HD Supply Holdings' CEO Discusses Q3 2013 Results - Earnings Call Transcript

Dec.10.13 | About: HD Supply (HDS)

HD Supply Holdings (NASDAQ:HDS)

Q3 2013 Earnings Call

December 10, 2013 8:00 AM ET

Executives

William P. Stengel – SVP, Strategic Business Development and Investor Relations

Joseph J. DeAngelo – President and CEO

Ronald J. Domanico – SVP and CFO

Evan Levitt – SVP and CFO

Analysts

Ryan J. Merkel – William Blair

Sam J. Darkatsh – Raymond James

Flavio S. Campos – Credit Suisse

David J. Manthey – Robert W. Baird

Dean Dray – Citi Research

Andrew Obin – Bank of America/Merrill Lynch

Matt Vittorioso – Barclays Capital

Joseph A. Ritchie – Goldman Sachs

Operator

Good morning. My name is Simi, and I will be your conference operator today. At this time I would like to welcome everyone to the HD Supply 2013 Third Quarter Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question-and-answer session. (Operator Instructions)

I would now like to introduce your host for today’s conference, Mr. Will Stengel. Sir, you may begin.

William P. Stengel

Thanks, Simi. Good morning ladies and gentlemen and welcome to the HD Supply Holdings 2013 third quarter conference call. A copy of the third quarter earnings press release can be found on the Investor Relations tab of the company’s website at www.hdsupply.com.

Joe DeAngelo, HD Supply’s Chief Executive Officer will lead today’s call and provide an overview of our third quarter results. Following Joe’s remarks, Ron Domanico will provide a third quarter financial overview and Evan Levitt will provide a preliminary update on November results, and the outlook for the balance of the year. We will then conduct Q&A and we will conclude with Joe providing closing remarks.

Please note that some of the information you will hear in today’s discussion will include forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. Forward-looking statements are subject to known and unknown risks and uncertainties many of which maybe beyond our control. We caution you that the forward-looking information presented is not a guarantee of future events and that actual events may differ materially from those made in or suggested by the forward-looking information contained in the presentation.

For more information please refer to our risk factors discussed in our registration statement on Form S1 as amended that was declared effective on June 26, 2013, and those described from time-to-time in our and HD Supply Inc.’s other filings with the US Securities and Exchange Commission. Any forward-looking information presented is made only as of the date of this presentation and we do not undertake any obligation to update or revise any forward-looking information.

This presentation contains certain non-GAAP financial metrics. For a reconciliation of such metrics to the nearest GAAP metric, please see our earnings press release.

For Q&A, please limit your remarks to one question and one follow-up if necessary. We want to make sure we have an opportunity for as many people as possible to ask a question within our allocated 60 minutes. We appreciate your cooperation and thank you for participating on the call.

With that, I will now turn the call over to Joe DeAngelo.

Joseph J. DeAngelo

Well, thank you, Will. Good morning and thank you for joining us today for our 2013 third quarter earnings conference call. Before I move forward with my remarks on today’s call, I want to take a moment to thank Ron Domanico for his contributions to HD Supply over the last four years. Ron’s previous experience has been instrumental in helping HD Supply in its transition to a public company.

As we noted in our third quarter earnings release, Ron will be retiring from HD Supply effective April 17, 2014. We’re delighted to announce that Evan Levitt has been promoted to the position of Senior Vice President and Chief Financial Officer effective tomorrow.

Evan has held the position of Vice President and Corporate Controller for HD Supply since the separation of the company from The Home Depot in 2007, and has been an integral part of the management team that brought HD Supply through its debt restructurings and a subsequent IPO.

Evan’s previous experience includes the position of Assistant Controller and Director of financial reporting at The Home Depot, as well as various other accounting and operational financial roles. His extensive depth of knowledge in our company and industry, together with his strong rapport with the field teams will continue to be a tremendous asset for our management team moving forward. We expect a seamless transition and excited to have Evan in a larger leadership role at HD Supply.

I was very pleased with our solid performance in the third quarter. Our third quarter sales grew by 7% versus the prior year to $2.3 billion, driven by continued execution of our growth initiatives. We delivered this level of performance in the face of increasing market uncertainties and difficult prior year comparables.

Our performance represents our 14th consecutive quarter of year-over-year sales growth. On an organic basis, sales growth for the third quarter was 6% over the same period last year. We believe this represents approximately 400 basis points in excess of estimated HD Supply market growth rate. Ron will clarify our approach to calculate in our market estimates later in the discussion.

We delivered gross margin of 29.1%, up 40 basis points versus prior year. This strong performance was driven by execution of our category management initiatives, offset by the mix impact of lower gross margin businesses growing faster, as well as the Crown Bolt year-over-year headwind, which we estimate at approximately 20 basis points.

Adjusted EBITDA grew to $226 million and 11% increase versus the prior period, representing an operating leverage of 1.5 times. We define operating leverage as adjusted EBITDA growth divided by total sales growth. We continue to get solid operating leverage while at the same time investing for future growth.

Our sales growth, improving gross margins, and reduction in interest expense translated into adjusted net income for the third quarter of $75 million, up $65 million versus our third quarter last year, which represents adjusted net income per diluted share of $0.38. Our four primary businesses units, Facilities Maintenance, Waterworks, White Cap, and Power Solutions continue to deliver growth in the excess of our market estimates in the third quarter. Our Facilities Maintenance business delivered 4% organic growth, against the tough comp in the third quarter last year.

Net sales in the third quarter were negatively impacted by few concurrent unusual headwinds, including weather, non-reoccurring customer activity, and general weakness in the institutional vertical. The institutional vertical represents approximately 6% of Facilities Maintenance sale and sells primarily to military housing customers.

