The Home Depot BU657 Case Presentation May 6, 2006

The Home Depot Group Presenters Anouska Harris Kevin Melo Kate Richard Rafael Torres

Agenda Home Depot - Overview Business Strategy Analysis of Accounting Policies Evaluating Performance Is the Strategy Viable? Closing Remarks

Home Depot – Overview(1) Case Date: 1986 The Home Depot: Founded in 1978 Market: Do it yourself (DIY) market selling a large selection of building materials and home improvement products 3 stores opened in Atlanta 1979 and grew rapidly in the “sunbelt” geography. Sales in 1979: $7mm The Home Depot went public 1981 Initially traded over the counter Listed on NYSE (HD) in 1984

Home Depot – Overview(2) 1985 Sales: $700mm Assets: $380.2mm Earnings: $8.2mm Customers: 23.3mm Markets served:15 Stores: 50 Employees: 5,400

Business Strategy (1) What is Home Depot’s Business Strategy?

Business Strategy (2) What is Home Depot’s Business Strategy? Focused on DIY segment of market Keep costs low through low overhead, purchase discounts, and high inventory turns Attracting customers through aggressive advertising and competitive pricing Providing high quality service to customers

Business Strategy (3) What is Home Depot’s Business Strategy? Provide high service to target customers with well paid ee’s well trained ee’s well stocked stores Focus on the relationship (helping customers choose the right product and provide assistance throughout the project) Shopping convenience (7 days, evening hours)

Analysis of Accounting Policies Revenue Recognition Cash-and-carry basis Inventory Valuation Stated at lower of cost or market FIFO method Overall Impression Nothing unusual for retail sales company

Dupont Ratio Analysis Net Profit Margin = Measures how many cents of income is earned on each dollar of sales Asset Turnover = Measures how efficiently assets are used to generate sales Financial Leverage = Measures degree of indebtedness (risk) Return on Equity = Measures rate of return on Shareholder’s investment Evaluating Performance (1)

Evaluating Performance (2) Net Profit Margin:8,219,000 =1.17% 700,729,000 Asset Turnover:700,729,000 = ,193,000 Financial Leverage:380,193,000 = ,092,000 Return on Equity:8,219,000 =9.23% 89,092,000

Evaluating Performance (3) Profitability Net Profit MarginHome Depot1.2%3.3%4.0% Hechinger4.8%5.2%5.3% Return on EquityHome Depot9.2%17.6%15.7% Hechinger15.8%18.9%19.1% Asset Management Total Asset TurnoverHome Depot Hechinger Debt Management Financial LeverageHome Depot Hechinger Dividend Payout RatioHome Depot000 Hechinger Sustainable Growth RateHome Depot9.2%17.6%15.7% Hechinger14.7%18.0%18.1%

Evaluating Performance (4) Physical Analysis (from Exhibit 1) Average Sale per customer is $30 Stores are getting bigger but not selling more Sales per Store ($M) Sales per Transaction$ 30.07$ 30.27$ 30.14$ 28.00$ Sales Transactions per Store (K) Sales per Square Footage$ $ $ $ $ 85.83

Evaluating Performance (5) Time-Series vs. Cross-sectional approach Exercise (15 minutes) Gross Profit Margin Inventory Turnover Debt to Asset Which company would you invest in?

Evaluating Performance (6) Cash Flow Analysis (pg 5-56) Negative cash flow from operations for all 3 years Inventory increases Store expansions (property and equipment) Most cash provided through LT Debt Hechinger had positive cash for all 3 years

Evaluating Performance (7) Assessment: Home Depot is expanding fast Loosing control of costs Heavy reliance on debt financing

Is The Strategy Viable? (1) Can they continue to provide low prices and offer high levels of service? Is their growth strategy sustainable?

1987 Projected Income Statement 1986 Net Sales (5-54)$700,729,000 Assume 1987 Net Sales$1,000,000,000 EBIT = Earnings Before Interest and Taxes EBIT/Sales Average Annual Decline = EBIT/Sales = = Assume 1987 EBIT = $9,500,000

1987 Projected Income Statement EBIT $9,500,000 (Previous Slide) Interest (Exp-Inc) (8,725,000) (Same as 1986/5-54) Profit Before Tax 775,000 Taxes (0.461) (357,275) Net Income $417,725

1987 Projected Cash From Operations Net Income $417,725 (Previous Slide) Add Back Non-Cash Expenses (5-56) Depreciation 4,376,000 (Same as 1986) Deferred Income Tax3,612,000 (Same as 1986) Working Capital 8,405,725 Changes in Working Capital (5-57) Inventory (46,994,000) (Avg.  1985 and 1986) Receivables (11,484,500) (Avg.  1985 and 1986) Payables 24,560,000 (Avg.  1985 and 1986) Net Cash From Operations$(25,512,775)

Cash Required for Expansion (5-47) Site Acquisition and Construction$6,600,000 Inventory (Net of Vendor Financing) 1,800,000 8,400,000 x 9 Stores Cash Required for Expansion $75,600,000

Total Cash Needed Net Cash From Operations $(25,512,775) Cash Required for Expansion (75,600,000) Total Cash Needed in 1987 $(101,112,775)

Line of Credit Line of Credit = $200,000,000 $88,000,000 Outstanding, $112,000,000 Available ??? (5-64) Note 3 – Restrictions 1. Minimum tangible net worth of $150,000,000 (1985), increasing annually to $213,165,000 by Jan 1989 Tangible Net Worth = Total Assets - Goodwill - Current Liabilities - Long-Term Debt - Other Liabilities Tangible Net Worth = $71,218,000 (Default)

Line of Credit Restrictions 2. Debt to tangible net worth ratio of no more than 2 to 1 = Total Liabilities/ (Assets – Goodwill) =0.8  3. Current ratio of not less than 1.5 to 1 =Current Assets/ Current Liabilities =2.3 

Line of Credit Restrictions 4. Ratio of EBIT to Interest Expense, net, of not less than 2 to EBIT (Previous Slide)$9,500,000 x 50% Max. Net Interest Expense $4,750,000 Current Interest (Previous Slide) $8,725,000 Default

The Home Depot –Update 1987 Dramatic increase in profitability in 1986 and 1987 Sales continue to grow = 1986: $1.001 billion 1987: $1.454 billion Net Earnings = 1986: $23.8 million 1987: $54.1 million Return on Sales = 1986: 2.4% increase 1987: 3.7% increase Number of transactions per store = 38% increase from 1985 to 1987 (466, ,000) Positive Cash flow of: 1986: $66.8 million 1987: $56.2 million

The Home Depot –Update 1987 Dramatic increase in profitability in 1986 and 1987 Company Stock Price = 2/3/1986: $ /2/1987: $ (increase of 70%) Debt to Equity = 1985: : 0.91 Home depot took steps to reduce operating costs which led to an increase in profitability without sacrificing growth. Markets rewarded these developments, enabling the company to issue equity and reduce debt.

The Home Depot –Update 2006 Revenues: $81.5 billion Net Earnings: $5.8 billion Assets: $44.5 billion Stores: 2042 Stock Price: (4/28/06) $ Week HighLow Jul Apr 2005 *2005 Annual Report Data

Hechinger –Update 2006 Was a Home Improvement Retail Industry “giant” with 200 stores Revenues: $2,199,067 (3 consecutive years with declining sales and million dollar losses. Could not handle competitive market pressures (Home Depot & Lowe’s). Files CHAPTER 11 in Liquidated assets Home Décor sell “Hechinger brand” through e-tailing network.

Closing Remarks What value is there in Ratio Analysis? Pros / Cons How do analysts assess a company?