ALEXANDRIA, VA (Jan. 14, 2000) -- The Home Depot (NYSE: HD) is a Merchant King. This means it isn't quite like the companies we normally invest in here, but I believe it's an excellent investment in its own way. What follows is a case for why I believe Home Depot belongs in this portfolio.

Running through our Rule Maker criteria, it's got a dominant brand -- so much so that Office Depot sprang up to copy it in another niche. According to one story I heard, the founders of Office Depot sent Home Depot's founders a whole lot of free office supplies to soothe any ruffled lawyers. (And it worked, too.) Home Depot has stores all over the map nationally, and is expanding worldwide. It recently put competitor Hechinger out of business, and before that Builder's Square. Lowe's (NYSE: LOW) is still hanging in there, but as a clear #2 with a big target painted on its back. And Home Depot didn't need to use any dirty tricks to cripple competitors; it's simply a better place to shop with lower prices, greater selection, and better service than anybody else.

A Merchant King focuses on repeat-purchase business even more than a traditional (ex-Cash King) Rule Maker. Being a Merchant King is all about combining low overhead and high inventory turnover, and no matter how the housing market goes, Home Depot is poised to serve both new construction and maintenance/repair/upgrade needs from lumber to carpeting to light bulbs to lawn care. Its strategy is to win customers back again and again by being the cheapest and most convenient place to shop for home improvement products, and providing free training classes on do-it-yourself home improvement projects. The Home Depot is not trying to extract the highest margin possible from each individual sale but instead aims to lure each customer back year after year.

Letting customers into the warehouse fulfills our convenience criterion by providing a wider selection of goods than a smaller store could. As for having a store conveniently nearby, according to the most recent annual report (for fiscal 1998, a new one should be out soon), Home Depot operated 753 stores (707 domestically, 46 elsewhere on the American continents). They were busy expanding their possibilities with another 167 stores scheduled to open over this past year. The company has a target of 1,600 stores by the end of fiscal 2002.

Home Depot hasn't even yet touched Europe, Asia, or Africa. Further, the company is busily experimenting with new store formats like the EXPO design centers and Villager's Hardware stores, both variations away from the standard warehouse format. Home Depot also has direct marketing subsidiaries like Maintenance Warehouse, which sells through catalogs, and National Blinds and Wallpaper Inc., which takes special-order telephone sales advertised through magazine ads. The company also has a new PRO section in a couple of stores aimed at efficiently delivering custom bulk orders to professional construction contractors, which I can tell you is doing quite well in Austin, Texas at least.

Looking to the financials, the most recent 10-Q (Q3 '99) was filed in December and covers operations through October 31, 1999. It has a nice little table right up front comparing the three-month and nine-month results for comparable periods in 1999 and 1998, and the numbers are good. Sales increased about 27%, gross profit increased 32%, and net profit increased 45%. Earnings per share grew a bit over 40%. All of this easily blows away criterion #6: 10% sales growth per year.

Just as importantly, their balance sheet is in decent shape. With $5.2 billion in inventory and almost $20.8 billion in nine-month Cost of Merchandise Sold (same thing as Cost of Goods Sold), it takes Home Depot a little under 68 days to sell everything in the store. ($5.2 billion divided by $20.8 billion equals 0.25, or 25%. Then, multiply 0.25 times 270 days -- the nine-month period of sales -- to arrive at our magic number of 68 days in inventory.) That's the same number of days as it took a year earlier, and as you can see it takes them an average of a little more than two months to sell everything in one of their stores. Not quite Dell (Nasdaq: DELL), but as a hardware store, they don't have to deal with Dell's level of inventory depreciation either.

Sidenote: If you look up the above numbers on your own, you'll notice I had to grab the year-earlier 10-Q (Q3 '98) to get the year-ago inventory number. This is customary because the balance sheet does not compare the one-year-earlier numbers for some reason. Rather, it uses the figures from the beginning of the fiscal year (January, in this case), presumably from the annual report.

