Home Depot as the Market Leader in the Home Improvement Retail Industry - Case Study Example

The company name is The Home Depot, Inc. The company is traded on the New York Stock Exchange with the ticker symbol HD.

Home Depot Inc., NYSE:HD.

• Why the company is chosen for study and financial analysis

Home Depot is the world’s largest home improvement retailer with sales of $ 88.5 billion. The company has 1,977 stores in the US, 180 stores in Canada and 115 stores in Mexico which stock 30,000 to 40,000 products. The company has consistently made a Gross Margin of over 34% in product lines that are generally undifferentiated from other home improvement retailers. The net earnings in 2015 were 7.9%. These are impressive numbers for the retailing industry. This financial performance has led to the company’s stock outperforming the S&P 500 Index and the S&P Composite Retail Index for the past 5 years (Home Depot 10-K, 2015, p 16, 21). In the study we hope to understand the company’s business model and identify some of the reasons for its success.

• Direct link to the company’s SEC 10-K report

The direct link to The Home Depot, Inc. SEC form 10-K filing for the fiscal year 2015 is given below:

<<http://www.homedepotar.com/assets/pdf/2015-10-k-sec-filed-form.pdf>>

• The company’s position on the Fortune 500 list

The Home Depot, Inc. is ranked 33 in the Fortune 500 list for 2015.

• Page Numbers for key financial statements

The page numbers of the Form 10-K for key financial statements is as below:

• Income Statement – page 33
• Balance Sheet – page 32
• Statement of Stockholders Equity – page 35
• Statement of Cash Flows – page 36

Part – 2

• What does the company produce?

Home Depot is a retailer of materials and products for home improvement such as flooring, roofing, siding, windows, cabinets, counter-tops, sheds, lighting, water heating systems and ventilation systems. The company also sells tools and equipment needed for taking up home improvement projects. The company caters to three primary customer groups: (Home Depot 10-K, 2015, p 2)

• “Do-it-yourself” (DIY) Customers - These are typically home owners who buy the company’s materials and products and complete their own projects and installations.
• “Do-it-for-me” (DIFM) customers – These are home owners who buy materials and products and hire a skilled workman to install and complete the project.
• Professional Customers – These are contractors or professional renovators/ remodelers who take up home improvement contracts from home owners who buy supplies from Home Depot.

• Trend analysis from the financial statements

The data from The Home Depot financial statements are shown below together with the trend analysis.

Fiscal year

Trend Analysis

(in $ million)

2015

2014

2013

2015

2014

2013

Net Sales

88,519

83,176

78,812

9,707

112.3%

4,364

105.5%

Base

100.0%

Cost of Goods Sold

58,254

54,787

51,897

6,357

112.2%

2,890

105.6%

Base

100.0%

Gross Profit

30,265

28,389

26,915

3,350

112.4%

1,474

105.5%

Base

100.0%

Gross Profit %

34.19%

34.13%

34.15%

Finished Goods Inventory

11,809

11,709

11,057

752

652

Base

106.8%

105.9%

100.0%

Note: The Home Depot, Inc. being a retailer only has finished goods inventory and no raw materials or work-in-process inventory.

The Form 10-K for fiscal year 2015 shows finished goods inventories for the years 2015 and 2014. The figure for 2013 has been taken from the Form 10-K for that year.

• Diversity in products, divisions and other reporting entities

Home Depot operates as a single reporting entity --- North America. Sales outside the US (in Canada and Mexico) totaled $ 8 billion in the fiscal year ended Jan 2016. The net sales in various product categories are shown in the table below (Home Depot 10-K, 2015, p 41).

Part – 3

• Comments on inventory in the Home Depot 10-K report

Since Home Depot is a retailer, the only inventory in the financial statements is Merchandise Inventory i.e. Finished Goods inventory. The value of this inventory is stated at the lower of cost (using FIFO – first in first out method) or market as determined by the retail inventory method (Home Depot 10-K, 2016, pp 37-38).

Approximately 71% of the total merchandise inventory is valued under the retail inventory method and the remaining under the cost method. Merchandise inventory values are calculated by applying a cost-to-retail ratio to the ending value of inventories. Independent physical inventory counts or cycle counts are taken on a regular basis at each store and distribution center to ensure that the figures stated in the Financial Statements are accurate. Shortfalls in inventory may occur for reasons such as theft, loss, inaccurate records of receipt or damage and deterioration of goods. The company treats such shortfalls as “Shrink” and examines this as a percentage of Net Sales. The company reports that actual “shrink” values did not vary materially from estimates in any of the recent 3 years (Home Depot 10-K, 2015, p 27).

