HD Supply's (HDS) CEO Joseph DeAngelo on Q3 2018 Results - Earnings Call Transcript

|
About: HD Supply (HDS)
by: SA Transcripts

HD Supply (NASDAQ:HDS) Q3 2018 Earnings Conference Call December 4, 2018 8:00 AM ET

Executives

Charlotte McLaughlin - IR

Joseph DeAngelo - CEO

Bradley Paulsen - President, Supply Facilities Maintenance

Evan Levitt - CFO

Analysts

Ryan Merkel - William Blair

David Manthey - Robert W. Baird

Jason Makishi - Barclays

Evelyn Chow - Goldman Sachs

Deane Dray - RBC Capital Markets

Hamzah Mazari - Macquarie Capital

Patrick Baumann - J.P. Morgan Chase

Ryan Cieslak - Northcoast Research

Operator

Good day, ladies and gentlemen and welcome to HD Supply Third Quarter Earnings Conference Call. As a reminder, this conference call maybe recorded. I would now like to turn the conference over to Charlotte McLaughlin, Investor Relations, you may begin.

Charlotte McLaughlin

Thank you, Candy [ph]. Good morning, ladies and gentlemen and welcome to the HD Supply Holdings 2018 third quarter earnings call. As a reminder, some of our comments today maybe forward-looking statements based on management's beliefs and assumptions and information currently available to management at this time. These beliefs are subject to known and unknown risks and uncertainties, many of which may be beyond our control. Including those details in our periodic SEC filings. Please note, that the company's actual results may differ materially from those anticipated and we undertake no obligation update these statements. Reconciliation of such non-GAAP financial metrics with the corresponding GAAP measures are available at the end of our slide presentation and then our 2018 third quarter earnings release, both of which are available on our IR website at www.hdsupply.com.

Joseph DeAngelo, our CEO will lead today's call. He will be joined by Bradley Paulsen. President of our Facilities Maintenance Business Unit; and Evan Levitt, our CFO; who will provide additional color on our financial performance. There will be an opportunity for Q&A. For those participating, please limit your remarks to one question and one follow-up if necessary. Thank you for your continued interest in HD Supply.

And with that, I will turn over the call over to Joseph DeAngelo.

Joseph DeAngelo

Thank you, Charlotte. Good morning, everyone. Thank you for joining us today for our 2018 third quarter earnings call. As always, it is my privilege to share our company's results with you on behalf of the over 11,000 HD Supply associates who work hard every day as one team driving customer success and value creation.

I want to begin by turning to Page 3. The team has a lot to be proud of in the third quarter. We delivered exactly what we said we would when we communicated with the market back in September. Sales and earnings performance were at the high-end of our expectations. We delivered 18% sales growth for the third quarter of fiscal 2018 and 9% sales growth on an organic basis, well in excess of our 300 basis point target [indiscernible]. I was pleased with our earnings performance of 16% adjusted EBITDA growth while continuing to generate strong free cash flow of $453 million on a trailing 12-month basis.

Early in the quarter, we promoted Brad Paulsen to run the Facilities Maintenance business unit. Brad joined the company in late 2015 to lead our Facilities Maintenance Merchandising team, and quickly assumed responsibility in other areas, including pricing analytics and inventory management. We're excited about the experience and passion that Brad brings to Facilities Maintenance. He is a natural leader, and he's off to a great start. You will hear from Brad shortly.

I want to take a moment to update you on our ongoing investments in Facilities Maintenance. We're seeing these investments positively impact our top line with third quarter sales growing approximately 500 basis points in excess of market. We believe we are in the early stages of realizing the full benefits of our investments. Our enhancements to our sales associate coverage model were employed in early 2018, and the feedback has been positive from both our associates and our customers. As we highlighted during our Investor Day, we also implemented a sales console for our sales associates. This console provides our field associates with dynamic customer and product data, improving our ability to be helpful and collaborative with our customers to provide the best solutions for their specific needs. Like all of our productivity tools, our sales console is continually evaluated and improved. I review and interact with our best sales performers, and their continued excellence speaks to the success of our ongoing investments.

