Strength in Numbers: Financial Performance of the Home Depot, Inc.
As the world’s largest home improvement retailer and the second-largest retailer in the United States, the Home Depot, Inc., is literally a safe bet. Founded in 1978 by a couple of Jewish entrepreneurs, Bernie Marcus and Arthur Blank, operating with a shoestring budget on the heels of their dismissal from the corporate board of Handy Dan – the leading home improvement chain at that time – the Home Depot has become in 25 years entrenched as the financial frontrunner in the home improvement industry (Marcus, Blank & Andelman, 1999). Incorporated and centrally located in Atlanta, Georgia, the company now boasts of annual sales revenue of over $50 billion, generated in over 1,500 full-service warehouse-style stores by the efforts of more than 280,000 employees. The company has also been named one of the Top Ten most admired companies and “Most Admired Specialty Retailer” by Fortune magazine for the ninth consecutive year (Home Depot, Inc., 2003).
General Information
Led by CEO and Chairman Robert Nardelli, the board of directors consists of twelve members, mostly independent, including original chief investor Ken Langone (Home Depot, Inc., 2003). They oversee the operations of the company’s “big box” Home Depot stores, averaging 108,000 square feet in size and featuring a home improvement product mix of 40,000 to 50,000 items. In addition, Home Depot operates a number of subsidiaries: 52 EXPO design center stores, catering to the upscale décor market; five Home Depot Supply stores, featuring full lines of contractor supplies, for plumbers especially; Georgia Lighting, an electrical supply warehouse outlet; and Maintenance Warehouse, from which virtually any product from a given Home Depot geographical market can be shipped to any other (Home Depot, Inc., 2003) Of these subsidiaries, the EXPO design centers have proven among the most profitable, contributing significantly to Home Depot, Inc.’s total revenue as well as a profit margin increase in recent years from 5.8% to an above-industry-average 6.3% (Home Depot, Inc., 2003).
Listed on the Dow Jones Industrial Average and the Standard & Poor’s 500 Index, the Home Depot trades on the New York Stock Exchange under the ticker symbol “HD.” In the current corporate climate, marred by the gross financial improprieties of Enron and others, Chairman Nardelli has wisely implemented a number of accountability initiatives – including the expensing of stock options, formation of a corporate compliance council, and improved internal procedures – in order to “ensure continued clarity in our financial reporting” (Home Depot, Inc., 2003, p. 3). Home Depot’s independent auditor is the noted accounting and tax firm KPMG LLP.
Industry Trends
Retailing in general has historically been a difficult industry in which to thrive, due to typically thin profit margins and constantly changing consumer buying patterns. Despite a rather sluggish economy, some positive industry-wide trends nonetheless include: sales increases owing to low financing rates available to consumers; low interest rates available for home buyers (which translates directly to increases in home improvement purchases); and a steady but low rate of inflation, running at around 2-3% in recent years (Plunkett Research, 2003). On the other hand, negative economic factors include: weakening consumer confidence; slowly but steadily increasing unemployment; bankruptcies among major retailers like K-Mart; record levels of default among debt-ridden consumers; and relative uncertainty about the future, in light of global terrorism and tension (Plunkett Research, 2003). Trends more specific to retail indicate a move away from high-dollar service and specialization to volume discounting and “one stop shopping.” This general trend has been reflected in others, such as the decline of the “Mom-n’-Pop” operation; the ongoing struggles of department stores and mall outlets to stay afloat; proliferation of “superstores” and “supercenters;” fierce competition; and a lack of pricing power (Sack, 2000; Plunkett Research, 2003). Finally, many companies, including Home Depot, are currently seeking to further exploit opportunities through the Internet and other forms of technology in order to maximize revenues.
The home improvement retailing industry is dominated by two corporations: Home Depot, and Lowe’s, its chief competitor. Some trends specific to home improvement have in recent years included a strong housing market, which contributed to sales revenue increases for Home Depot and Lowe’s of 27% and 30% respectively in 1999 (Home Centers Differentiate, 2000). As Upbin (2003) notes, the currently dominant industry trend is a marketing effort geared toward the female population, with corresponding changes in the stores in everything from product mix to merchandising strategies to wider aisles (research indicates a general aversion among females to tight physical spaces). Such a strategy has paid off handsomely for Lowe’s especially, having increased its average ticket to $57, compared to $50 at Home Depot (Upbin, 2003).