• Finished Goods Inventory turnover ratio

The Finished Goods Inventory turnover and number of days are shown in the table below.

Fiscal year

(in $ million)

2015

2014

2013

2012

Year-end Finished Goods Inventory

11,809

11,709

11,507

10,710

Cost of Goods Sold

58,254

54,787

51,897

Number of days Inventory

74

77

78

• Cost of Goods manufactured in 2015

Cost of goods manufactured in 2015 = Closing FG Inventory + Cost of Goods sold in 2015 – Opening FG Inventory

= 11,809 + 58,254 – 11,709

= $ 58,354 million

• Costs and sources of materials

The company has a global sourcing program to obtain high-quality and innovative products directly from manufacturers around the world. In addition to US sourcing operations, the company maintains sourcing offices in China, Taiwan, India, Italy, Mexico and Canada. The acquisition of Interline has provided the company additional sourcing offices in China, Thailand and Indonesia (Home Depot 10-K, 2015, p 4).

Home Depot has proprietary and exclusive brands of products in each of its product departments. In addition, the company sells a wide range of branded products such as EGO and Husky tools, Hampton Bay lighting, fans and patio furniture, Vigoro lawn care products, Glacier Bay bath fixtures and Life Proof carpets (Home Depot 10-K, 2015, p 4).

The Home Depot 10-K report does not speak specifically of costs of materials but as noted earlier, the Gross Margin has been over 34% in each of the three recent years suggesting good control over materials costs.

• Challenges and Opportunities for the company

Inventory management is a critical success factor in the retailing industry. As Alain Fares points out in a 2015 PWC publication, the traditional inventory practice in retailing is to keep a wide variety of products in the stores or at distribution centers in the belief that product non-availability would result in lost sales. This is the reason that retailers typically stock over 50,000 SKUs. This model has been challenged by discounters like Aldi and Lidl who stock only around 3,000 SKUs offering a limited product range compared to traditional retailers but scoring over them in reduced costs of procurement, logistics and delivery (Fares, 2015).

The PWC article includes the chart shown above which shows the tradeoffs that retailers make in deciding on an optimum inventory plan. The inventory plan starts with the sales forecast and demand plan. The product range and the need for visual merchandising need to be factored in. The inventory levels also depend upon the suppliers and the dependability of the supply chain. The inventory plan impacts the Cost of Goods Sold (COGS) by the discounts offered to clear slow-moving stock, damage and deterioration in stores, shrinkage of stock due to theft or wrong shelving etc. The inventory costs impact the Operating Expenses (OPEX) and the working capital impacts the Weighted Average Cost of Capital (WACC). Successful companies constantly evaluate these trade-offs (Fares, 2015).

Home Depot has attempted to strike a balance between the compulsions of a physical retailer to offer off-the-shelf products and the e-retailer who can deliver a larger variety of products but with a small time delay in order fulfillment. In addition to the 30,000 to 40,000 products stocked at its 2,000+ stores, the company offers an enhanced selection of over 700,000 products through the company websites (Soni, 2015). Through an initiative named “Interconnecting Retail”, the company has rolled out various on-line ordering programs for its customers. These have been code named “BODFS” (for Buy online, Deliver from Store), “BOPIS” (for Buy online, Pickup in Store), and “BOSS” (for Buy online, Ship to Store) and “BORIS” (for Buy online, Return in Store). Employees at the Home Depot stores have been provided with smartphones and web-enabled handheld devices to help the customer complete his purchasing action complementing in-store products with products available on-line (Home Depot 10-K, 2015, p 3).

This initiative has helped Home Depot increase its sales revenue though the number of stores and the total retail space have remained substantially constant over the past few years. More importantly the Inventory Turnover Ratio for Home Depot has increased over the last few years and is significantly better than its main competitor Lowe’s (Soni, 2015).

The adding of e-retailer capabilities to its wide-spread bricks and mortar presence is a significant opportunity for Home Depot for business growth and increased profitability. The share of on-line sales to net company sales has increased for Home Depot from 3.5% in 2013 to 4.5% in 2014 and 5.3% in 2015 (Home Depot 10-K, 2015, p 21).

Part – 4

• Risk and uncertainty factors from the Home Depot 10-K Report

The major risk and uncertainty factors discussed in the Home Depot 10-K report are as below (Home Depot 10-K, 2015, pp 7-12).