We're also seeing fantastic results from our investment in Web and Mobile, with 70% of Facilities Maintenance sales being placed electronically, improving the efficiency of the customer/associate relationship. In November, we piloted our updated Facilities Maintenance web platform; we expect to see this fully rolled out by the end of the fiscal year. Early results are encouraging, as we aim to make it even easier for our customers to identify the product they need and correspondingly make it easier to buy. This enables our sales associates spend less time processing transactions, freeing them to focus on value-added solution selling.

Moving on to our Construction and Industrial business unit we continue to see the team outperform and gain market share. This performance is a direct result of the great sales leadership under John Stegeman, our unique expertise within 14 different specialty construction trades under one roof, and a robust end market. We continue to see good long-term projects across the country, including major airport renovations, construction of new sports and entertainment complexes, corporate headquarters, data centers, and distribution centers. Additionally, the A.H. Harris integration is progressing extremely well. We continue to be ahead of our originally planned schedule and expect the integration to be largely complete by the end of fiscal 2018. Realization of synergies are on-track, and we are seeing the benefits of an integrated sales team supported by strong category management execution. I couldn't be more pleased with the enthusiasm and hard work of our associates as we complete this integration.

Across our business, we continue to deploy capital for the highest return opportunities available. We believe that quality M&A is a core competency and a key value creation lever and we look forward to executing future opportunities in both businesses as we identify compelling value. Our third quarter also saw the team execute on the successful refinancing of our debt obligations. Evan will speak more about this later, but the interest savings will continue to benefit our free cash flow generation over the next several years. We also continue to execute on our capital allocation strategy, opportunistically taking advantage of the recent financial market weakness in the third quarter and in the fourth quarter. During the third quarter, we purchased 2.4 million of our outstanding shares for $91 million. During the fourth quarter, through November 30, we repurchased an additional 3.3 million shares for $125 million. As of November 30, we have $156 million remaining under our second share repurchase authorization.

As part of our continuing capital allocation strategy, our Board of Directors has approved an additional $500 million share repurchase authorization, bringing our total unused authorization to $656 million. We will exit 2018, our first fiscal year, with our portfolio optimized and our capital structure normalized as a stronger company. We look forward to continuing to focus on our two market-leading businesses where we have the ability to service our customers better than anyone in the industry. I am proud of the performance of each of the 11,000 HD Supply associates who work hard every day to deliver on our promises to our customers, fellow associates, and shareholders.

I'll provide some closing comments following Q&A but will now turn the call over to Brad to introduce himself and update you on the recent Facilities Maintenance activity.

Bradley Paulsen

Thank you, Joe, and good morning. I want to begin by extending my thanks to the entire Facilities Maintenance team who have made my transition period seamless. In my first 90 days, I traveled across the country and saw firsthand the hard work and commitment of our over 5,000 associates who I'm now honored to lead and represent. During my three years at HD Supply, I've worked with every function of our Facilities Maintenance business and had a key role in setting the company's current strategy. I firmly believe that this strategy is appropriate to deliver an outstanding customer experience and to maximize return for our shareholders. I am confident in the ability of my leadership team to execute and position Facilities Maintenance for continued sales outperformance in our highly fragmented market.

To that end, I am pleased to announce that Alyssa Steele has joined our team and will serve as our Chief Merchandising Officer. Alyssa brings the strongest credentials from both, home improvement and e-tailing, and is someone with whom I've had the privilege of working with for many years. I am incredibly proud of our team's execution in the most recent quarter; their efforts plus the continued realization of benefits from our recent investments were the key drivers in our sales acceleration. Our team is fully committed to better leveraging our cost structure and improving our profitability as we grow. While our team plans for an expected weaker SG&A leverage in the second and third quarter of 2018, due to difficult comparisons from the prior year plus recent pressure from product mix, freight, and labor costs, our team is focused on enhanced cost leverage and we expect to start seeing improvement in the fourth quarter and throughout 2019.