Excluding the impact of these unusual items, organic sales for Facilities Maintenance would have increased by approximately 6% in the third quarter, which represents approximately 400 basis points better than our estimated market growth.

Facilities Maintenance continues to execute very well and is having another record setting year of performance. The business delivered 8% organic sales growth compared to November 2012, which was – which is impressive, even November 2012, 13% organic growth over the prior November. Evan will share more detail regarding HD Supply’s overall November sales performance later in the call.

Our Waterworks business delivered 14% sales growth, approximately 11% of which was organic. This was 900 basis points higher than our market estimates. Our White Cap business had a 11% organic sales growth, which was 800 basis points higher than our market estimates. Both businesses continue to perform very well, with good initiative momentum, despite limited market tailwinds. Our Power Solutions business had 1% organic sales growth in the third quarter. And the pace of end markets that we believe went backward slightly as well as difficult prior year comparables. We estimate this is approximately 200 basis points better than our estimate of market growth.

Sales trends in this business are generally uneven as specific customer purchasing behavior can vary month-to-month and quarter-to-quarter. The addition of new customers also makes for uneven comparables. Ron, will provide more specifics on the year-over-year comparisons. In light of this market uncertainty, we’re also evaluating Power Solutions cost structure and aligning our best talents to key leadership roles to ensure the business is well positioned to perform despite slower growth and uncertain end markets. We’re encouraged by the momentum this business is building. And believe we are taking appropriate actions to further enhance our differentiated position.

Our controllable execution is on track, we continue to execute our growth initiatives across the entire company, which contributed approximately $116 million of incremental sales or nearly 80% of our growth in the quarter.

We continue to make investments in these initiatives including $16 million of SG&A primarily for sales associates as well as inventory and capital expenditures to ensure product availability and high service levels. The businesses are benefiting from these investments. Facilities Maintenance delivered $15 million of incremental third quarter sales from growth initiatives focused primarily on sales force effectiveness and category management. Since the beginning of this fiscal year, Facilities Maintenance, so we added approximately 150 associates to support these growth initiatives and added approximately 1 million square feet of distribution center capacity associated with opening new facilities and expanding or relocating existing facilities.

Growth initiative execution enabled Waterworks deliver $64 million of incremental sales in the third quarter from an issue of products that is fusible plastics and meters as well as new location growth, which was particularly strong in North Dakota and New England. White Cap had $24 million of incremental sales from growth initiatives in the third quarter driven primarily by sales force effectiveness, category management and the continued growth of 10 new locations that were added in last 12 months.

Our Power Solutions business is focused on sales force effectiveness and category management showed $9 million of incremental sales growth. Along with these two areas of growth, as I mentioned Power Solutions has also focused on lowering a structural cost to match expand market realities.

Now turning to our end markets, as you may recall we developed our end market growth estimates based on multiple quantitative and qualitative inputs including supplier and competitor intelligence, third-party subscription based data and proprietary HD Supply field level market and customer defects. Through the quarter, we saw a general increase on uncertainty in our end markets as a natural backdrop impacted our markets sales visibility. Our share current perspective on the end markets is based on what we saw for the quarter and what we are feeling today.

For the residential markets, the strength that we saw earlier in the year moderated, with single family starts growing only 15% in August, for the recently revised U.S. census data versus our previous expectations up 20% to 25% year-over-year growth. We are however, seeing signs of the residential markets where we are improving. We’ll get another data point December 18th, on September, October and November single family starts are released.

Our Waterworks business is well positioned to benefit from this emerging residential recovery, as its historical residential exposure was as high as 60% of total sales versus approximately 25% today. For the non-residential market, we saw continued sluggishness. Certain local markets are improving while other markets remain weak.

In addition to geographical differences, certain pockets within non-residential are showing different levels of strength. For example, we’re seeing strength in warehouse and hotel construction, and weakness in government and publicly funded university segment. In total, we believe this market was roughly flat in the third quarter, and we’re still not seeing broad consistent non-residential strength.

Non-residential is a primary market for our White Cap business that continues to execute despite the market headwind. For the infrastructure market both municipal water and electrical utilities slowed with the increased economic uncertainty resulting in mixed spending patterns across the country. We saw a general trend of lower customer project spending, reduced preventive maintenance spending, and greater focus on great fixed expenditures.

We believe that both of these customer segments tend to be more sensitive to general economic uncertainty, which negatively impact their propensity to spend in an environment with limited forward visibility. We believe the municipal market – water market was down approximately mid to low single-digits and the electric utility market was roughly down – flat to down slightly for the quarter.

In contrast, the MRO market remains stable. We believe this market grew at approximately 1% to 2% in the third quarter. As we begin to develop our fiscal 2014 perspective, we believe it is appropriate to be conservative in our end market outlook, given the current uncertainty. We will continue to refine our view based on market intelligence and additional data.

However, preliminary 2014 end market expectations, are that residential will grow at a mid-teens rate, non-residential will be flat to up low single-digits. Municipal will be flat to down low single-digits, electric utilities will be flat to down low single-digits and the MRO market will remain steady between 1% to 2%.

In addition, we previously disclosed the controllable execution framework as part of our presentation materials at the Baird Industrial Conference on November 6. In that material, we detailed our long-term growth targets to deliver HD Supply sales growth that is 300 basis points above the HD Supply market growth estimates.

Waterworks, White Cap, and Facilities Maintenance acquired to deliver 200 basis points to 500 basis points better than our market growth estimates. Power Solutions acquired to deliver flat to 200 basis points above our market growth estimates. We believe that framework positions us well with the performance of best-in-class competitors, especially giving – given our strong historic comparable. It also provides a consistent framework to model our company going forward, that is flexible to adjust the individual perspective on market recovery timing.

To be clear, our strategy is unchanged, and we’re intensely focused on controllable execution that exceeds these framework targets. Our third quarter performance during which we delivered approximately 400 basis points in excess of our market estimate is a good example.