• Competition from other home improvement stores, building materials supply yards and from installers of home improvement projects. On-line and multi-channel retailers with a lower cost structure than Home Depot are also identified as a risk factor.
• Meeting changing customer expectations both in terms of the products and services from the company’s stores as well as from on-line purchasing is named as a risk factor.
• The need to attract and retain qualified associates while controlling labor costs. Customers expect a high level of product knowledge and customer service from the associates.
• The Data Breach incident in the fourth quarter of 2014 where there was theft of customer information including payment card data has caused the company financial losses and loss of reputation. This has required the company to take up a major revamp of its Information Systems. This topic has been discussed in greater depth in the next section.
• The company’s financial performance depends upon stability in the housing, residential construction and home improvement markets. These in turn depend on general economic conditions, the employment market and the home mortgage and loans rates.
• The company depends on relationships with suppliers and the robustness of the supply chain to ensure that products are available uninterrupted to its stores and distribution centers.
• The Data Breach incident and resulting contingencies

In September 2014, attackers used a third party vendor’s logon credentials to access Home Depot’s corporate computer network. The attackers installed memory scraping malware on over 7,500 self checkout Point of Sales terminals at various Home Depot stores. The malware grabbed information on 56 million debit and credit cards and over 53 million e-mail addresses in a 3 to 6 month period in 2014. The stolen payment cards were put up for sale and some were bought by carders. The e-mail ids became targets for large phishing campaigns (Hawkins, 2015).

In the second quarter of fiscal 2015, the company entered into a settlement agreement with the payment card companies American Express, Discover, Master Card and Visa in respect of their claims against the company. This settlement was towards the card companies’ costs of investigation and issue of duplicate cards. Further claims could emerge after fuller investigation. Over 57 class action suits have been filed in various courts in US and Canada against the company. All the US cases have been consolidated into a single class action case on behalf of the customers and the financial institutions claiming damage from the Data Breach at the Georgia District Court. Actions alleging breaches of fiduciary duty, waste of corporate assets and violation of the Securities Exchange Act have been filed against members of the company’s Board of Directors and executive officers. Various federal and state agencies are also investigating the Data Breach and the company’s response to the incident (Home Depot 10-K, 2015, pp 55-57).

The Home Depot Form 10-K report says that the ultimate amount paid against these claims and the expenses associated with the legal, investigative and consulting fees and the costs of upgrading the IT systems could have a serious effect on the company’s financial position, results of operation and cash flow in future periods. The accrued liabilities so far are shown below (Home Depot 10-K, 2015, p 56). These exceed the insurance coverage the company maintains for network security and privacy of $ 100 million in fiscal 2015 and 2014.

The liability for Data Breach is the major contingency in the Home Depot report which could impact the company for several years.

• Cost accounting issues related to product lines or divisions

The tabulation showing the break-up of revenue between various product lines has been shown in Part-2, Section 3 above. The merchandise inventory is valued at the lower of the cost or the market using the retail inventory method as stated in Part-2, Section 1 above.

The retail inventory method values stock at the weighted average selling price of all products sold by the retailer (with a common cost to selling price factor applied to all products) and not at the cost at which they were procured. The retail inventory method was invented to overcome the tedious task of identifying the purchase cost of each of the thousands of SKUs stocked and sold by the retailer. The retail inventory method can inflate the inventory value of the retailer and can cause serious errors. For example, the margin that an individual product line earns could be distorted by the inventory valuation process. When the retailer adjusts retail prices for any specific product line, the margins earned by all product lines appear to change. Dheeraj Gupta in a 2013 article argues that the retail inventory method was appropriate when computer technology was not available. In the present day, it is easily possible to track millions of records of purchase costs and selling prices of various SKUS and retailers should use present technology for accurate tracking of costs and margins (Gupta, 2013).

• Changes in accounting methods and whether these are material to the financial statements

In the first quarter of fiscal 2015, the company changed its accounting policy in respect of shipping and handling costs from the company’s stores and distribution centers to the customer and from on-line order fulfillment centers. These costs are now included in Cost of Sales whereas they were previously included in Operating Expenses. This change, the company has said, is to better align these costs with the related revenues in the gross profit calculation. The Earnings Statements for 2014 and 2013 have been restated to reflect this change. The Cost of Sales for 2014 has increased by $ 565 million and that for 2013 by $ 475 million due to this change. The operating expenses for these years have decreased by the same amounts. The Sales, Operating Income and Net Income remain unchanged (Home Depot 10-K, 2015, p 43).

The change in accounting policy to include shipping and handling in Cost of Sales is logical in a retailing business. Though the Operating and Net Income are unchanged, the Gross Profit margin would be lower as a result of this change. The change would also increase the value of the inventory and to that extent impact the balance sheet.