I would also like to take a moment to address the section 301 Chinese tariffs. Our organization currently does not have any permanent investment, joint ventures or even buying office in China which allows us to be nimble and making adjustments that help offset the current tariff impact.

Our category management team is partnered throughout the year with our suppliers to develop plans that will allow us to continue to deliver value to our customers. We will continue to execute these plans which include negotiating lower prices on Chinese products by taking advantage of the strength in U.S. dollar and incentives provided by the Chinese government to their manufacturing base. Additionally, as part of our continuous supply chain enhancement, we are always evaluating the best locations from which to source our products. While we are committed to offsetting as much of the tariff impact as possible, we do intend to pass on price increases where rising cost are unavoidable.

We have recently begun making some modest price increases consistent with the current competitive environment and the early indication is that the market is accepting these changes. We believe the current tariff environment is manageable where we can maintain our gross margin rates. But we do plan to monitor the environment closely and we'll take swift actions as they become necessary. I am incredibly encouraged by what I've seen in my first 90 days and I'm excited about the opportunity to lead our team, help our customers and deliver value to our shareholders. I appreciate the opportunity to speak with you today and look forward to meeting more of you.

I will now turn the call over to Evan.

Evan Levitt

Thank you, Brad, and good morning, everyone. On Page 4, we highlight areas of recent investor focus. First is tariffs. We have yet to see a substantial impact from the section 301 tariff as it does take time for those cost to work their way through the supply chain. However, as Brad said, we believe the current environment is manageable. Our initial focus is always to avoid or offset as much as the cost as possible, so we do intend to pass along unavoidable cost increases.

We expect that price increases to offset unavoidable tariff related cost could mean an additional 100 to 150 basis points of sales growth over time as these costs work their way through the supply chain. For our construction and industrial business, rebar cost continue to be the largest tariff impact. Similar to last quarter, we are tapping on 100% of the rebar cost increase year-over-year, but are unable to pass along enough of the price increase and maintain prior year's rebar gross margin rate. The impact is that we earn the same or slightly more gross margin dollars than prior year for every unit of rebar sold and our overall profitability is maintained. The rebar price increase contributed almost 300 basis points of sales growth for our construction and industrial business in the third quarter and 30 basis points of gross margin compression. We are seeing signs of stabilizations in the rebar market and expect the year-over-year impact to diminish over the next few quarters.

Next is the non-residential construction end market. As Joe indicated, the non-residential construction end market remain strong across our 15 priority districts. We continue to see strength in large multi-year multi-billion dollar projects which give up confidence in the future health of the market. We do not see any signs of a slowdown.

Hurricanes and wildfires; this quarter, we saw the impact of two hurricanes: one in the Carolinas and the other along the floor [indiscernible] Southern Georgia. We are fortunate that no HD supply associates or immediate family members were injured during these storms. The net impact of these storms on our business was not material. Many Americans are now dealing with the aftermath of recent wildfires in populated areas of California. Our hearts go after those affected as many lives have been lost, homes have been destroyed and families have been displaced.

HD supply is again been fortunate that no associates or immediate family members were injured in the devastation. We have seen a modest negative sales impact in November as a result of growth closures and inaccessible parts of the state preventing deliveries. HD supply has assisted both our customers and first responders in these parts of the country during the disasters and we will continue to help during the rebuilding phase. These events are generally mutual for HD supply with initial sales disruption followed by some additional demands during clean up and recovery.

Now turning to Page 5, our view of third quarter results. In terms of highlight, we delivered sales of $1.6 billion, an increase of $242 million or 17.7% over the third quarter of 2017. Our organic sales from that period increased 9.4% of the third quarter of 2017. Our gross margin rate of 39% was down 60 basis points from the third quarter of 2017.

The AH tariff acquisition contributed 40 basis points of [indiscernible] with business mix associated with the strong organic growth throughout construction in industrial business comprised in the remainder of the decline. Adjusted EBITDA for the third quarter of 2018 was $248 million, up $34 million or 15.9%. On Page 6, I will discuss the specific performance of our individual business units in more detail.