Accounting Statements
The following are financial statistics from the Home Depot, Inc., 2002 annual report related to earnings and profitability (in parentheses are percentages of total revenue):
Total revenue $58,247,000,000
Cost of goods sold $40,139,000,000 (68.91%)
Gross profit $18,108,000,000 (31.08%)
Net interest $42,000,000 (.07%)
Income taxes $2,208,000,000 (3.79%)
Total operating expenses $12,278,000,000 (21.07%)
From the balance sheet, assets and liabilities (with percentage of total assets in parentheses):
Total assets $30,011,000,000
Total current assets $11,917,000,000 (39.71%)
Property, plant and equipment $17,168,000,000 (57.21%)
Other long term assets $244,000,000 (.81%)
Total current liabilities $8, 035,000,000 (26.77%)
Long term liabilities $2,174,000,000 (7.2%)
Contributed capital $5,858,000,000 (19.51%)
Retained earnings $15,971,000,000 (53.21%)
Working capital as reflected on the 2002 balance sheet amounted to $3.88 billion, an increase of $22 million from 2001. This figure, viewed together with a working capital ratio of 1.48 (down slightly from 1.59 in 2001) indicates relatively high liquidity, meaning Home Depot should have no problem meeting current liability obligations as they come due.
Information from the statement of cash flows likewise indicates healthy cash management, in an age of dot.com busts and irresponsible accounting techniques. True to its reputation, Home Depot generally maintains more than sufficient cash on hand to cover any immediate operating expenses and meet its short term obligations:
Net cash in/out from operating activities $4,802,000,000
Net cash in/out from financing activities ($2,165,000,000)
Net cash in/out from investing activities ($2,934,000,000)
Net increase/decrease in cash ($289,000,000)
Ending cash balance $2,188,000,000
Prior year’s ending cash balance $2,477,000,000
Percentage Analysis of Profitability
In order to help assess growth in relative profitability, rather than mere sales growth, the following is a percentage analysis for the preceding three years:
2003 2001 2000
Sales 100% 100% 100%
Cost of goods sold 68.9 69.8 70.1
Gross margin 31.1 30.2 29.9
Operating expenses 21.1 20.9 20.7
Operating income 10.0 9.3 9.2
Interest income 0.1 0.1 0.1
Interest expense (0.0) (0.1) (0.1)
Income before tax 10.1 9.3 9.2
Income tax 3.8 3.6 3.6
Net earnings 6.3 5.7 5.6
From this information, it may be seen that Home Depot has steadily increased gross margin, likely through improved merchandising and loss prevention techniques. Combined with a comparatively low increase in operating expenses, the considerable jump in gross margin led to a correspondingly significant increase in net earnings proportionate to total sales revenue.
Current Assets and Return on Assets
As a measure of profitability, as well as overall efficiency and thus stockholder value, return on assets is determined by dividing net income by average total assets. In turn, average of total assets is found by dividing the sum of beginning and ending total assets by two:
Average total assets = $30,011,000,000 + $26,394,000,000/2 = $28,202,500,000
Return on assets = $3,644,000,000/$28,202,500,000 = 12.92%
This reveals not only an improvement for Home Depot over recent years but a positive measure of efficiency against the market, in which rival Lowe’s currently gives a return on assets of 9.56% (Yahoo, 2003). Significant current asset measures of Home Depot include:
Current assets ending 2002 $11,917,000,000
Current assets ending 2001 $10,361,000,000
Net change in dollars $1,556,000,000
Net change in percent 15%
In terms of balance sheet data, the Home Depot appears to be in solid financial condition. Whereas cash flow has been reduced from $2.48 billion to $2.188 billion, net receivables have jumped from $920 million to over one billion dollars, net property and equipment holdings have increased from $15.37 billion to $17.17 billion, and notes receivable have increased from $83 million to $107 million. So it seems excess cash is being properly reinvested back into the business as well as into interest-bearing instruments.
Ratio Analysis
Financial ratios can help determine relative performance by analyzing the impact of various interrelated factors. Net receivables, for example, as of 2003 were $1.07 billion, up from $920 million in 2002, for a change of 11.63%. At the same time, net sales increased from $53.55 billion as of 2002 to $58.25 billion recorded in 2003, an increase of 10.87% (Home Depot, Inc., 2003). Since receivables increased in slight disproportion to sales, Home Depot has actually reduced its asset utilization or turnover efficiency.
Current assets come to $11.92 billion, whereas liabilities stand at $8.04 billion. The current ratio or working capital ratio (current assets/current liabilities) for Home Depot is therefore 1.48, which is roughly the industry average, as Lowe’s reports a 1.44 current ratio (Yahoo Finance, 2003). Dividing sales by receivables as of 2003 leaves an accounts receivables turnover rate of 54.44, compared to a rate of 58.21 from 2002. This may indicate a drop in processing efficiency, perhaps the result of adjusting to a number of new technology investments at the Home Depot.