As part of our annual planning process and given an uncertain market environment, we’re also in the process of assessing opportunities to reduce structural cost. We understand the importance of giving in front of uncertain markets and we’ll take the required steps to position the company for profitable growth.

To clarify, we do not plan to change our strategy or investment approach, rather our focus will be to ensure that we identify our best functional talent and drive increased focus on key business activities that enable us to accelerate strategic growth and also reduce costs.

We will always work to analyze and eliminate lower value-added activities that can distract from delivering to our full potential. Evan will take you through our emerging views of these opportunities a little later in the call. On a separate note, we continue to listen to your helpful perspective on preferred guidance and multi-sales strategies. We expect to provide you a formal decision on our approach when we report fourth quarter and 2013 fiscal year results next spring. While we’ve not finalized our formal approach we acknowledge that monthly sales detail is coupled for various reasons. We’ve shared monthly data as part of our recent disclosures and believe it has been added.

We also acknowledged the inherent difficulty and providing annual estimates earlier in the fiscal year given the nature of our diverse end markets. I’ll provide some closing comments following Q&A. I will now turn the call over to Ron and Evan for a financial overview of our third quarter performance, preliminary look at November sales results and also for the balance of the year. Ron?

Ronald J. Domanico

Thanks Joe. It’s been a privilege working with you and the senior management team at HD Supply. I’ve had an opportunity to meet with many of you on today’s call over the past few years and we greatly appreciate your support of the company. Having worked directly with Evan over the past four years I am certain that this will be a seamless transition and know that he will continue to be a great asset to the company moving forward.

As Joe mentioned, we reported net sales of $2.3 billion for the third quarter, an increase of a $151 million or 7.0% compared to the third quarter of fiscal 2012. Our sales growth is attributable to one, our growth initiatives that contributed $116 million or approximately 80% of our total growth.

Two, our end markets that contributed $29 million, and three, the Water Products acquisition that contributed $21 million. To clarify, we estimate the blended HD Supply market growth by calculating the weighted average of our four large businesses end market exposure and our end market growth estimates. We estimated low single digit decline to municipal and electrical utility markets, flat non-residential construction, mid-teen growth and residential construction and a stable 1% to 2% growth in MRO.

Gross profit increased by $52 million or 8.4% to $668 million compared to $616 million for the same period last year. The increase in gross profit driven by Facilities Maintenance, Waterworks and White Cap was primarily due to sales growth from growth initiatives which contributed approximately $36 million. As Joe mentioned, gross margin was 29.1% of net sales, an increase of approximately 40 basis points compared to 28.7% of net sales for the third quarter of fiscal 2012. We estimate the Crown Bolt comparable headwind at approximately 20 basis points. Operating income from the third quarter of 2013 increased by $46 million or 40% to a $160 million compared to a $114 million from the same period last year.

The improvement was due to higher net sales and gross profit and a $27 million reduction in acquisition related amortization expense. Adjusted EBITDA was $226 million an increase of $22 million or 10.8% as compared to third quarter last year. In the first nine months of fiscal 2013 adjusted EBITDA was $608 million an increase of $79 million or 14.9% as compared to the same period in 2012. The increase in adjusted EBITDA from the third quarter of fiscal 2013 was driven by Waterworks, $13 million; Facilities Maintenance, $7 million; and White Cap, $5 million, partially offset by Crown Bolt of a net negative $3 million.

Operating leverage in the third quarter for HD Supply was 1.5 times. Adjusted net income from continuing operations in the third quarter of fiscal 2013 was $75 million, an increase of $65 million compared to $10 million adjusted net income in the third quarter of fiscal 2012.

Our adjusted net income per diluted share was $0.38 in the third quarter. As you may recall, we arrived at adjusted net income by starting with income from continuing operations and adjusting for cash taxes, amortization of acquisition related intangibles other than software, losses or gains on the extinguishment and modification of debt, goodwill and other intangible impairments and costs related to the IPO.

For the third quarter, we delivered $51 million of income from continuing operations and added back $24 million associated with these adjustments. On a year-over-year, net sales, gross profit, and adjusted EBITDA were negatively impacted by the change in contract terms and the Crown Bolt agreement with The Home Depot as a result of our contract extension.

The new seven-year exclusive contract through January 2020, adjusted pricing levels and eliminated the volume guarantee as compared to the original contract. As a result of the new agreement, the third quarter and first nine months of fiscal 2013, included a reduction of $6 million and $18 million respectively. This has had an equal impact on net sales, gross profit, and adjusted EBITDA.

Evan will provide some more specifics on fourth quarter comparability considerations shortly. Revenue for our Facilities Maintenance business was $610 million, up $23 million or 3.9% compared to $587 million in the third quarter of fiscal 2012. We estimate that the MRO market grew between 1% and 2%, accounting for $8 million in sales growth.

Growth initiatives contributed approximately $15 million of the year-over-year sales increase. Adjusted EBITDA was $119 million, up $7 million or 6.3% versus $112 million in the comparable period a year ago. Operating leverage was 1.6 times.

As Joe mentioned, excluding the unusual items, Facilities Maintenance third quarter organic growth would have been approximately 6%, which represents very solid performance especially given its prior year comparison of 14% organic growth. Facilities Maintenance delivered 8% organic growth in November.

Revenue for our Waterworks business was $633 million, up $80 million, or 14.5% compared to $553 million in the third quarter of 2012. We estimate that our Waterworks market grew approximately 2%, accounting for $2 million in sales growth.

Growth initiatives contributed approximately $64 million, or 80% of the year-over-year sales increase. The December 2012 acquisition of Water Products contributed sales of approximately $21 million, while commodity deflation associated with PVC and ductile iron reduced sales by $ 8 million. Organic sales growth was up 10.6% compared to the third quarter of 2012.

