D/E ratio Archives - Consilue

D.E.B.T. – a success story of a US giant Home Depot Inc.

administrator — Sun, 11 Nov 2018 20:44:47 +0000

COMPANIES ARE CREATING VALUE FOR THEIR SHAREHOLDERS IN A MORE AND MORE ORIGINAL WAYS. THEY BET ON VARIOUS THINGS: INNOVATIVE BUSINESS MODELS, ECONOMIES OF SCALE, COMPETITIVE ADVANTAGES ETC. APPROACHES DIFFER AND SOME MAY EVEN LOOK STRANGE FOR THOSE THAT DO NOT REALLY HAVE A STRONG FINANCIAL BACKGROUND – CASE OF HOME DEPOT INC.

Company Home Depot Inc. is a US retail giant, selling equipment for home, garden and workshop. Their products and services are sold throughout the network of 2.200+ stores in USA, Canada, Mexico and online. The company is the biggest retailer worldwide in its segment. In financial year 2017 the company generated 101,0 billion USD net sales and 16,5 billion USD EBITDA. More than all non-financial legal entities in a smaller country such as Slovenia, EU.

Why is increasing the financial debt beneficial?

The company operates in a smart way. Part of the success story is linked also to the financial structure and its restructuring. In last years the company is increasing the level of financial debt and decreasing the level of equity. In this way Home Depot Inc. is increasing its Return on equity (ROE). Meaning, the shareholders’ equity is being managed in a more and more efficient way. Let’s look more in details how this is possible.

Development of invested capital and return on equity (ROE) of Home Depot Inc.

Source: Home Depot Inc. Consilue analysis.

Invested capital as at the end of FY 2017 amounts to 28,5 billion USD. Financial debt equals 27 billion USD and shareholder’s equity 1,5 billion USD. One can quickly notice that the indebtedness measured as D/E ratio is »very high«, 1611%. Nevertheless, the ratio as such is not really problematic. The key is to consider the market (not book value) indebtedness ratio. In the case of Home Depot Inc. future returns on invested capital are expected significantly above the weighted average cost of capital (WACC). The market value of equity therefore significantly (more than 100x) exceeds its book value, making the healthy debt levels significantly higher.

The more value the company creates, the higher the optimal levels of debt. As the debt levels built, the ease of creating value for shareholders increase. And the system works as a spiral. The more debt there is, the higher the value for shareholders.

Financial debt and debt management

Financing mix with a leverage as in the case of Home Depot Inc also brings challenges. A mistake in managing financing can have serious consequences. Financial debt can quickly show its other face. Proper supervision of risks and stabilization of future cash flow is therefore of crucial importance. Management of Home Depot Inc. is well aware of this fact. They are eager to continuously strengthen the underlying competences. Especially those that influence the increase in gross margin and further development of competitive advantages.

Financial debt is being managed carefully. Risks related to new obligations and danger of eventual liquidity gaps are continuously addressed in a proper way. The majority of debt is of long-term nature. Its maturities match the maturities of underlying projects. The company does not seek to create »fast« profits at the expense of differences in maturities. The company is aware of risks and the fact that this is not really their business.

Table of financial debt as at the end of FY 2017 (m’ USD):

Short-term financial debt
Loans given by the consortium of banks	1.559
Short-term portion of long-term financial obligations	1.202

Long-term financial debt
Bond – Sep 2017; Var. OM; quarter interests	/
Bond – Sep 2018; 2,25%; semi-annual interests	1.137
Bond – Jun 2019; 2,00%; semi-annual interests	998
Bond – Jun 2020; Var. OM; quarter interests	499
Bond – Jun 2020; 1,80%; semi-annual interests	748
Bond – Sep 2020; 3,95%; semi-annual interests	501
Bond – Apr 2021; 4,40%; semi-annual interests	998
Bond – Apr 2021; 2,00%; semi-annual interests	1.343
Bond – Jun 2022; 2,625%; semi-annual interests	1.243
Bond – Apr 2023; 2,70%; semi-annual interests	996
Bond – Feb 2024; 3,75%; semi-annual interests	1.093
Bond – Sep 2025; 3,35%; semi-annual interests	995
Bond – Apr 2026; 3,00%; semi-annual interests	1.287
Bond – Sep 2026; 2,125%; semi-annual interests	9.86
Bond – Sep 2027; 2,80%; semi-annual interests	993
Bond – Dec 2036; 5,875%; semi-annual interests	2.949
Bond – Sep 2040; 5,40%; semi-annual interests	495
Bond – Apr 2041; 5,95%; semi-annual interests	988
Bond – Apr 2043; 4,20%; semi-annual interests	988
Bond – Feb 2044; 4,875%; semi-annual interests	978
Bond – Mar 2045; 4,40%; semi-annual interests	977
Bond – Apr 2046; 4,25%; semi-annual interests	1584
Bond – Jun 2047; 3,90%; semi-annual interests	738
Bond – Sep 2056; 3,50%; semi-annual interests	971
Financial leasing – fixed and variable liabilities until Jan 2055	984
Minus: Short-term portion of long-term financial obligations	-1.202

Total	27.028

Source: Home Depot Inc. Consilue analysis.