Net sales for our facility's maintenance business were $810 million during the third quarter of 2018, up $56 million or 7.4% from the third quarter of 2017. We estimate that the MRO market grew approximately 2% in the third quarter of 2018. Facility's maintenance gross margins were flat form the third quarter of 2017. We continue to see next mixed headwinds in facility's maintenance with a lower margin hospitality vertical and HDAC category growing faster than the remainder of the business.

On a year-to-date basis, our facility's maintenance gross margin rate is up approximately 10 basis points from fiscal 2017. We continue to expect facility's maintenance gross margin rate to be flat, but slightly up through the full year of 2018, and as we previously indicated, flat gross margin from the current environment represents strong performance and highlights our ability to maximize the growth of gross profit dollars. Facility's maintenance adjusted EBITDA for the third quarter of 2018 was $149 million, an increase of $5 million or 3.5% from the third quarter of 2017. As expected, leverage continue to be impacted by the additional investment spend of $3 million and freight and labor cost. We expect SG&A leverage in facility's maintenance to improve in the fourth quarter as cost become easier and we continue to focus on cost containment.

Net sales for our construction and industrial business were $803 million during the third quarter of 2018, up $186 million or 30.1%. On an organic basis, excluding the recently acquired AH tariff business, our construction and industrial business grew 11.8%. We estimate the overall market was up approximately 5% to 6% for the quarter and rebar pricing contributed around 300 basis points of growth. Construction in industrial gross margin decreased approximately 20 basis points. Rebar margins drove 30 basis points of this decline while the mix associated with the acquisition of AH tariff contributed an additional 20 basis points to the decline, partially offset by category management. We are seeing the rebar market begin to stabilize and we expect the unfavorable gross margin impact to lessen over the next few quarters.

Excluding AH tariff and rebar impacts, gross margin rate at construction and industrial increased slightly as the team continues to focus on category management initiatives. Construction and industrials adjusted EBITDA for the third quarter was $99 million, up $29 million or 41.4%. The team was able to leverage SG&A well with EBITDA as the percentage of sale up 1000 basis points.

Turning to Page 7; in the last 12 months, we generated $453 million of free cash flow. During fiscal 2018, we expect to generate approximately $475 million to $500 million of free cash flow. This is adjusted from our previous estimate of $500 million of free cash flow as we are looking at opportunities to bring inventory in early to better-navigate the current tariff environment. Also keep in mind that the original AH tariff's acquisition cost of $380 million was reduced to $362 million as less inventory was delivered and expected upon closing of the transaction.

Business [indiscernible] us to invest in additional inventory for the AH tariff branches. The impact on total cash generation is neutral, but it does result in a lower cash outflow for the acquisition of the business and higher operating investment for inventory. We continue to believe that about $500 million of free cash flow is the correct normalized level of 2018 free cash generation for HD supply. As Joe discussed previously, we executed a series of successful refinancing transactions in the third quarter. We fully regained our $1 billion, 5.75% senior notes due 2024 using cash on hand, borrowings under or revolving credit facility and the issuance of new $750 million 5.38% senior notes due 2026. This refinancing locks in a historically attractive lower interest rate, avoid with the step up at interest of 7% that would otherwise have occurred in April of 2019 and extends the maturity date on the senior unsecured notes to 2026.

Shortly after the new senior unsecured notes offering, we refinanced our existing term loans into an aggregate term loan trench at a reduced interest rate of LIBOR plus 175 basis points. We also set this opportunity to reinvest some of our interest savings into fixing a larger portion of the interest on our outstanding debt. Prior to our refinancing activity, less than 50% of our debt had a fixed interest rate. We entered into an interest rate slop to effectively fix the interest rate on $750 million of our outstanding term loan for the entire five-year term. As a result, today, over 75% of our debt is effectively fixed, reducing our exposure to future increases in interest rates. Our weighted average interest rate is now approximately 5%.

