight economic environment, but also to better branded/quality products for an emerging class or dual income household.

The strategy of rolling out new stores may need to be reassessed due to financial constraints, however, the strategy in terms of the concept store, targeting new markets and maintaining their service levels has been successful to date and may be sustainable in the future for the following reasons:

• Leading market position.
• Presumably HD has good relationships with leading manufacturers
• Cost leadership with well managed industry margins
• A strong respected reputable brand, with a good track record in this segment
• Well respected management team

We do however believe that the strategy may be impacted by the following factors:

• Risk of increasing interest rates and a sustained downturn in the building and alterations cycle
• Increased competition as evidence by a move to this segment by others including some retail giants (Wal Mart).
• Gaining market share through margin compression.
• Increased debt levels and reduced profitability resulting in declining stock price
Barriers to entry into this industry are medium to high in our view however, the large players differentiate themselves through quality, distribution infrastructure, branding, service levels and innovation in specialised areas.

Presumably the volume growth is/has been driven by growth in construction in residential alterations and expansion and the renovation of existing homes. Construction growth may slow down due to interest rate levels rising. Price growth is driven primarily by input price growth and HD has historically been able to pass on increases.

PORTERS 5 FORCES
Entry barriers • Barriers to entry into the industry are medium to high, thus the large manufacturers differentiate themselves through quality, distribution infrastructure, branding and innovation in specialised areas.
• Large cpaex required to start up similar offering and cometing with HD on pricing may be difficult due to cost leader status.
• Premium suppliers will supply to any new company, but pricing may be an issue.
• Capex medium to high, being warehousing, goods, basic setup costs may be low for bigger retail outlets but high for smaller start ups.
Threat of substitutes THE THREAT OF SUBSTITUTES IS LOW
This resides mainly with the manufacturer of the goods that are sold

Bargaining power of buyers THE BARGAINING POWER OF BUYER IS LOW
Price increases are typically passed on to the customer. Consumer does not dictate the pricing.

Bargaining power of suppliers THE BARGAINING POWER OF SUPPLIERS IS MEDIUM TO LOW
With inventory of 25000 units and with the scale that HD provides, suppliers need HD to stock their items.

Rivalry amongst producers THE RIVALRY IS MEDIUM BUT PERHAPS RISING

Question 2:

Ratio analysis allows the comparison of two different sized companies on a like-for-like basis. Hechinger is considered comparable to Home Depot, in that both companies offer products in the ‘Home Improvement’ segment of the market. Both have similar product lines and similar supply-chains. However, it must be noted that the two companies’ strategies differ, and while offering similar products, they actually operate within different segments of the market. Hechinger has pursued a more ‘upscale’ product line and approach when compared to Home Depot, meaning that they two are different competitors along price lines; they target different consumer markets. Hechinger’s strategy is less price-sensitive, which allows it higher margins, and less focus on such tight working capital arrangements as Home Depot must control.

That being said, by end FY1985, the companies appear to have a similar market share, and similar number of stores in operation. Hechinger was a long-established hardware company, which had recently entered the DIY space. It appears to also be growing at a rapid rate, with plans to open an additional 10 to 14 stores every year, keeping its growth in line with that of Home Depot. In 1981, Home Depot operated only 8 stores. This grew to 31 in 1984, and 50 in 1985, with plans for an additional 9 stores during the course of 1986. Year End Feb 1986
Sales: $700,729,000
No. Stores: 55
Sales per store: $12,740,527

Year End Feb 1985:
Sales: $432,779,000
No. Stores: 22
Sales per store: $19,671,772

Sales per store decreased year-on-year 85 to 86. The financial statements state this as the result of new stores taking a while to settle in and gain market share, however this is concerning, as it shows that Home Depot is less efficient at generating profits to shareholders, despite spending capital on acquiring, stocking, and fitting out these stores.

The following is a ratio analysis comparison of Home Depot to Hechinger:

