HD Supply: Still Yearning For The Days Of Old

| About: HD Supply (HDS)
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HD Supply (NASDAQ:HDS) is a great reminder of how private equity does not always get it right. Back in 2007, Home Depot (NYSE:HD) sold its supply business (HD Supply) to a consortium of private equity firms at a price of $8.5B. Home Depot retained a 12.5% ownership interest in the business, the portion of which it carried on its balance sheet being subsequently written down to a zero balance as the housing crash ravaged on. In a sign of the times, or possibly a sign of looking for a way to cut their losses, the private equity firms decided the timing was right to bring HD Supply to market with an IPO that was just recently completed. The IPO was originally anticipated to price between $22-$25 per share, but ultimately priced at $18 per share as market conditions deteriorated amid soaring interest rates which cast a pall both on the sustainability of the housing recovery and the willingness for investors to gamble on a still heavily indebted HD Supply. While the company has seen its business recover along with the housing market and the economy in general, it still carries a massive debt load at almost punitive interest rates. The fact that the company went ahead with the IPO that priced at $18 a share, as much as 25% below the high end of the previously anticipated range, is somewhat telling. HD Supply left anywhere from ~$240 to $425M in cash on the table by going ahead with the IPO that ultimately saw over 61M shares issued at a price significantly below expectations. The desire to push forward with the IPO rather than shelving it and waiting for market conditions to stabilize, should speak rather loudly as to the small window that the private equity firms might see in which they can recoup their investments. With over $6B in debt, the money potentially left on the table from the IPO sure would have gone a long way towards deleveraging the company and aiding in a return to profitability.

Background On HD Supply

The company is one of the largest industrial distributors in North America. It is important to note that HD Supply is not even close to be solely tied to the residential real estate market, even though its fortunes crashed as seemingly the same time the housing market crashed. The cause and effect of the housing market crash, and the financial market crash, impacted all types of construction outside of the residential market as well. A significant portion of the business for HD Supply is tied to commercial construction and infrastructure type projects.

HD Supply was cobbled together over the years through organic growth as well as numerous acquisitions. Home Depot, the previous owner of HD Supply, made the largest of the aforementioned acquisitions when it acquired Hughes Supply for $3.2B in early 2006 at a significant premium to its trailing EBIDTA. In retrospect, this acquisition would occur at the high water mark for the industrial distribution business prior to the recession.

In 2007, Home Depot decided to divest of its supply business (which had been formally renamed HD Supply) and found willing buyers in the form of 3 private equity firms (the Carlyle Group, Bain Capital and Clayton Dubilier & Rice) whom each took an equal stake in the company. An agreement was reached to sell HD Supply for $10B, but at the last minute the price was reduced to $8.5B to reflect deteriorating market conditions and the outlook for HD Supply itself. Of the total purchase price, about $2.3B was split equally between the private equity firms and the majority of the balance was financed through the issuance of a significant amount of debt. This deal was never touted as a leveraged buyout, but it is hard to argue it was anything but that considering the amount of debt HD Supply was saddled with as part of the acquisition.

The investment by the private equity firms amounted to ~$760M for each firm. With the stock now trading publicly with a share price of ~$19 a share with a market cap of $3.6B, the value of each firms holding in HD Supply is still worth far less than what was originally invested. Even if the private equity firms are able to recoup their initial investment, having that amount of capital tied up for a significant time period earning a zero or minimal return is considered a failure in the private equity world.

Why Investors Should Not Buy Into This Name

Investors have two reasons to avoid HD Supply. The first reason is the debt load the company carries, for which there is no short term fix. The ~$1B in proceeds raised from the IPO will go towards reducing the over $6B in debt that the company currently carries. The specific tranche of debt the company intends to retire carries a hefty 10.5% interest rate which is clearly far below investment grade. Even after retiring this debt, the company still faces the reality seen in the following two tables from the S1 prospectus filing prior to the IPO:

HD Supply is currently on the hook for over $500M in cash interest payments on an annual basis. The company generated about $8B in revenue during its last fiscal year. If you assume that the cash interest is reduced by about $100M by retiring $1B of debt carrying a 10.5% interest rate, the company will still devote close to 5% of its trailing twelve month revenue to debt service.

The second table shows the interest rate associated with each debt issuance outstanding for HD Supply. A quick glance shows that the interest rates range from 7% to 13%. Again, the company not only faces a mountain of debt, but it is forced to service this debt at interest rates significantly above that of its competitors. If you are looking for a competitive disadvantage, you need look no further.

The second reason investors should think twice before jumping into HD Supply is that the markets that the company serves have made a huge turnaround over the last 18 months, but the results of HD Supply do not necessarily reflect this. The table below shows the operating results for the company over the last 5 years:

For the most recent fiscal year, HD Supply saw revenue grow ~14% from the prior year. This is certainly respectable growth, but nothing to crow home about and far behind the growth rates seen at other companies tied to a recovering housing and industrial supply market in the US. The company also managed to generate $320M in operating income for the year ended February 2013 (after backing out a goodwill impairment). Here again, in the midst of what has already been a significant recovery, HD Supply is not generating enough income from operations to simply offset the annual interest expense it is forced to incur.

Investment Outlook

There are enough red flags associated with HD Supply to make me want to stay on the sidelines and not invest in this name. The private equity firms still control a significant amount of the outstanding shares, and the way the company was brought to market in a rush it would seem to be a good bet that these companies will look to sell their shares when the opportunity arises. The lack of a significant cash hoard, with only slightly more than $100M in cash not restricted for upcoming debt payments, will prevent the company from opportunistically creating shareholder value. The debt load is massive, and the cash generated from operations is not material enough to put a significant dent in this balance through redeeming debt in the near term. HD Supply certainly is levered to a market that could continue to recover, and the company could ride that recovery as well. However, there are plenty of other names that have significantly more upside potential than this particular company if you are looking to ride a recovering US housing and industrial supply market.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.