Adjusted EBITDA was $55 million, up $13 million or 31% compared to $42 million in the same period last year. Operating leverage for Waterworks was 2.1 times.

Revenue for our Power Solutions business in the third quarter of 2013 was $472 million, up $4 million, or 0.9% compared to $468 million in the same period prior year.

In the third quarter 2013, we estimate that our Power Solutions market declined approximately 1% accounting for $5 million in sales reduction, which was more than offset by $9 million increase in growth initiatives. Adjusted EBITDA was $21 million in line with the third quarter of 2012.

Power Solutions third quarter had a comp of 9% in the same period last year, which was the result of the large utility project in Pennsylvania that began shipping in the third quarter of 2012 and continued through the first half of 2013. In August, the pace of this particular project slowed significantly due to overall budget evaluation and rationalization of multiple capital projects. Tough comparables continue for Power Solutions in the fourth quarter, during which they delivered 11% average daily sales growth versus prior year.

As Joe mentioned, we believe it is appropriate to assess Power Solutions cost structure and take action to ensure it is aligned for market realities. Revenue for our White Cap business was $352 million, up $34 million, or 10.7% versus $318 million in the third quarter of 2012. In the third quarter 2013, we estimate that our White Cap market grew approximately 3%, accounting for $10 million in sales growth.

Growth initiatives contributed approximately $24 million of the year-over-year sales increase. Adjusted EBITDA was $27 million, up $5 million, or 22.7% compared to $22 million in the same period last year. Operating leverage was 2.1 times.

From a balance sheet perspective at the end of the third quarter, net debt was $5.5 billion and our trailing 12 months adjusted EBITDA was $762 million. Net debt to adjusted EBITDA was 7.3 turns, down roughly 2 turns from fiscal year end 2012, and down almost 1 turn since the June 2013 initial public offering.

We had significant liquidity of approximately $1 billion at the end of the third quarter of fiscal 2013. Cash generated by the business will be used to invest in our growth initiatives and continue to pay down the ABL facility. We have no material bank debt maturities until 2017, and no note maturities until 2019.

We paid cash taxes of $1 million in the third quarter primarily associated with Canadian and U.S. state taxes. We estimate cash tax expense of approximately $2 million for the fourth quarter, which would result in 2013 annual cash tax payment of approximately $8 million.

We continue to have a favorable tax asset that includes a significant gross federal, net operating loss carryforward of approximately $2.4 billion. The tax affected amount of our federal and state NOLs are reserved with $1.30 billion valuation allowance. Our future cash tax payments could be significantly reduced by the utilization of NOL carryforwards. We will provide more specific detail around our expected 2014 cash tax payment next spring.

From a CapEx perspective, we continue to have low requirements and spend $32 million in the third quarter, primarily for new locations, IT system enhancements, and facility maintenance. Nine months fiscal year-to-date CapEx spending was $96 million, or approximately 1.4% of net sales.

With that, I’d like to introduce Evan Levitt, who will take you through our emerging views on structural cost enhancements, our November sales performance, the outlook for the remainder of the year, and updated guidance for the balance of fiscal 2013. Evan?

Evan Levitt

Thanks, Ron, and good morning, everyone. I’m sure that over the coming months I’ll have an opportunity to meet as many of you on today’s call. I’m excited about the new opportunity and the bright future of our company. I truly believe that we’re well positioned in large, attractive growth markets, and are poised for recoveries.

To achieve our full potential, I’ll be intensely focused on one, fueling growth; two, delivering operational leverage; and three, paying down debt. I want to take this opportunity to thank Joe and the entire HD Supply management team for their continued support and partnership.

As Joe mentioned, part of our annual planning process focuses on ensuring appropriate levels of costs that are aligned with market realities. We’re in the early stages of analyzing our functional associate staff levels, as well as potential facility closures associated with footprint optimization. We would expect any one-time charges to be focused on strategic to better position us for profitable long-term growth. Our preliminary estimates of potential charges range from $5 million to $20 million. But we will continue our evaluation and communicate the details of the final analysis in the upcoming months.

Our latest month – fiscal month ended December 1, so we can provide a preliminary estimate for November sales. We are not prepared to comment on other November financial metrics at this time. There were 18 selling days in November and we delivered net sales in November $633 million, which represents 9.2% growth versus prior year. Preliminary November year-over-year average daily sales growth by business were 8.1% for Facilities Maintenance, 13.7% for Waterworks, or 9.7% for Waterworks on an organic basis, 9.2% for White Cap, and 7.4% for Power Solutions.

As we look towards the fourth quarter, please note two items that will impact comparability with prior year. First in fiscal 2012, we had one extra week of results. This 53rd week occurs approximately every five years, which keeps our fiscal year end on the Sunday closet to January 31.

In fiscal 2012, we generated $148 million in sales and $14 million in adjusted EBITDA in this 53rd week.

As Ron mentioned, the second item that will impact comparability is Crown Bolt contract extension agreement with The Home Depot. To adjust the 2013 fourth quarter for comparability, you should consider $25 million in non-recurring adjusted EBITDA generated in the fourth quarter of 2012, comprised of $6 million associated with adjusted pricing levels and $19 million associated with the volume guarantee.

To adjust the full-year 2013 results for comparability, you should consider $43 million in non-recurring adjusted EBITDA generated in the fiscal year 2012, comprised of $24 million associated with adjusted pricing levels and $19 million associated with the volume guarantee. These adjustments impact net sales, gross profit and adjusted EBITDA equally.

The Crown Bolt and 53rd week comparison issues will not be a factor in fiscal year 2014. We’re focused on finishing the year strong despite potential sales headwinds driven by end market, weather, and government uncertainty. We anticipate our fiscal 2013 revenue to be in the range of $8,500 million and $8,575 million, adjusted EBITDA to be in the range of $750 million and $760 million and adjusted net income per share in the range of $0.52 and $0.58.

