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effective or ineffective handling of an administrative situation. Copyright © 1988 by the President and Fellows of
Harvard College. Harvard Business School case 9-188-148.1.
1. Reprinted with permission from Barron™s, January 21, 1985.




348
349
Financial Analysis




9-33 Part 2 Business Analysis and Valuation Tools




yourself” (DIY) warehouse stores which sold a wide assortment of building materials
and home improvement products. Sales, which were on a cash-and-carry basis, were
concentrated in the home remodeling market. The company targeted as its customers in-
dividual homeowners and small contractors.
The Home Depot™s strategy had several important elements. The company offered
low and competitive prices, a feature central to the warehouse retailing concept. The
Home Depot™s stores, usually in suburbs, were also the warehouses, with inventory
stacked over merchandise displayed on industrial racks. The warehouse format of the
stores kept the overhead low and allowed the company to pass the savings to customers.
Costs were further reduced by emphasizing higher volume and lower margins with a
high inventory turnover. While offering low prices, The Home Depot was careful not to
The Home Depot




sacri¬ce the depth of merchandise and the quality of products offered for sale.
To ensure that the right products were stocked at all times, each Home Depot store
carried approximately $4,500,000 of inventory, at retail, consisting of approximately
25,000 separate stock-keeping units. All these items were kept on the sales ¬‚oor of the
store, thus increasing convenience to the customer and minimizing out-of-stock occur-
rences. The company also assured its customers that the products sold by it were of the
best quality. The Home Depot offered nationally advertised brands as well as lesser
known brands carefully chosen by the company™s merchandise managers. Every product
sold by The Home Depot was guaranteed by either the manufacturer or by the company
itself.
The Home Depot complemented the above merchandising strategy with excellent
sales assistance. Since the great majority of the company™s customers were individual
homeowners with no prior experience in their home improvement projects, The Home
Depot considered its employees™ technical knowledge and service orientation to be very
important to its marketing success. The company pursued a number of policies to ad-
dress this need. Approximately 90% of the company™s employees were on a full-time ba-
sis. To attract and retain a strong sales force, the company maintained salary and wage
levels above those of its competitors. All the ¬‚oor sales personnel attended special train-
ing sessions to gain thorough knowledge of the company™s home improvement products
and their basic applications. This training enabled them to answer shoppers™ questions
and help customers in choosing equipment and material appropriate for their projects.
Often, the expert advice the sales personnel provided created a bond that resulted in con-
tinuous contact with the customer throughout the duration of the customer™s project.
Finally, to attract customers, The Home Depot pursued an aggressive advertising pro-
gram utilizing newspapers, television, radio, and direct mail catalogues. The company™s
advertising stressed promotional pricing, the broad assortment and depth of its mer-
chandise, and the assistance provided by its sales personnel. The company also spon-
sored in-store demonstrations of do-it-yourself techniques and product uses. To increase
customers™ shopping convenience, The Home Depot™s stores were open seven days a
week, including weekday evenings.
Fortune magazine commented on The Home Depot™s strategy as follows:
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9-34
Financial Analysis




Warehouse stores typically offer shoppers deep discounts with minimal service
and back-to-basics ambiance. The Home Depot™s outlets have all the charm of a
freight yard and predictably low prices. But they also offer unusually helpful cus-
tomer service. Although warehouse retailing looks simple, it is not: As discounting
cuts into gross pro¬t margins, the merchant must carefully control buying, mer-
chandising, and inventory costs. Throwing in service, which is expensive and hard
to systematize, makes the job even tougher. In the do-it-yourself (DIY ) segment of
the industry “ which includes old-style hardware stores, building supply ware-
houses, and the everything-under-one-roof home centers “ The Home Depot is the
only company that has successfully brought off the union of low prices and high
service.2




The Home Depot
The Home Depot™s strategy was successful in fueling an impressive growth in the
company™s operations. The ¬rst three Home Depot stores, opened in Atlanta in 1979,
were a quick success. From this modest beginning, the company grew rapidly and went
public in 1981. The company™s stock initially traded over-the-counter and was listed on
the New York Stock Exchange in April 1984. Several new stores were opened in markets
throughout the Sunbelt, and the number of stores operated by The Home Depot grew
from 3 in 1979 to 50 by the end of ¬scal 1985. As a result, sales grew from $7 million
in 1979 to $700 million in 1985. Exhibit 1 provides a summary of the growth in the com-
pany™s operations. The company™s stock price performance during 1985 is summarized
in Exhibit 2.