Inventory turnover is another indicator of asset utilization, determined by dividing cost of goods by average inventory. Cost of goods sold in 2002 is $40.14 billion, and merchandise inventories recorded for the same year amount to $8.34 billion, giving an inventory turnover rate of 4.81, a respectable rate but down from 5.57 the previous year (Home Depot, Inc., 2003).
Depreciation and Long Term Assets
Changes in long term assets reflect continued growth of operations at Home Depot, with incremental increases in land, buildings and equipment. Construction in progress did slow up somewhat as of the 2003 report, which may be due to the fact that the company is deliberately slowing its rate of new store openings. The Home Depot accounts for its land, buildings, physical equipment and capital leases as assets on the balance sheet. Accumulated depreciation as of 2003 was listed at $3.57 billion, according to the straight-line method of estimating asset value. Depreciation and amortization are disclosed on the statement of cash flows at $903 million, as contributors to a positive net cash flow from operations of $4.8 billion (Home Depot, Inc., 2003).
As mentioned, The Home Depot, Inc., owns a number of subsidiary firms, so that the financial information from the consolidated reports includes all relevant data from these subsidiary holdings. The company also accounted for a number of new acquisitions in 2002: FloorWorks, Inc., Arvada Hardwood Floor Company, as well as common stock of Floors, Inc. In addition, the company acquired Madereria Del Norte, S.A. de C.V., a small home improvement chain in Juarez, Mexico; “Your ‘Other’ Warehouse;” and Soluciones Para Las Casas de Mexico, S. de R.L. de C.V. (Home Depot, Inc., 2003) In February, 2002, Home Depot sold all the assets of Home Depot Argentina S.R.L. In October, all assets of The Home Depot Chile were sold, at a net gain of $31 million, accounted for under “Selling and Operating Expenses” in the company’s statement of earnings (Home Depot, Inc., 2003).
Dividing long term assets by total assets yields the long term asset/total asset ratio, in the case of Home Depot a ratio of .57. Compared to a ratio of .58 for the previous year, this number represents a decrease in relative financial flexibility, i.e., a larger proportion of fixed or long term holdings. Sales to average fixed assets for 2002 was $58.25 billion to $17.17 billion, or a ratio of 3.39, a specific dollar measure of return on fixed asset investment (Home Depot, Inc., 2003).
Long Term Liabilities
Long term debt and other long term liabilities came to $1.81 billion, compared with $1.62 billion recorded in 2002, an 11.17% increase. Interest on outstanding long term notes due September 15, 2004 and April 1, 2006 is 6.5% and 5375% respectively (Home Depot, Inc., 2003). Home Depot offers three types of retirement plans, to which the company contributed $99 million for fiscal year 2002. Plan participants (such as myself) maintained a total of 33 million shares of company common stock in trust (Home Depot, Inc., 2003). Contingent liabilities totaled approximately $930 million under letters of credit for various transactions, including insurance programs and construction contracts, as well as acts of litigation-none of which is expected by management to “materially impact the Company’s consolidated results of operations or financial condition” (Home Depot, Inc., 2003, p. 39). Debt or liabilities were $8.04 billion. Dividing this by total assets, $30.01 billion, reveals the debt to total assets ratio, or degree of financial leverage. The company’s debt to total asset ratio is therefore 27%-up slightly from 25% the previous year, but “well within the prudent range of 50% or less” (Block & Hirt, 2002, p. 62).
Stockholders’ Equity
Total stockholders’ equity came to $19.8 billion, consisting mostly of $15.97 billion in retained earnings. Cash dividends of $0.21 per share were paid to preferred stockholders, totaling $492 million. This number divided by a net income of $3.66 billion comes to 13.44%, the dividend payout ratio or the percentage of earnings paid out in dividends. Dividend payout ratios from previous years were 13.02% for 2001 and 14.37% for 2000 (Home Depot, Inc., 2003). This is not a particularly high number, demonstrating that the Home Depot has a fairly conservative, long-term or forward-looking dividend payment policy.
Cash Flows
On the premise that a healthy, growing business obtains the majority of its cash flows from the revenues generated by normal operations, Home Depot is in good shape:
Net cash provided by operations $4,802,000,000
Net cash used in investing activities ($2,934,000,000)
Net cash provided by financing activities ($2,165,000,000)
Whereas large payments against debt left a negative net cash flow of $289 million for the year, the beginning year balance was $2.48 billion, so that the company ended the year with a considerable cash supply of $2.19 billion (Home Depot, Inc., 2003). Along with other factors such as a low debt-to-equity ratio and debt to total asset ratio, cash flow figures amount to further evidence that Home Depot is a conservative, financially independent operation. In fact, relatively all available indications are that The Home Depot, Inc., is a good investment precisely because of solid financial management.