Our fiscal 2013 adjusted net income per share range assumes a fully diluted weighted average share count of 172 million. At the midpoint of the range, our annual sales and adjusted EBITDA year-over-year performance translates into 9% and 21% growth respectively, after adjusting for the impact of the 53rd week and the Crown Bolt contract extension agreement with The Home Depot.

With that, I’d now like to turn the call over to the operator for questions.

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions) Our first question comes from Ryan Merkel of William Blair. Your line is now open.

Ryan J. Merkel – William Blair

Thanks. Good morning, everyone.

Joseph J. DeAngelo

Hi, Ryan.

Ryan J. Merkel – William Blair

So the first question I had is, on the outgrowth when we’re looking at 2014, given you’re a bit more cautious on the end market growth, does the outgrowth moves to lower end of that 3% to 5% range, just trying to figure out if that moves around depending on how strong the markets are?

Joseph J. DeAngelo

No. For us it’s the standard for framework, so we’ll always be – it’s going to be 300 basis points, and we’ll focus every ounce of our execution on over performing to that.

Ryan J. Merkel – William Blair

Okay. And then the second question I have is, you’ve discussed in the past this 18% incremental EBITDA margin. And I think you’ll be pretty close to that this year, ex the items from last year. So as we think about 2014, is there a still reasonable high level assumption or are there some other factors that we should consider?

Evan Levitt

That’s still a good assumption. However our current gross margin rate is about 29% and our SG&A rate, you can think of as about 50% fixed, 50% variable, so that gets you to about the 18%.

Ryan J. Merkel – William Blair

Okay, great. Thank you very much.

Joseph J. DeAngelo

Thank you.

Operator

Thank you. Our next question comes from Sam Darkatsh of Raymond James. Your line is now open.

Sam J. Darkatsh – Raymond James

Good morning. I just wanted to piggy back on Ryan’s last question there. What - does that 50-50 variable fixed at some point though there is a point of leverage and deleverage from a sales growth standpoint, where is that point Joe from a percentage basis top line as to where you begin to leverage your OpEx, maybe 3%, 4%, I’m just trying to get a sense of where you would have to grow the top line in order to begin leveraging OpEx?

Joseph J. DeAngelo

Sam, we believe that 18% incremental margin will remain for the foreseeable future. As the business rose, we do invest in infrastructure, as well as in other high return growth initiatives within the business. So with that mix, you can count on 18%.

Sam J. Darkatsh – Raymond James

Okay. And my second – first of all, before I ask my second question, I should congratulate you Evan on the new role and Ron best of luck and best wishes with your new chapter. I’m being rude for not having started with my preamble with that, it was a pleasure working with you Ron and best of luck with your new chapter.

Ronald J. Domanico

The pleasure was mine, Sam.

Evan Levitt

Thanks very much, Sam.

Sam J. Darkatsh – Raymond James

Could you talk about the pricing environment that you are seeing on a by segment basis with the environment that perhaps a little bit less robust than you and perhaps others in the industry had thought. What are you seeing by segment Joe from a competitive pricing standpoint?

Joseph J. DeAngelo

Yeah, sure. Well, I think, look, we’ve been through several years of very competitive pricing, so we’re not seeing a material change in terms of what’s going on out there.

So our Facilities Maintenance business for the last several years has been in a tough pricing environment. But it’s a pricing environment that when you’re working in unplanned type of product that really comes down to do you have the product and do you have the delivery mechanism to be able to deliver perfectly for next day installation of repair products.

So that’s the environment we’ve been in, and we’ve always been sharp on the right pricing for the right product that flow, and I think there is no net change there. So I’d say a continuation of aggressive pricing environment. Throughout the balance of the businesses as you move to have much more bid content that has been incredibly aggressive for the last five, six years.

So we haven’t seen any change with that and you always have to be sharp on your bid products and still have a lot of time. The one thing that we saw several years ago that we experience a little bit less out now, but not a whole bunch, but we saw periods where projects were being bid and rebid and rebid for extended period of time, 12 months, 18 months.

Now, we see projects being bid and typically being let on a normal – more normalized cycle basis. And so we believe that’s coming into a period as demand and markets recover, where that bidding intensity will still be intense, but it will be on a more normalized basis, meaning we only need to put the work in for one bid one time, versus we were putting in the work in for one bid four or five times, but it’s a tough environment out there.

Sam J. Darkatsh – Raymond James

Very helpful. Thank you very much and happy holidays to each of you.

Joseph J. DeAngelo

Thank you, Sam.

Operator

Thank you. Our next question comes from Hamzah Mazari of Credit Suisse. Your line is now open.

Flavio S. Campos – Credit Suisse

Hi, everybody. This is Flavio, I’m standing in for Hamzah today. Just had a quick question around pricing, I was wondering if you guys can give any color on what you guys are seeing on the pricing front, and if that - if there is any reflection of that on the gross margin expansion we’ve seen, and how does that play out on lower inflationary environment that might be seen within the next say few months?

Ronald J. Domanico

Yes. I think for us as opposed to some of the other competitors pricing hasn’t been the largest component of our gross margin accretion. Remember when you look at our gross margin – our gross margin performance that we’ve delivered particularly in this quarter, it’s the result of growing faster in our market and therefore cutting into better rebate tiers. And that really enforces our strategic view of being number one in the market and clearly being a distant number one as being a clear economic competitive advantage for us.

And it really is one where we’re very much focused on not only having the best programs with our suppliers, but making sure that we’re aligning up with preferred suppliers they’re going align their best people and their best product with us and we – our commitment will be to best avenue to market for those products.

