HD Supply An Expensive Play On Construction And MRO

| About: HD Supply (HDS)
This article is now exclusive for PRO subscribers.

Admittedly, I have a thing for the industrial/MRO distribution sector - I own MSC Industrial (NYSE:MSM) and follow others like Fastenal (NASDAQ:FAST), Grainger (NYSE:GWW), and WESCO (NYSE:WCC) pretty closely. Although it's a very competitive space with a strong cyclical component, it's a fragmented market where companies with a good business plan (e.g. MSC Industrial and Fastenal) can really make a name for themselves.

Into this mix comes one of the bigger dogs in the yard - HD Supply (NASDAQ:HDS). Once part of Home Depot (NYSE:HD) and then sold to private equity, HD Supply has already enjoyed a pretty good post-IPO run, rising about one-third since its debut. Although I do appreciate the leverage that HD Supply offers to a U.S. construction rebound, not to mention margin improvement and consolidation potential, I think the multiple today is demanding unless you are really bullish on the company's growth plans and the recovery potential of the U.S. construction market.

Debuting With A Thud

"Thud" may be a bit harsh, I'll admit, but HD Supply didn't come roaring out of the gates with this first quarterly report as a publicly-traded company. At a minimum, these results highlight the challenges in depending upon a big construction recovery to drive near-term growth.

Revenue rose 10% as reported (roughly 8% on an organic basis), coming in about 3% shy of the average sell-side guess. Although Facilities Maintenance was solid (up 12%), Power Solutions (up 4%) was a little soft. Relative to expectations, both Waterworks (up 14%) and White Cap (up 9%) were disappointing on weaker construction spending.

On a more positive, there was some slightly progress on margins. Gross margin improved about half a point, while operating income rose 12% and operating margin improved 20bp. EBITDA rose 13% for the quarter and managed to come in in-line with expectations, due to strong (up 15%) growth in the high-margin Facilities Maintenance segment.

Even so, "adjusted cash EPS" was about three cents shy of the mark. Management's new midpoint target for revenue was about 3% lower than the prior Street average, and the new EPS midpoint was 22% lower.

Not Your Typical MRO

Plenty of investors, writers, and analysts are going to try to draw parallels between HD Supply, Grainger, and Fastenal, and that's fine - peer analysis is a valuable part of investment analysis. Even so, I think it's worth noting that HD Supply really isn't quite like anything else out there.

A major part of the HD Supply story is the Facilities Maintenance business - a pure MRO business that targets multi-family property owners and uses a catalog-based approach to sell all manner of supplies ranging from electrical to plumbing to lighting to hardware to supplies (even things like linens). This is a high-margin business (34% of the revenue, but 57% of EBITDA), but HD Supply has only about 4% of what could be a nearly $50 billion/year market. While Grainger does do some of this, Interline Brands and Guest Supply are arguably the more direct comps.

After Facilities Maintenance, Power Solutions and Waterworks appear as the next-most significant operations. Power Solutions distributes a variety of electrical components, parts, and tools, and does compete with companies like WESCO and Anixter (NYSE:AXE). But there's also a larger "last mile" component here where HD Supply more directly addresses the utility and transmission/distribution markets.

Waterworks is a lot like you might imagine it do be - it's a business that distributes various products and components for the water infrastructure market, including pipes, fittings, valves and so on. Unlike the large majority of MRO businesses, this is a rather consolidated market, as HDS (20%) and Wolseley (OTCQX:WOSYY) (15%) control more than a third of the market.

Last and not least is White Cap - a business that distributes specialized tools, hardware, and engineered materials largely to the non-residential and residential construction markets. This business includes everything from cutting tools to rebar to fasteners to tilt-up brace systems, and non-residential construction is about 75% of the sales base.

All told, construction end-markets are more than one-third of HD Supply's revenue base. To that end, then, it really is a different business than that of Fastenal or MSC Industrial, both of which are more oriented towards industrial and manufacturing end-markets (particularly MSC Industrial). This isn't good or bad, it's just different, and I think it's important to understand why HD Supply's results may differ from some of its "peers" in the quarters and years to come.

Mixing Rebound, Organic Growth, And Margin Improvements

There are at least three significant prongs to the HD Supply story as I see it. First, the company is clearly levered to a recovery in the residential and non-residential construction markets in the U.S. As I have written on more than one occasion, that thesis is all well and good and there are interesting names to play it with (including Plum Creek (NYSE:PCL), Louisiana-Pacific (NYSE:LPX), Axiall (NYSE:AXLL) and NCI Building Systems (NYSE:NCS)), but waiting for that recovery has already been difficult and stressful. Even so, I *do*believe in an eventual recovery … I just don't know how "eventual" it will be.

On the other hand, HD Supply has some interesting growth ideas outside of waiting for a construction rebound. The company is focusing not only on expanding its product offerings and its geographical footprint (it has around 600 locations today, versus over 2,650 for Fastenal but about 400 for WESCO), but also on growing its share of wallet at its existing customers. To be fair, though, I can't think of a single MRO distributor who isn't trying to do that as well.

Still, I do think the company has at least one interesting idea with a good risk-reward trade-off. The company is looking to grow its Facilities Maintenance business beyond its historical core market of multi-family properties (apartments, mostly) and into healthcare and hospitality facilities. As the businesses that serve these markets are often small and limited in their offerings, I think HD Supply can make a lot of hay here.

The last major prong is margin improvement. HD Supply has been a very active acquirer over the years (50 deals brought in about $11 billion of annual revenue), has been hiring to advance its growth goals, and has long pursued a strategy of being many things to many different customers. That has had very real margin consequences, and investors can see that in the weak margins relative to companies like Grainger, Fastenal, and MSC Industrial. While this isn't an entirely fair comparison (for the previously mentioned reasons of comparability) and HD Supply does compare better to the likes of WESCO, Rexel, Anixter, and so on, the reality is that investors put a lot of emphasis on margins in this sector and HD Supply must succeed with its expressed intentions to boost margins - largely through a process of "growing into" its overhead/infrastructure.

Good Prospects, But High Expectations

I don't dislike HD Supply as a business, just as I don't dislike Fastenal as a business. What I'm not so fond of is the valuations assigned to these businesses. In the case of HD Supply, even 9% revenue growth (OTCPK:CAGR) over a decade and peer-level free cash flow margins only gets you to about $21 per share in value, and that's with a better discount rate due to the company's size and diversity. What's more, you could say that the company's large debt load (nearly $5.6 billion, net) would actually argue for a penalty.

Likewise, the company trades at a trailing EV/EBITDA ratio of about 16. That's less than Fastenal, I grant, and maybe not wholly out of line for a company so levered to a construction recovery, but it just strikes me as pricing quite a bit of the recovery into today's valuation.

The Bottom Line

Closer to $20, I'd be much more interested in HD Supply, as I do like it as a play on consolidation in the MRO industry, improving construction activity, and its own internal growth and margin improvements. For now, though, I'll be watching from the sidelines.

Disclosure: I am long MSM. 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.