• Management comments on profitability and other parameters

The management comments on the financial performance of the company are summarized below: (Home Depot 10-K, 2015, pp 18-26). The report provides the table below summarizing the company’s financial performance in fiscal 2015.

The points made in the Management Discussion and Analysis section of the 10-K report are:

• Store sales in 2015 increased by 5.6% over 2014. The number of customer transactions increased by 4.1 % , the average ticket value increased by 1.6% to 58.77 and the Sales per square foot increased by 5.2% to $ 370.55.

All these are important productivity measurement parameters in the retailing industry. The company has reported that all product departments showed increases in store sales compared to 2014. The average ticket value increase has been attributed to strong sales in big ticket purchases such as appliances, roofing and several installation service categories, partially offset by the strength of the US Dollar.

• Net sales increased by 6.4% to $ 88.5 billion in 2015 compared to $ 83.2 billion in 2014. Net earnings in 2015 were $ 7 billion compared to $ 6.3 billion in 2014. The Diluted Earnings per Share is $ 5.46 in 2015 compared to $ 4.71 in 2014.
• The net expenses related to the Data Breach incident provided in the income statement is $ 128 million in 2015 and $ 33 million in 2014.
• The sale of the company’s equity ownership in HD Supply resulted in $ 144 million addition to pre-tax earnings in 2015 and $ 323 million in 2014.
• The change in accounting policy to include shipping and handling costs in Cost of Sales instead of in Operating Expenses caused $ 565 million increase in Cost of Sales in 2015 and $ 475 million increase in 2014. There are corresponding decreases in Operating Expenses.
• The Gross Profit increased 6.6% to $ 30.3 billion in 2015 compared to $ 28.4 billion in 2014. Lower fuel costs and increased productivity of the supply chain has been attributed as the reasons for this increase. The change in product mix and lower margin sales in the newly acquired Interline product range have partially offset the improvement in Gross Profit.
• SG&A expenses in 2015 were $ 16.8 billion, an increase of 3.2% from $ 16.3 billion in 2014. SG&A was 19.0% of Net Sales in 2015 compared to 19.6% in 2014. This is the result of strong expense control measures and has been helped by the higher store sales number.
• Operating income for 2015 was 13.3% of Net Sales compared to 12.6% for 2014.
• Interest and other expenses were 0.9% of Net Sales in 2015 compared to 0.6% in 2014. The increase is due to the pre-tax gain on sale of equity ownership in HD Supply being lower at $ 144 million in 2015 compared to $ 323 million in 2014 and the interest costs on the $ 4.0 billion additional long term debt issued in 2015.
• The provision for income tax was 36.4% of net income in both 2015 and 2014.
• Net Cash from Operating Activities was $ 9.4 billion in 2015 compared to $ 8.2 billion in 2014. $ 664 million of the increase was due to higher comparable store sales, $ 644 million from Accounts Payable and Accrued Expenses partially offset by $ 422 million increase in Merchandise Inventory to support increased Net Sales.
• Net Cash used in Investing Activities was $ 3.0 billion in 2015 compared to $ 1.3 billion in 2014. The difference is due to the $ 1.5 billion paid to acquire Interline and the $ 179 million realized in 2014 from Sale of Investments.
• Net Cash used in Financing Activities in 2015 was $ 5.8 billion in 2015 compared to $ 7.1 billion in 2014. The change in due to $ 2.0 billion increase in Long Term Borrowings, partially offset by $ 501 million more for dividend payments and $ 230 million lower short-term borrowings.
• There are also extensive details about Share Repurchase plans, debt instruments and interest rate swap programs.

Part – 5

• Comments on costs and fluctuations in the MD&A

The Home Depot 10-K Report speaks of a multi-year initiative named Project Sync launched in 2015 and being rolled out to suppliers and the Regional Distribution Centers in the US. The project aims to create an end-to-end solution that would reduce lead times from supplier to shelf, reduce transportation expenses and improve inventory turns. This new initiative would ensure that most customers would receive the products ordered within 2 days in the US (Home Depot 10-K, 2015, p 20).

The increase in store sales, average ticket value and sales per square foot mentioned in Part -4 have all contributed to lower costs of operations. The increase in big ticket items such as appliances and roofing orders contributed to the increase in average ticket value.

• Pricing decisions and competition

The principal risk factor identified in the Home Depot 10-K Report is strong competition from other home improvement suppliers, independent supply yards, on-line and mail order suppliers and from contractors and home improvement installers. Customers are able to compare prices quickly through smartphones and other web connected devices (Home Depot 10-K, 2015, p 7).