The financial structure is despite the relatively leveraged financial mix, stable. What makes it sustainable is the value that is being created. Additionally, the lenders are also well aware of the fact that the ratio Net debt / EBITDA as at the end of FY 2017 amounts to »only« 1,4x. This fact additionally strengthens the position of the company. It messages that in case of tightening, the financial debt can still be relatively quickly repaid with operational cash flow.

The success story described above still has space to develop further. The debt levels are not yet optimal, meaning that in the area of debt management there is still space for improvements and value creation. Yield to maturity for 10-year bonds is below 5,0%, meaning that eventual increase of debt levels is further improving the weighted average cost of capital.

The developments described are strongly appreciated by the investors. The value of the Home Depot Inc. stock in last 7 years strongly outperformed competitive peer companies. The growth was truly significant, from 30 USD/share to 200 USD/share. Furthermore, the company was also paying out dividends. Compounded annual growth rate (CAGR) of the Home Depot Inc. stock in the period that matches FY 2011 – FY 2017 amounts to 28,5%, compared to the 9,6% growth of S&P Retail index.

Chart: Stock price development

Source: Bloomberg. Consilue analysis.

As we see, the financial debt is taking the nature of equity. D.E.B.T. is the magic word or key to a success of Home Depot Inc. The more the indebtedness increases, the more the value increases. On the given case we see how event the financing structure can become the source of value creation for shareholders and even a strategic competitive advantage of a company.

Is value creation in your company addressed in a sufficiently advanced way? Do you know the specifics and best practices that would fit your company best? Does your strategy hide innovative financial & business approaches or you think it is just another block of paper in your drawer? Which strategic decision may hit your competitors next?

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Case study: Fast company growth brings financing challenges

administrator — Thu, 25 Jan 2018 16:01:29 +0000

Pain: Financing of company growth opportunity

A mid-size wholesaler came across a business opportunity on the mature market, that would boost the company growth. The management performed some preliminary market tests first and got a very positive feedback. They were well aware that their reaction needs to be fast and sound if they want to succeed. Main specifics that significantly impacted their response were 1) net working capital intensive business and 2) relatively modest operational margins. The business opportunity is in terms of revenues 5x the current level and large portion of the growth will have to be at least temporarily financed also with debt. This was the reason why Consilue was engaged – to advise the client on the most appropriate financing mix, play its role of the independent trust-worthy intermediary and to speed up the process of gathering funds.

Addressing the pain: Growth strategy comes first

The scale of the opportunity surprised everyone in the company. Since the client had at that time relatively modest understanding of the developments that resulted in it, the project was approached more strategically. Consilue dig into the understanding of the structural changes first. The market analysis and the industry analysis pointed out significant moves on both supply & demand side. To name the most significant ones:

– opening of the market for more competitive non-EU suppliers (release of EU tariffs & quotas)

– competitors have long-term trading alliances linked to EU suppliers and are non-responsive

– concentrated industry, but very rigid competition

– tensions of clients to seek new, more flexible alternatives to intensify the competition

After in-depth financial and business analysis of the company, we figured out that the competitive advantage of the client on which the idea of the future success is based, significantly depends on the particular currency exchange rate and can therefore be of temporary nature. There were also speculations about the possible responses of dominant players which are financially much stronger and already have all the facilities needed.

Reflecting all these facts, the Consilue together with the company management prepared the financial projections (income statement, statement of financial position, cash-flow statement) under various scenarios of corporate growth development. The projections revealed the financing needs as well as most optimal financing mix and the target maturities. Based on the findings the communication and negotiation with governmental crediting institutions and commercial banks continued.

Due to the temporary nature of the competitive advantage, the client was also advised how to act after they gain their target market share in order to rather develop a long-lasting competitive advantages and thus consolidate their position on the market.

Results: Company growth financing CHECKED

The client received the funds in very short time period. Consilue supported the client in the process of funding with value-added advices. Thanks to us, the client was able to replace part of its current funding activities (factoring; non-competitive interest rate loans) with carefully selected, less risky in terms of maturities, cheaper and more tailored sources of funding.

Client’s testimonial:

We are fully equipped for our attack. We understand the background. We did not lose much time. We fully & truly believe into this opportunity. So let’s attack!

Thanks to our consultants for a great support, responsiveness and proactive thinking. Also the approach to financing is smart – we will leverage the company gradually as the business progress, we carefully chose the liability types and select the maturities in a way that related risks are minimized.

Advisor’s thought:

In cases when a company comes across such a big business opportunity and the financing needs for company growth increase so much, that it might be challenging to persuade risk-averse creditors such as banks and governmental institutions. In these cases, the key role in the process is carried by the consultant, who independently reviews the feasibility of the project, review the growth strategy and underlying risks, estimates the financing needs, determines the optimal financing mix, attributes most appropriate types of funding, maturities etc. With the help of the consultant often not only the funding is agreed faster, but also the costs of company growth financing decrease, since the future business risks are perceived as lower and funds gathering process is normally more transparent and straight-forward.

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