So it’s kind of the way we deal with a top pricing environment that we’ve had for a long time as opposed to some other folks that are just coming into a tougher pricing environment is by being closer and closer to our supply base.

Flavio S. Campos – Credit Suisse

Yes, that’s very helpful. And if I could just have a quick follow on, I mean this is a good comparison with your competitors, but then when you look at the Power Solutions business that has been like on this low single-digit growth right now, just a little different from one of your largest electrical distributor competitors. Can you talk a little bit about what you see in this business, if you’re going to need to right-size it or what is the dynamics that is leading to this slowdown?

Ronald J. Domanico

Yes, I think it’s really important in our Power Solutions business to realize that the bulk of our business as opposed to other standup competitors is electrical utility business. So we have a very large electrical utility business, a much smaller electrical and end use contractor business. So when you look at those electrical utilities customers, they tend to be very conservative customers. There is a long cycle time in terms of gestation period to be able to capture an outsourcing of their supply chain needs. And there also tends to a constriction in their spending as the economic environment become less certain.

So as we enter those less certain environments, we’re going to make sure that we’re very lean in terms of our support structure, and we’re very focused in making sure that all of our resources are field oriented particularly within the wall of those utilities, so that we can gain more of their wallet share even if their spending is constricted. So I think it’s one where – I think we have various different dynamics in total than other competitors they have a much larger electrical contract or end use business.

So it’s really all about what’s happening in the supply chain organization with electric utilities. We see a level of conservatism; we are going to reflect that level of conservatism. I want to make sure all of our resources are focused on making sure they are successful and being leaner on the support side from a corporate standpoint and much heavier on a field support standpoint.

Flavio S. Campos – Credit Suisse

That’s very, very helpful. I’ll hop back in the queue. Thank you, guys.

Ronald J. Domanico

Thank you.

Operator

Thank you. Our next question comes from David Manthey of Robert W. Baird. Your line is now open.

David J. Manthey – Robert W. Baird

Hi. Thank you, good morning. First off, it’s good to see the uptick in FM in November. And I would imagine that as you look at the other segments just seasonally that’s going to be a little bit less significant of an indicator. But when you look at the longer cycle business, if you look at the White Cap and Waterworks and so forth, could you give us any anecdotal data that you’re hearing out there or just conversation in terms of what those segments might look like into 2014, are you feeling any better, I know you have a guidance here for the market growth that looks like a continuation of what we’ve seen, but are there any ways of hope that you are hearing at this point?

Ronald J. Domanico

Look at I mean I think I’m going to be conservative in my comments and you can just put that in the bank as we go forward David as you look at it. I mean, there are – when you look at the residential market, I think we got a big data point coming up mid-December to see what really happened in that market and our view will be updated based on what we see there.

And then on the non-res side, as we’ve discussed, hey, there are pockets of good geographical execution certainly the energy for Houston and Fort Worth, the tech for Boston and Austin, San Jose and distribution has been strong at Atlanta, Dallas, Riverside, Phoenix, Cincinnati, like that. So you have certain areas that are doing well both from a geographic perspective and from a product content perspective. But right now for us, we’re going to make sure we do our planning based on having a conservative end view of the marketplace.

David J. Manthey – Robert W. Baird

Okay. And then as it relates to the FM business, it’s a segment which you got a tremendous success over the past several years here. And as you look at your internal growth initiatives, how sustainable is that? As you look out over the next three to five years, is there any impediment, any sort of scale that you reach that makes things difficult in terms of the ability to outgrow the market. Because it just seems like you had great success and I’m wondering about the sustainability of that.

Ronald J. Domanico

Well, we operate in a $48 billion market there maybe a 4% share player. So we believe there is a plenty of runway from a market standpoint to be able to make it happen. We invested heavily in making sure that our infrastructure was an SAP backbone and our distribution center with very repeatable expansion and new model builds like you just saw, put on 1 million square feet. Our processes, that we’ve been executing for year, year-in and year-out and need to try these for running that business since 2005.

So I think our playbook is well oiled it will constantly get better and it’s one that we are going to strive to constantly making that a better and better business and the capturing the richer portions of that market share out there.

David Manthey – Robert W. Baird

Yes, it sounds great, Joe. Thank you and best of luck Ron and congratulations to you Evan.

Ronald J. Domanico

Thank you.

Evan Levitt

Thank you.

Operator

Thank you. Our next question comes from Dean Dray of Citi Research. Your line is now opened.

Dean Dray – Citi Research

Thank you. Good morning everyone. Hey, I know we have had a pricing come up a couple of different times but would you give specific pricing action in the quarter by business. So what was pricing how does that contribute in FM and Waterworks and so forth for the quarter?

Ronald J. Domanico

Dean, that’s not something that we are going to discuss publicly.

Dean Dray – Citi Research

Okay. But you know your competitors do, Grainger provides pricing in the quarter, WESCO provides it as well but that’s not something that you will be providing?

Joseph J. DeAngelo

We’ll take it that under advisement, and consider the future.

Dean Dray – Citi Research

Okay.

Ronald J. Domanico

Yes, I think the key is being – look, we will never be disclosing anything that we believe is competitively sensitive, that would have a negative impact either from a customer standpoint or from a supplier standpoint. So that decision will come to my desk. But I can probably give you a 90% on it right now that we probably will not be disclosing that in the future and we will focus on overall gross margin execution.

Dean Dray – Citi Research

Okay. And then for – you mentioned earlier by in the call about some non-recurring items in the quarter whether I think there was some action with military customers. If you just could quantify those and maybe provide some color and what might those items look like in the fourth quarter?

Ronald J. Domanico

Sure Dean. As we discussed last quarter 2012 was unseasonably warm comparing that to a cooler summer this year. We haven’t estimated headwind for HVAC seal related products of approximately $5 million in the quarter. That occurred primarily in August.