Insert table once calculations have been checked

RATIOS (HOME DEPOT) 1986 1985 RATIOS (HECHINGER) 1986 1985 Profit Before Taxes / Sales (%) 1.66% 6.07% Profit Before Taxes / Sales (%) 7.80% 9.40% x Sales / Average Assets 1.84 1.74 x Sales / Average Assets 1.48 1.72 x Average Assets / average Equity 4.27 3.11 x Average Assets / average Equity 2.21 2.12 x (1 - Average Tax Rate) 0.62 0.62 x (1 - Average Tax Rate) 0.62 0.55 = Return on Equity (%) 8.09% 20.29% = Return on Equity (%) 15.82% 18.85% x (1 - Dividend Payout Ratio) 0.67 0.44 x (1 - Dividend Payout Ratio) 0.93 0.95 = Sustainable Growth Rate 5.42% 8.93% = Sustainable Growth Rate 14.71% 17.91% Gross Profit / Sales (%) 25.90% 26.42% Gross Profit / Sales (%) 29.30% 30.10%
Selling, General and Administration Expense / Sales (%) 23.18% 20.61% Selling, General and Administration Expense / Sales (%) 21.60% 21.10%
Interest Expense / Sales (%) 1.46% 0.95% Interest Expense / Sales (%) 2.10% 1.30%
Interest Income / Sales (%) 0.21% 1.21% Interest Income / Sales (%) 2.20% 1.70%
Inventory Turnover 1.35 1.36 Inventory Turnover 4.50 4.50
Average Collection Period (Days) 15 11 Average Collection Period (Days) 32 33
Average Acc Payable Period (Days) 38 37 Average Acc Payable Period (Days) 58 61

When comparing Home Depot to Hechinger, it can be seen that HD is not performing nearly as efficiently, in terms of ROE as well as basis net profit.
Hechinger reports a ROE of 15.82% compared to 8.09% for Home Depot. While both business report a decrease in ROE from 85 to 86, HD’s is more significant at a xx percent decrease (compared to a 19% decrease for Hechinger) please check average tax rate on ratio calc – not sure how to calculate this and this will change the ROE.
This is a change from YE1985, where the two companies appeared to be running in line with each other in terms of ROE. It appears that HD’s expansion programme has resulted in it becoming far less efficient, and less able to turn the stores and the inventories into actual cash.

When analyzing inventory turnover (net sales over cost of sales), Hechinger produces a far more efficient ratio at an average of 4.50, compared to the average of 1.30 of Home Depot. This means that for every dollar Hechinger spends in order to sell its products, it generates $4.50 of sales income, compared to $1.30 at Home Depot. Home Depot’s inventory t/o is far lower than that of Hechinger, meaning that either Home Depot’s Cost of Sales is far higher, or sales margin amounts too low. This is most likely due to the companies different pricing models, as Home Depot competes in the market by offering the lowest prices.

Hechinger’s growth rate, when analyzing the ratios, appears to be consistent and sustainable, while HD’s has dropped off over the last year. As Home Depot adds new stores, large amounts of capital expenditure is necessary, as well as a time lag in converting these costs into profits. At their current large rate of expansion, it appears that this is not sustainable, as the current stores are not able to generate enough profits to support the expansion process.
The capital expenditure required to open new stores is large, and the increase in Capex over the past financial year for Home Depot has been substantial.

1986 1985

Leasehold Improvements 23,748,000 11,743,000
Construction in Progress 27,694,000 14,039,000

Significant increase in Capex (double in one year) due to company’s expansion.

As mentioned, due to the low margins present in a business such as Home Depot, the working capital policies need to be very strict and efficient. Home Depot has a far more efficient turnaround in debtors collections that Hechinger. This seems to be in line with what one would expect, given the two companies different strategies. While Hechinger has high enough margins to off-set the debtors collection periods, Home Depot requires the maximum amount of sales to turn into cash as possible, and as quickly as possible,. Home Depot’s good management has so far kept working capital in check, with a Collection Period of 15 days versus an accounts payable period of 38 days. In this way, they collecting debt faster than they are having to pay it back, resulting in a generally cash-positive situation. Hechinger also appears favourable on this front, as their collection period averages 32 days, while accounts payable is at 58. A point to note, however, is that while Home Depot is currently managing their accounts well, it has increased to an average of 15 days in FY1986 from 11 days in FY1985. Due to the low margins, this collection period must constantly be kept in check, to avoid Home Depot defaulting on their creditors, and incurring interest charges.

A free cashflow analysis of Home Depot has been calculated. Insert FCF once happy

Due to the large number of stores currently on Home Depot’s books, and the highly capital intensive nature of property assets, the CAPEX amount is resulting a negative Free cash Flow. This tells us that their earnings generated are not sufficient to fund the high costs of their growth.

To conclude, Home Depot appears to be entering a period of difficulty, with high anticipated costs due to their expansion. If they can continue to manage their working capital well, they should be able to continue to produce consistent returns. However, when comparing Home depot to Hechinger, a similar-type company with a different profit margin and consumer base, it appears that Hechinger is the better performer. Profit as a percentage of sales is consistently higher than that of Home Depot, as well as having a far higher sustainable growth rate. Their profit levels are far higher than that of Home Depot’s, indicating a better relationship between sales and costs. During the financial years of 1984 – 1986, Hechinger has outperformed Home Depot.