Here's Why Investors Should Stay Away From HD Supply
Summary
- HD Supply distributes maintenance, repair and operations supplies.
- HD Supply’s interest expense serves as a hindrance to profitability and cash flow.
- HD Supply’s liabilities exceed assets.
It's important for long-term investors to develop a guide for doing their investment research. Over the years I have developed questions to guide me in my thinking when researching the publicly traded universe. Right now, let's talk about HD Supply (NASDAQ: NASDAQ:HDS).
1.) What does the company do?
When you buy shares in a company you effectively become part owner of that company. Therefore, it's important for an investor to understand what a company sells. HD Supply distributes maintenance, repair and operations or MRO supplies. It caters to individuals and organizations that need building supplies, water infrastructure supplies such as pipes and conduits, electrical parts, and construction supplies. HD Supply believes it is a market leader in these types of products. The company, in its present form, got its start when Home Depot (NYSE: HD) bought MRO distributor Warehouse/America Corporation in 1997. Home Depot sold HD Supply in 2007 to an investment fund.
2.) What do the fundamentals look like?
Investors should also look for companies that grow revenue and free cash flow over the long-term, retaining some of that cash for reinvestment back into the business and for economic hard times. Excellent revenue and free cash flow growth serve as catalysts for superior long-term gains. HD Supply expanded its revenue 38% since 2011. The company's growth initiatives, characterized by acquisitions and volume growth, contributed to top line expansion. However, the company turned losses every year since 2011 with the exception of FY 2014. HD Supply bled free cash flow from FY 2012 to FY 2014, according to Morningstar. Heavy indebtedness has created huge amounts of interest expense, causing the company to go into the red.
Things are starting to look up for HD Supply and its shareholders in FY 2015. In the most recent quarter, HD Supply expanded its revenue 6% year-over-year. HD Supply's net income registered at $242 million vs. a net loss of $12 million last year. However, its operating income only exceeded interest expense by a scary 1.6 times due to its high level of long-term debt. The rule of thumb for safety lies at five times or more. HD Supply's debt exceeds assets giving it a stockholder's deficit.
3.) How much management-employee ownership is there?
Investors should always look for businesses where the managers and/or employees own a lot of stock in the company. Managers with a great deal of stock in the company will take better care to maximize company profits, which will enhance share price and their personal wealth along with the wealth of shareholders. According to HD Supply's latest proxy, the company's CEO, Joseph DeAngelo, owns 1% of the company's stock, which means his interests are aligned with shareholders at large. He definitely has his work cut out for him.
4.) How does its "Report of Independent Registered Public Accounting Firm" stack up?
Every year a company employs external auditors to audit financial statements and evaluate whether it maintains adequate financial controls. At the conclusion of the audit, you want to see a letter from auditors with the language "unqualified" or "fairly presents", which generally means that the financial statements and internal systems in constructing them were clean or adequate. If you see "qualified" or "adverse" in the auditing letter's language then deeper issues in a company's financial statements may exist. HD Supply's auditors gave its financial statements a "presents fairly" opinion. The company also maintained adequate internal controls.
5.) What types of risk does it have?
It's always important for investors to weigh the various risks, such as exposure to political risk in parts of the world where war is the norm, competitive positioning, and market price risk. HD Supply operates mostly in the United States and Canada, which means that political risk is minimal. The company operates in a highly fragmented and competitive business. It competes with the likes of W.W. Grainger (NYSE: GWW), which sports better fundamentals than HD Supply. According to Morningstar, HD Supply is trading at a forward P/E ratio of 16 vs. 19 for the S&P 500 as a whole, giving it a low market price risk on this basis.
6.) What does its forward analysis look like?
I would like to see HD Supply grow its operating income to a more conservative level relative to its interest expense. HD Supply needs to pay down its long-term debt or, at the very least, avoid taking on more long-term debt. The company could achieve this if it continues to grow its top line. Finally, given this company's high level of long-term debt and low interest expense coverage I am going to stay away from this company at the present time.
This article was written by
Analyst’s Disclosure: The author is long HD, GWW. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
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