This should not impact our comparability for the fourth quarter. We also had a $6 million headwind in the quarter from sales associated with the state government business and a retail store energy efficient lighting replacement program.

For the state government contract, we strategically decided not to meet the economics of the proposed contract and it was ultimately awarded to competitors. The retailer decided to switch from a revamping program with Facilities Maintenance to a full fixture replacement program.

We expect these two items to have a comparability impact in the fourth quarter of about $2 million. And finally, there was a $4 million sales headwind in the quarter due to 2012 sales of carbon monoxide detectors as a result of legislation mandating the installation of such detectors in Washington, California and New York. We expect a comparability impact in the fourth quarter of approximately $5 million. So excluding these items Facilities Maintenance organic growth would have been 6% which as we stated previously we believe to be very strong performance especially given the prior year comparison of 14% organic growth. And our strategy is intact at Facilities Maintenance. We delivered 8% organic sales growth in November.

Dean Dray – Citi Research

Great. And then just for my last question, it would be, regarding the 2014 assumptions for Waterworks, if you’re getting mid-teens growth in residential. Eventually you’re going to see a lift on the water municipalities in terms of what their exposure were on the resi side, so that’s 25% of the Waterworks market exposure. So what are you assuming in terms of that residential lift? Is there a lag coming in for 2014, but how would you characterize that positive?

Joe DeAngelo

Yeah, I would characterize that we have been waiting for this lag to be able to digest itself through. So we look at all of new developed lots that need to be consumed and we believe we are close to a tipping point on that Dean. So we will be able to give you a lot more better view once we really see what the residential market is when we are talking in the spring because you will have a very good read on that. And we’ll also have a very good read on how many of those developed lots have been consumed and you turn to new there.

We are starting to see new turn in certain geographic areas. And so, our expectation is that we are getting close. I mean, we’ve been predicting it for the last two or three years we’ve been counting these lots. And I believe 2014 will be a time that we will be able to see some of that start to flow through. But we’d like to give you a more informed view in this spring.

Dean Dray – Citi Research

Thank you.

Joe DeAngelo – Chief Executive Officer

You are welcome.

Operator

Thank you. Our next question comes from Andrew Obin of Bank of America. Your line is now opened.

Andrew Obin – Bank of America/Merrill Lynch

Yes. Good morning guys. Can you give us some color us to what are you sort of seeing on state and federal spending and how is it going to play out just from the end market perspective going to next year?

Ronald J. Domanico

Yeah. I think it’s a great question Andrew. It’s one that we are kind of weighted with bated breadth as we go into December, January timeframe and having the year-end that closes in January. I think we’re going to be stuck in the mix of something that we can’t predict at the moment.

What we saw was, a constriction of federal spending and unlike prior periods, when you have the federal calendar year ending in September there was normally this big rush to spend in September. And we didn’t see to use it or lose it happen this year. And so I think that was a difference in terms of the way that kind of take through. And on a state and local level what we are seeing, it is highly, highly, highly localized and so when you have a very well run city we see that spending pattern is more consistent with what we would expect and when it’s not to low run city it tends to be very much shut down.

But we did see a pronounced heightening of both – of the water specifically and it went from projects being – projects started being delayed and for better maintenance started being delayed. And so we really can’t predict it but we are taking a very conservative look at it in our guidance.

Andrew Obin – Bank of America/Merrill Lynch

So stay tuned until January?

Ronald J. Domanico

Yeah. I think until January I really don’t know what’s going to happen as we go through December and January.

Andrew Obin – Bank of America/Merrill Lynch

And then the second question, could you guys just provide a more specific outlook for net debt at the year end 2013 and also 2014 if you can share that?

Evan Levitt

Yes. Andrew as you know we’ve currently got $480 million outstanding on our asset backed lending facility. We’ll use available cash to pay that down and that is a revolving credit facility, so we can draw on that again in the future for a seasonal cash flow needs or other needs. Our high interest debt becomes callable beginning in 2015.

Prior to that date to redeem that debt would require us to make – make late call payments, which essentially are voluntary interest payments through the date of the earliest call date. So that likely doesn’t make a lot of sense for us prior to 2015. Beginning in 2015, the debt becomes callable at a premium that steps down over time. That schedule of the premium stepping down is disclosed in our filings and it’s at that time it likely makes sense for us to begin paying down that debt.

Andrew Obin – Bank of America/Merrill Lynch

And net debt number...

Evan Levitt

Consider paying down that debt.

Andrew Obin – Bank of America/Merrill Lynch

And net debt number?

Evan Levitt

That information that we may provide in the spring when we update you on our 2014 outlook.

Andrew Obin – Bank of America/Merrill Lynch

Okay. Thank you.

Operator

Thank you. Our next question comes from Matt Vittorioso of Barclays. Your line is now opened.

Matt Vittorioso – Barclays Capital

Yes, good morning, I was just hoping to get a little more color on the Waterworks performance obviously it’s been very good and sorry if I missed it. You talked about these growth initiatives that have enabled you to outperform the underlying market by I think it was 900 basis points. Just any more detail on what those actual initiatives have been even from a high level. Also curious if there are any big projects within Waterworks.

I know you highlighted within the power segment that there is a larger project that had kind of rolled off. Is there any project revenue associated with the outperformance at Waterworks, any color on that stuff would be great? Thank you.

Joseph J. DeAngelo

Sure. So I’d probably refer you to the page seven in the document that we’ve put out, you look at where Waterworks is focusing on driving their outperformance and it’s been new product and services primarily, adjacent offerings and the new locations. If you look at those adjacent offerings that Waterworks has put in place over the last three or four years, is they’ve become really prime in storm drains, prime in water treatment plants, inside events.