We continue to benefit from our federal net operating leverage [ph] which fully offset our current federal income tax liability. In mid-year 2019, we expect our net operating loss tariff boards to be fully utilized, at which time we will become a regular federal income tax payer. We expect cash taxes next year to be in the range of $40 million to $50 million.

Fiscal year 2020 will be the first year in which we are regular tax payer for the full year. Our expectations through 2020 for annual free cash flow continue to be approximately $500 million despite the change to cash taxes. Our ongoing GAAP tax rate will be approximately 26%. Through November 2018 under our second $500 million share repurchase authorization announced in August of 2017; we have purchased 9.1 million shares of HD supply stock for an average price of $37.81 or a total of approximately $344 million. We have approximately $156 million remaining under this authorization. Including the completion of our initial $500 million share repurchase authorization; we have reduced our outstanding share count by over 12% since the first quarter of 2017. On November 30, 2018, our board of directors authorized an additional $500 million share repurchase program bringing our total unused authorization to $656 million. We will continue to opportunistically repurchase shares in the open market, pursuant to our 10B51 plan.

Our capital allocation strategy remains the same. We will opportunistically deploy capital to the most attractive return opportunities available. These include organic investments in the business [indiscernible] acquisitions and the return of cash to shareholders currently through our existing share repurchase authorization.

On Page 8, we provide third quarter 2018 monthly sales trend performance as well as the 2017 comparable. In August of 2018, we delivered sales of $513 million, an increase in average daily sales of approximately 17.7% versus August of 2017. Organic sales growth in this period was 9.9%. In September 2017, we delivered sales of $481 million, an increase in average daily sales of approximately 19.4% versus September 2017. Organic sales growth from the same period was 10.9%

In October 2018, we delivered sales of $618 million, an increase in average daily sales of approximately 16.3% versus October 2017. Organic sales growth in this period was 7.7%. In both years, there were 27 days in August, 9 days in September and 25 days in October. November 2018, the first month of our fiscal fourth quarter 2018 ended November 25, so we can provide our preliminary sales results.

We will now provide information on November results beyond sales. November sales were approximately $426 million which represents average daily sales growth of approximately 14.6% versus 2017. Organic sales growth from November was 6.8%. Average daily sales growth versus prior year by business was approximately 23.1% for Construction and Industrial and approximately 7% for Facilities Maintenance. Construction and Industrial's organic sales from November was approximately 6.6%.

On Page 9, we share our perspective on our fourth quarter 2018 guidance. We now expect sales to be in the range of $1.375-1.425 billion, adjusted EBITDA to be in the range of $173-183 million, and adjusted net income per diluted share to be in the range of $0.63-0.86. Our adjusted net income per diluted share range assumes a weighted average diluted share count of 180 million as of November 30th, 2018, and does not contemplate additional share repurchases.

As we have shared previously, the fourth quarter of fiscal 2018 includes a 53rd week, which occurs every five or six years. Our guidance includes the impact of the 53rd week and the holiday shift, whereby this year's Christmas Eve and New Year's Eve fall on a Monday. Last year's Christmas Eve and New Year's Eve fell on a Sunday. Our Construction and Industrial business will be closed on Christmas Eve and New Year's Eve, resulting in two fewer selling days during this period. Adjusting for this, the midpoint of our fourth quarter 2018 sales growth and adjusted EBITDA growth are expected to be 12% and 13% respectively.

On Page 10, we update our guidance walk for the full year. We are increasing our 2018 guidance of net sales to now be in the range of $5.976-6.026 billion. Adjusted EBITDA is now expected to be in the range of $857-867 million, and we expect full-year 2018 adjusted net income per diluted share to be in the range of $3.33-3.38. This assumes a fully diluted weighted average share count of $183 million.

On Page 11, we provide our initial end market outlook for 2019. We believe the MRO market will continue to grow approximately 1-2%. Our non-residential construction end market estimate is up low-to-mid-single digits and our residential construction market estimate is up low-to-mid-single digits. These specific estimates imply an approximate 3% growth estimate for HD Supply's end markets in 2019.