While I've got the other balance sheet up, let's compare current assets between Q3 '99 and Q3 '98. Here, the rule of thumb is that cash is GOOD, and everything else is BAD. For Home Depot, Cash & Equivalents and Short-term Investments increased from $516 million to $976 million. I like that. Accounts Receivable increased from $459 million to $648 million, a 41% increase, which is ahead of the 27% increase in sales. That's something to watch as we much prefer to see receivables growing no faster than sales, but I'm not worrying yet. (Keeping a close eye on this sort of thing could've warned you of Lucent's recent fall. See our special on Lessons from Lucent.)

Now, let's look to the liabilities side of the balance sheet. Here, current liabilities are all considered GOOD except for any interest-bearing debt. Accounts Payable increased 21%, in line with sales. Rising payables is a very good thing, as it means the company is getting free short-term loans from its suppliers. In contrast, receivables are the reverse -- that is, giving free loans -- and are a cost of doing business that should be minimized. Normally all this stuff is hidden inside the Flow Ratio, but I like to look at it separately in order to get a better feel for the company.

The next thing to keep your eyes peeled for is any interest-bearing debt, whether the short- or long-term variety. Home Depot has some of both. Add together Long-term Debt and Current Installments of Long-term Debt on the 10-Q to arrive at $743 million as of 10/31/99, and compare it to $1,329 million the year before. I love the direction, a 44% decline, but even combined with the 89% increase in cash two paragraphs up, the end result is $976 million in cash divided by $743 million in debt, which is a cash-to-debt ratio of only 1.31, and we're looking for at least 1.50. I can live with this (especially since they seem to be using the money to finance rapid growth), but it does violate our criteria and is something to watch closely and remind management about in conference calls and shareholder meetings.

The final two criteria are ones a Merchant King isn't going to meet, and which would alarm me if it did: Gross Margins and Net Margins. Merchant Kings are low-price, high-volume distributors, and price is the main weapon with which they attack and defend against competition. They sell commodity products, and the profit margin is the chink in the armor their competitors aim for. Merchant Kings WANT it small, and compensate with volume and with vigorous and perpetual reductions in overhead. Scrutinize inventory turnover, scrutinize accounts receivables and payables, scrutinize operating expenses, cash and debt levels. But if net margin gets too high in this type of company, they're getting soft and giving competitors an opening to undercut on price and thereby win market share.

This is why I'm HAPPY that Home Depot's net margin is only 5.8% -- less than our typical 7% minimum. The company offers the best deal possible for its customers, and their customers know it. If the net margin did hit 7%, Home Depot could afford to cut its prices some more.

Similarly, the company's gross margins of 30% fall short of our 50% threshold. The reason for the low gross margin is because Home Depot buys its product from suppliers and only marks it up enough to cover overall expenses and make a reasonable net margin. Think of Home Depot's gross profit as its fee for distributing the product. Of course, two-thirds of that "fee" goes to running their stores and paying their employees. With operating expenses running at only 20% of sales, Home Depot runs a pretty tight ship. But they should always strive to run an even tighter one. That's the name of the game for a Merchant King.

Touchy-feely investor that I am, what I like best about this company is that Home Depot's founders, Bernie and Arthur, still run the company. Such founders provide vision and leadership rather than the canned financial management of a hired-gun CEO. That said, the financials are extremely important, and it would be a bad habit to take my word for their accuracy in the above paragraphs. If you're considering Home Depot as an investment, be sure to follow the above links that I used in preparing this article. It's a good practice to become comfortable with evaluating the financials on your own, and I just KNOW it would make Matt and Phil happy if you went and calculated the Flow Ratio.

Finally, the Rule Maker port had a strong day thanks to a big gain in Intel (Nasdaq: INTC), which scored estimate-beating fourth quarter earnings last night. Read all about it in this morning's Fool Breakfast News and tonight's Drip Port. Also, on our Rule Maker Companies board, Fools are already crunching the numbers and discussing the results in this thread.

Related Links:
Home Depot vs. Lowe's, 1/3/00 Drip Port
Home Depot: Value Creation Despot, 8/12/99 Fool on the Hill
Home Depot's 1999 10-K Business Description

- Oak