Really doubled and tripled down our efforts on automated meters and also we’ve entered the high density polyethylene pipe. So it’s a fusible pipe solution, so it’s a new set of piping solutions that we didn’t have primary in our mix before. So those are the big areas that we really added a lot of resources to and we made sure that they are prime on national basis. In many cases when we went into the downturn, we were prime in one region in each of those.

We had a level of expertise to build off of and we’ve nationalized those programs. So you can see that that’s been a very well executed process by our Waterworks team.

Matt Vittorioso – Barclays Capital

And you are taking market share from others on these initiatives?

Joseph J. DeAngelo

In all cases.

Matt Vittorioso – Barclays Capital

All cases. Okay. Great. Thanks. Just on the project side, was there any project revenue associated with Waterworks, is that a project type of segment at all?

Joseph J. DeAngelo

Well, there is a lot of project in there that’s why – it’s our most bid based business. So you’re always bidding projects anywhere from small type of extension projects to very large projects. So there is continuous project mix and it tends to equalize over time but we could take it through. For instance, we had some very big meters that we’re comping against projects in our North region and the team kind of outperformed with other stuff.

So I think in all cases, they have project mix as their primary execution and it tends to bounce out on a national basis. If we went region by region you would see a lot more lumpiness.

Matt Vittorioso – Barclays Capital

Got it. Thanks, helpful. Thank you.

Joseph J. DeAngelo

Thank you.

Operator

Thank you. And our final question comes from Joe Ritchie of Goldman Sachs. Your line is now open.

Joseph A. Ritchie – Goldman Sachs

Thank you, and good morning.

Joseph J. DeAngelo

Good morning, Joe.

Joseph A. Ritchie – Goldman Sachs

So my first question is on the organic growth trajectory for 4Q, you are off to a great start in November at 8.5%. Evan, I think you may have touched on this earlier on a previous – with a previous question. But it looks like you’re stepping down December, January, and the guidance is pretty wide, they call it negative growth to mid single-digit growth in the next two months. So if you could just maybe talk about the puts and takes over the next couple of months and what you’re seeing, that would be helpful.

Evan Levitt

Sure Joe. Well, our current guidance is based on what we currently know. The biggest variable, of course, is the uncontrollable items such as our end markets and other macro events. That’s the government budget process that we’re going to go through again as we get close to January. But to the extent these uncontrollable items are favorable, like we had in November, then we’d expect that there would be some upside to our guidance range. On the put side if the uncontrollable environment deteriorates, we can see a downside pressure towards the lower end of our range.

Joseph A. Ritchie – Goldman Sachs

Okay. And the uncontrollables, just to be clear, they relate predominately to municipal budgets?

Evan Levitt

No, I wouldn’t limit it to municipal budget. Certainly the government is the large macro event. We’ve got weather-related environments that you’ve been seeing inclement weather throughout much of the U.S. over the last couple of weeks and then the general resi and non-resi markets as well. But we see a lot of uncertainties in the marketplace right now and so we’re being what we believe is appropriately conscious.

Joseph A. Ritchie – Goldman Sachs

Okay. And then I guess my follow-on question as you look out to 2014 and the long-term growth that you’re expecting from your initiatives, it seems to be, you are guiding to a long-term growth forecast of 3%, is that how we should be thinking about 2014 and specifically as it relates to leverage, if you can talk a little bit about how we should expect the – your EBITDA leverage to look like going forward. I know it was about 1.5 times this past quarter, but are you expecting that same type of leverage moving forward or should we expect that to improve as you start levering some of the costs that you’ve already put in place?

Evan Levitt

Joe, on page six and page seven of the presentation that we’ve provided, we think it provides a pretty good framework – flexible framework for you to really enter what you believe are the end market growth assumptions. And then you can add 300 basis points for our outperformance that’s what that we commit to strive to and commit to try to exceed.

As far as leverage, you can add that to your model in terms of what HD Supply delivers based on your assumptions. And as I mentioned earlier, it’s unlikely that we’ll pay down significant high cost debt in the near-term given the make whole provisions, but we will use available cash to pay down the asset-backed lending facility.

Joseph A. Ritchie – Goldman Sachs

The comment was more around your operating leverage and the sales force that you have in place today and whether you’re actually going to get more operating leverage based on what you already have today, or is the incremental spending going to have to continue such that your EBITDA leverage will move lower than 1.5, which is where we were today versus something perhaps higher. I mean, 2013 you guys are going to do roughly two times EBITDA leverage. And so, I’m just trying to understand whether that trends lower or trends higher going forward?

Evan Levitt

I see. We do continue to invest in the business and we expect to continue to invest in the business in the future. So, as we mentioned earlier, we think that 18% flow through is a good framework for your model.

Joseph A. Ritchie – Goldman Sachs

Okay. Great. Thanks for answering my questions.

Operator

Thank you. At this time, I’d like to turn the conference over back to Mr. Joe DeAngelo for closing comments.

Joseph J. DeAngelo

Well, thank you. Thanks for your questions. So in summary I am very pleased with our solid performance this quarter as we executed and delivered growth in excess of our market estimates and margin expansion despite increasing market uncertainty. Our strategy is unchanged and our investment approach to drive profitable growth is intact.

As we always do, it’s appropriate to continuously evaluate our structural cost base to make sure we are aligned and positioned for long-term profitable growth. Our November performance is encouraging. We take a conservative end market view of the balance of the year and 2014. Thanks again for your participation on today’s call and your continued support. Thank you.

Operator

Thank you sir. Ladies and gentlemen, thank you for participating in today’s HD Supply’s third quarter earnings conference call. This call will be available for replay beginning at 11 AM Eastern Standard Time today through 11:59 PM Eastern on December 17, 2013. The conference ID number for the replay is 9936-6550. The number to dial in for the replay is 1-855-859-2056 or 404-537-3406. You may all disconnect. Everyone have a wonderful day.

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