The company has responded with equipping its own stores personnel with smartphones and web-enabled hand held devices to assist customers supplement their in store purchasing with on-line ordering from the company’s own websites.

Though not included in the 10-K Report, Home Depot on its website also offers a low price guarantee which says that if the customer finds a lower price from its competitors, they would beat that by 10%.

• Corporate Social Responsibility and Sustainability

Home Depot offers over 10,000 products through a program named Eco Options. Through this program the company sells Energy Star certified appliances, LED light bulbs, tankless water heaters and other products that enable customers to save on their utility bills. The company estimates that in fiscal 2015, customers saved over $ 700 million in electricity costs and received over $ 300 million in product cost rebates through the purchase of the company’s Energy Star rated products. The customers saved over 70 billion gallons of water resulting in $ 590 million savings in water bills through the use of the company’s WaterSense labeled bath faucets, shower heads, aerators , toilets and irrigation controllers (Home Depot 10-K, 2015, p 4).

The company also operates a recycling program through its stores. In fiscal 2015, 680,000 pounds of CFL bulbs and 930,000 pounds of rechargeable batteries collected from their customers were recycled. The company also recycled 170,000 lead-acid batteries collected from their customers under a lead-acid battery exchange program. The company also recycled over 20,000 tons of cardboard collected through its stores (Home Depot 10-K, 2015, p 4).

• Discontinued operations and any extra-ordinary items

The Home Depot Form 10-K does not report any discontinued operations during 2015. The major extra-ordinary item is the Data Breach incident which has been discussed in Part 4 Section 2 above.

The acquisition of Interline in August 2015 for $ 1.7 billion can be treated as an extraordinary item. Interline is a leading national distributor and direct marketer of broad-line maintenance, repair and operations (MRO) products. The acquisition is expected to help Home Depot expand its share of the MRO product market and to gain new customers presently served by Interline. The fair value of the assets acquired that has been included in the 2015 financial statements is shown below (Home Depot 10-K, 2015, p 43).

The Intangible Assets acquired include Customer Relationships valued at $ 310 million and trade names valued at $ 253 million. Goodwill is valued at $ 788 million. These values will be examined annually for impairment. Any impairment would be charged to the income statement in that year.

5. Main competitors for Home Depot

Home Depot is the leader in the home improvement market with a market share of 27.2%. The only significant competitor is Lowe’s with a market share of 18.4%. Lowe’s ranking in the Fortune 500 list is 50 compared to 33 for Home Depot. The next competitor Bed Bath & Beyond is ranked 258.

The chart below shows the revenue trends of the two companies (Soni, 2015). The chart clearly shows that Home Depot is averaging faster revenue growth than Lowe’s.

Home Depot also scores higher than its peers on most profitability indices. The chart shown below includes not only Lowe’s and Bed Bath & Beyond from the home improvement market but also other companies from the broader consumer discretionary market such as Michael’s and Williams-Sonoma. Also included in the chart are the S & P 500 Index, the Dow Jones Industrial Average and the S & P Consumer Discretionary Sector Index (Soni, 2015).

Home Depot is also ahead of its competition in the important metric for the retail industry of Sales per square foot of retail space as shown in the chart below (Soni, 2015).

This improvement has been due to Home Depot not having added to its store locations in recent years and encouraging the growth of on-line ordering. Lowe’s, has been adding stores and with the acquisition of Orchard Hardware Supply, has added 72 small format supply stores, typically 36,000 square feet each, on the West Coast. These smaller stores serve urban neighborhoods that are less densely populated and stock products of specific interest to the community it serves. The small store format has been successful for other retailers such as Wal-Mart and could be worthy of emulation by Home Depot Lowe’s also has an e-commerce presence which contributed 2.5% of its net sales in 2015 compared to 5.6% for Home Depot (Soni, 2015).

Summary and Conclusions

The analysis clearly shows that Home Depot is the market leader in the home improvement retail industry with 27.2% market share and impressive sales growth and profitability. The company has successfully integrated on-line ordering capability with its wide spread physical store locations which has helped improve its performance metrics.

The major concern for the company is the financial liabilities that could arise from the Data Breach incident of September 2014. If the financial costs in future years are similar to what has been provided in 2015 and 2014, the company will be able to easily absorb them. If the costs are significantly higher, the company may have some headwinds.

One criticism of the company is that it has not attempted to expand outside North America despite its dominance of the home improvement market and the strong brand image. Most other large retailers have expanded into Europe and the Asia-Pacific with success. The small format store strategy of its main competitor Lowe’s also appears interesting for Home Depot to attempt emulation.

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