A Franchise in Action
Home Depot

by George Runkle (TMFRunkle@aol.com)

ATLANTA, GA (Dec. 14, 1998) -- In my last column, I wrote about franchises. I wasn't talking about a McDonald's franchise, or Dairy Queen. Rather, I defined a franchise from a definition John Train gave in his book, The Money Masters. He called a franchise a company that "has attained a privileged position of some sort, so that another company can't muscle in to squeeze its prices and profits."

After writing that report, I received an e-mail from Fool Bill Stecker, who mentioned three other important ingredients: Recognition, Emotion, and Retention. Let's build on these three items and John Train's definition.

I thought of one company that fits the definition quite quickly. Years ago when I was in college, I worked selling building supplies. The store I worked at sold mostly to contractors, and although homeowners were welcome, we weren't set up for them. You had to know what you wanted, and you placed your order with us at our order desk. If you needed help, we'd give it to you, but with a line of impatient contractors behind you, that wasn't the most comfortable of situations. Still, many homeowners liked shopping at our store. We could advise you on the difference between types of windows, door hardware, or types of interior doors. Also, we sold high-quality merchandise.

Out of curiosity one Sunday during those years, I went to a local home center to see what it was like. The experience was like shopping at your standard discount store. I saw the reason contractors didn't shop there, the merchandise was low quality, and actually priced quite high considering what you were getting. Trying to get advice was not possible. The employees had that demoralized, disinterested look common in many service businesses. However, the store layout was good, you could walk down the aisles and see whatever you wanted. In a building supply store, liked I worked in, you needed to know you wanted an Anderson Window, or a hollow core interior birch door. You couldn't see them on display. The home center was friendlier in that manner. Still, with its inferior merchandise, bored staff, and poor pricing, I was not impressed.

It seems to have taken forever, but finally a store was set up that combined a customer friendly layout, helpful staff, and high quality merchandise at good prices. It is Home Depot (NYSE: HD). It sells merchandise to both contractors and homeowners. It doesn't sell cheap junk to make you think you're getting a bargain, and the prices are also quite good. It has a contractor's order desk, so a builder doesn't get tied up behind a homeowner trying to decide if he wants a treated yellow pine 2X4 or not. It has knowledgeable people on the floor to help the homeowners, not just clean up spills. I personally had a very pleasant experience buying the blinds for my new house. The saleslady was very knowledgeable, and helped me through all the arrangements.

To help keep their customers' loyalty, they also have classes on different areas of home repair. If you learn to do more projects there, you will attempt to do more in your home, and buy more from that store. Here's a part of Retention. Of course, as we homeowners know, Retention is built in anyway -- there is always something that has to be done. They have displays showing you how to do different types of jobs, like how to install tile, install lights, and so on. When you go through this store, you feel valued. Could this be the Emotion part of what Fool Bill Stecker wrote to me about? I think so.

Now, could other companies come up to compete with Home Depot? Yes, and in some localities they have. First, they have to come up with the capital to set up the mega-stores that Home Depot has. They have to train the staff, come up with the marketing plan, and most of all, develop a reputation. How would you advertise? "We're Just Like Home Depot" doesn't have a really good ring as a slogan. Home Depot has become the Home Depot of home centers. It has Recognition.

Let's move on to numbers. How has Home Depot done in the past, and what is predicted for the future? Its earnings are expected to grow at a 23% annualized rate for the next five years. Earnings are expected to increase 28% in FY 1999 from the year before, and then 23% FY 2000. It's Gross Profit Margin is an astounding 27.8%, and its debt ratio is 37% (total debt/total assets). Now, Home Depot is trading with a rather high P/E, of about 50. This isn't too unusual today for strong companies. Since DRiPs allow you to take advantage of dollar cost averaging, this isn't so much of a problem. If you make regular purchases, and the stock falls to a lower PE, your cost basis will drop accordingly as you buy more shares. I should mention the company has a direct stock purchase program, you can completely bypass a broker. It's $250 minimum to get in, and the initial fee to set up the DRiP is $5. Check out their website at www.homedepot.com for more information.

Obviously, Home Depot isn't the only franchise business available to us as investors. Provided Jeff Fischer lets me write some more columns here (hint, Jeff, hint), I'll look at other possibilities. Feel free to post your suggestions on the DRiP companies message board.

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12/14/98 Close
Stock Close Change JNJ 78 7/8 - 15/16 INTC 111 9/16 -4 7/8 CPB 54 13/16 - 15/16 MEL 64 15/16 - 9/1
Day Month Year History Drip (2.45%) 0.04% 27.68% 8.74% S&P 500 (2.17%) (1.94%) 17.60% 19.96% Nasdaq (3.07%) 0.89% 25.25% 23.41% Last Rec'd Total # Security In At Current 11/02/98 8.055 CPB $52.880 $54.813 09/01/98 9.727 INTC $80.238 $111.563 11/09/98 8.578 JNJ $74.090 $78.875 10/07/98 1.000 MEL $48.560 $64.938 Last Rec'd Total # Security In At Value Change 11/02/98 8.055 CPB $425.95 $441.51 $15.56 09/01/98 9.727 INTC $780.50 $1085.21 $304.71 11/09/98 8.578 JNJ $635.55 $676.59 $41.04 10/07/98 1.000 MEL $48.56 $64.94 $16.38 Base: $2200.00 Cash: $262.88** Total: $2531.13

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The portfolio began with $500 on July 28, 1997, adds $100 on the 1st of every month, and the goal is to have $150,000 in stock by August of the year 2017.

**Transactions in progress:
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