INDUSTRY AND COMPETITION
The home improvement industry was large and growing during the 1980s. The industry
sales totaled approximately $80 billion in 1985 and strong industry growth was expected
to continue, especially in the do-it-yourself (DIY) segment, which had grown at a com-
pounded annual rate of 14 percent over the last 15 years. With the number of two-wage-
earner households growing, there was an increase in families™ average disposable in-
come, making it possible to increase the frequency and magnitude of home improvement
projects. Further, many homeowners were undertaking these projects by themselves
rather than hiring a contractor. Research conducted by the Do-It-Yourself Institute, an
industry trade group, showed that DIY activities had become America™s second most
popular leisure-time activity after watching television.
The success of warehouse retailing pioneered by The Home Depot attracted a number
of other companies into the industry. Among the store chains currently operating in the
industry were Builders Square (a division of K Mart), Mr. HOW (a division of Service
Merchandise), The Home Club (a division of Zayre Corp.), Payless Cashways (a divi-
sion of W.R. Grace), and Hechinger Co. Most of these store chains were relatively new
and not yet achieving signi¬cant pro¬tability.

.........................................................................................................................
2. Reprinted with permission from Fortune, February 1988, p. 73.
351
Financial Analysis




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Among The Home Depot™s competitors, the most successful was Hechinger, which
had operated hardware stores for a long time and recently entered the do-it-yourself seg-
ment of the industry. Using a strategy quite different from The Home Depot™s, Hech-
inger ran gleaming upscale stores and aimed at high pro¬t margins. As of the end of
¬scal 1985, the company operated 55 stores, located primarily in southeastern states.
Hechinger announced that it planned to expand its sales by 20 to 25 percent a year by
adding 10 to 14 stores a year. A summary of Hechinger™s recent ¬nancial performance
is presented in Exhibit 3.


THE HOME DEPOT™S FUTURE
The Home Depot




While The Home Depot had achieved rapid growth every year since its inception, ¬scal
1985 was probably the most important in the company™s seven-year history. During
1985 the company implemented its most ambitious expansion plan to date by adding 20
new stores in eight new markets. Nine of these stores were acquired from Bowater, a
competing store chain which was in ¬nancial dif¬culty. As The Home Depot engaged
in major expansion, its revenues rose 62 percent from $432 million in ¬scal 1984 to
$700 million in 1985. However, the company™s earnings declined in 1985 from the
record levels achieved during the previous ¬scal year. In ¬scal 1985, The Home Depot
earned $8.2 million, or $0.33 per share, as compared with $14.1 million or $0.56 per
share in ¬scal 1984.
Bernard Marcus, The Home Depot™s chairman and chief executive of¬cer, com-
mented on the company™s performance as follows:
Fiscal 1985 was a year of rapid expansion and continued growth for The Home
Depot. Feeling the time was ripe for us to enhance our share of the do-it-yourself
market, we seized the opportunity to make a signi¬cant investment in our long-
term future. At the same time, we recognized that our short-term pro¬t growth
would be affected.
The Home Depot™s 1985 annual report (Exhibit 4) provided more details on the ¬rm™s
¬nancial performance during the year.
As ¬scal 1985 came to a close, The Home Depot faced some critical issues. The com-
petition in the do-it-yourself industry was heating up. The ¬ght for market dominance
was expected to result in pressure on margins, and industry analysts expected only the
strongest and most capable ¬rms in the industry to survive. Also, The Home Depot had
announced plans for further expansion that included the opening of nine new stores in
1986. The company estimated that site acquisition and construction would cost about
$6.6 million for each new store, and investment in inventory (net of vendor ¬nancing)
would require an additional $1.8 million per store. The company needed signi¬cant ad-
ditional ¬nancing to implement these plans.
Home Depot relied on external ¬nancing”both debt and equity”to fund its growth
in 1984 and 1985. However, the signi¬cant drop in its stock price in 1985 made further
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Financial Analysis




equity ¬nancing less attractive. While the company could borrow from its line of credit,
it had to make sure that it could satisfy the interest coverage requirements (see Note 3 in
Exhibit 4 for a discussion of debt covenant restrictions). Clearly, generating more cash
from its own operations would be the best way for Home Depot to invest in its growth
on a sustainable basis.


QUESTIONS
1. Evaluate Home Depot™s business strategy. Do you think it is a viable strategy in the
long run?




The Home Depot
2. Analyze Home Depot™s financial performance during the fiscal years 1983“1985.
Compare Home Depot™s performance in this period with Hechinger™s performance.
(You may use the ratios and the cash flow analysis in Exhibit 3 in this summary.)
3. How productive were Home Depot™s stores in the fiscal years 1983“1985? (You may
use the statistics in Exhibit 1 in this analysis.)
4. Home Depot™s stock price dropped by 23 percent between January 1985 and Febru-
ary 1986, making it difficult for the company to rely on equity capital to finance its
growth. Covenants on existing debt (discussed in Note 3 of Exhibit 4) restrict the
magnitude of the company™s future borrowing. Given these constraints, what specific
actions should Home Depot take with respect to its current operations and growth
strategy? How can the company improve its operating performance? Should the com-
pany change its strategy? If so, how?
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Financial Analysis




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EXHIBIT 1
The Home Depot, Inc. “ Summary of Performance During Fiscal Years 1981“1985

NET EARNINGS STOCKHOLDERS™
NET SALES
EQUITY
$ in millions
$ in millions
$ in millions




89.1
14.1
700.7




80.2
65.3
10.3
432.8




8.2
The Home Depot




5.3
256.2
117.6
51.5

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