General Conclusions
Though frequently under the gun from critics both inside and outside of the company, CEO and Chairman Bob Nardelli has done well to manage assets and stabilize the rapid, often sporadic growth of the firm in recent years. As he notes in the annual report: “With $19.8 billion in equity, a low debt-to-equity ratio of 6.7%, and strong liquidity, the financial strength of the Home Depot is unparalleled and is an enabler of our transformation” (Home Depot, Inc., 2003, p. 3). Analyst Christopher P. Shea agrees: “From a valuation standpoint, even with modest growth rates, its low cost of debt coupled with continued earnings expansion leaves Home Depot trading at half its intrinsic value” (Gallagher, 2003, ¶ 4).
Recent activity on the New York Stock Exchange reveals that investors are perhaps just now beginning to appreciate Nardelli’s disciplined approach to management, as the price of Home Depot has eclipsed the $30 mark for the first time in months (Yahoo Finance, 2003; Gallagher, 2003). On the other hand, it may be that the Home Depot has merely adjusted to inevitable pains normally associated with growth: “The market has brought Home Depot’s stock price down to levels more closely associated with a mature growth company…” (Gallagher, 2003, ¶ 10). In other words, though its days of record-shattering growth appear to be over, Home Depot is now an attractive purchase for investors seeking a more reliable, conservative stock in a steadily growing company within a stable industry
As an employee at Home Depot and an owner of company common stock, I would cheerfully recommend the company to loaning institutions, for example, as a highly credit-worthy or low-risk operation. Home Depot has earned a reputation for having deep pockets. Whereas it seems that its stock price has leveled somewhat and the company has settled into a more conservative pattern, I would definitely invest in Home Depot stock, and at the same time counsel investors to balance such an investment with purchases of faster growing stocks, perhaps representing firms dealing in emergent technologies.
At one time, I admittedly had serious reservations about supporting the likes of Bob Nardelli, or endorsing his rather bland style of financial conservatism. When I was hired by Home Depot back in 1998, founders Bernie Marcus and Arthur Blank were still at the helm, and still wildly popular with employees and investors alike. Stock price experienced frequent spurts in value and splits were not uncommon. Marcus and Blank had a great sense of vision, supported by a set of bedrock values that defined the Home Depot culture for decades to come (Marcus, et al, 1999). By their particular brand of renegade entrepreneurship, they were able to grow a huge business, one that has made a significant impact on the American retail industry. However, signs of disarray were evident even in 1999, among them shoddy and overstocked stores, and low gross margins owing to overemphasis on sales at the expense of processing operations. Due to the careful stewardship of Bob Nardelli and the current top management team - marked by responsiveness to customer demand, an emphasis on conservative growth and competitiveness through investments in employees and technology - the Home Depot’s future is as bright as ever.
References
Block, Stanley B., & Hirt, Geoffrey A. (2002). Foundations of Financial Management (10th ed.). New York: McGraw-Hill.
Gallagher, Kathleen. (2003). Home Depot on upswing, analyst says. Milwaukee Journal-Sentinel Online. Retrieved June 18, 2003 from
http://www.jsonline.com/bym/invest/jun03/148190.asp
Home Centers Differentiate. (2000). Chain Store Age. Retrieved June 16, 2003 from Proquest database.
Home Depot, Inc. (2003). 2002 Annual Report. Atlanta: Homer TLC, Inc.
Home Depot, Inc. Fundamentals. (2003). MSN Money. Retrieved June 16, 2003 from
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Marcus, Bernie, Blank, Arthur, & Andelman, Bob. (1999). Built From Scratch: How a Couple of Regular Guys Grew the Home Depot from Nothing to $30 Billion. New York: Random House.
Plunkett Research (2003). Retail industry trends. Retrieved June 16, 2003 from http://www.plunkettresearchcom/retail/retail_trends.htm
Sack, Karen J. (2000). Retailing: general. Standard & Poor’s Industry Surveys. Retrieved June 16, 2003 from http://www.netadvantage.com/standardandpoors.com
Upbin, Bruce. (2003). Merchant princes. Forbes, 171, 52-56. Retrieved June 16, 2003 from Proquest database.
Yahoo Finance (2003). Profile-Home Depot, Inc. Retrieved June 16, 2003 from http://biz.yahoo.com/p/h/hd.html
Yahoo Finance (2003). Profile-Lowe’s Companies, Inc. Retrieved June 16, 2003 from http://biz.yahoo.com/p/L/LOW.html