On Page 12, we give our initial thoughts around 2019. We expect to generate 300 basis points of sales outgrowth on top of the 3% end market growth estimate. Additionally, we expect to deliver 9-10% adjusted EBITDA growth on a 52-week basis. Free cash flow is expected to be approximately $500 million based on this adjusted EBITDA level, with working capital investment equal to approximately 18% of sales growth, capital expenditures of about 2% of sales, cash interest to be approximately $100-110 million, and cash taxes to be approximately $40-50 million.

On Page 13, we summarize and consolidate our fourth quarter and fiscal year 2018 outlook views. In summary, we are pleased with our performance through the first three quarters of the year. We are focused on a strong finish to fiscal 2018 and we are preparing for a successful fiscal 2019.

Thank you for your continued interest in HD Supply, and Candace, we are now ready for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And, our first question comes from Ryan Merkel of William Blair.

Ryan Merkel

Nice quarter, good one. So, first of all, on the fourth quarter EBITDA guidance, the margins are coming in a little bit weaker than I was expecting. Can you just talk about what the main drivers are there? I'm guessing it's still mix, but maybe just walk through that for us.

Evan Levitt

So, we actually do expect improvement in the Facilities Maintenance operating leverage for the fourth quarter. The fourth quarter does have some noise in it relative to the 53rd week, and particularly, the holiday shift that I mentioned. With Christmas Eve and New Year's Eve falling on a Monday this year versus a Sunday last year, our Construction and Industrial business will be closed those two days, so we've got two fewer selling days in the quarter, where we still have our normal operating expenses for those days related to rent and payroll. Even our Facilities Maintenance business -- those businesses will be open and making deliveries for Facilities Maintenance on those days, but they'll be lighter-volume days.

Ryan Merkel

And then, just to avoid any confusion, can you just confirm what the 2019 EBITDA guidance is? I'm coming up with 9.30-9.40, but just want to confirm that.

Evan Levitt

Ryan, as I said, it's 9% to 10%, and right now, it's more of a framework than official guidance. We'll give specific guidance on the next call, but right now, we're thinking 9% to 10% EBITDA growth off of our 2018 52-week EBITDA, and you can see what the projected 52-week EBITDA is on our guidance walk in the presentation, where we break out the impact of the 53rd week.

Ryan Merkel

And then, lastly, on the price impact of 100 to 150 basis points, when do you think you'll be realizing that? And then, is that a broad-based price increase, or is it more isolated?

Evan Levitt

It's not broad-based. It will be targeted in the products and categories where we see cost increases, and where the market allows and the market moves, so we do expect that 100 to 150 basis points -- and, it's over the next several quarters as it flows through the supply chain.

Operator

And, our next question comes from David Manthey of Baird.

David Manthey

First off, assuming the share repurchase during fiscal '19, as you look to the end of the year, what type of total debt to EBITDA do you feel you'll be at? And, I guess maybe a more generalized question -- you've clearly run with much higher levels of leverage in the past, but what is the range that you're comfortable with today in terms of total debt to EBITDA?

Evan Levitt

So, today, David, we're at about 2.5x debt to EBITDA leverage, which is right at the midpoint of the range that we'd like to remain in, which is 2-3x. We have no issue going to the lower end of that range or the higher end of that range, as our capital allocation strategy is an opportunistic strategy. We buy back stock opportunistically, we're interested in M&A opportunistically, and obviously, we're growing our business and investing in our business organically. Could we go above 3x if the right opportunity presents itself? Yes, we could, with the intent that we would quickly pay down debt to get within that 2-3x range again. And so, we like where we are right now. We do generate a fair amount of cash at the end of the year, and as you've seen, we've been aggressive with our share repurchase program over the last couple of months.

David Manthey

And, given the high percentage of sales that are coming in via the web and the app today, how are you changing your approach to sales and how are salespeople remaining relevant to their customers as their roles have morphed over time?

Joseph DeAngelo

So, the role of our salesperson is actually continuing to increase. With the highly trained, highly technical sales team that we have, we view them as being a truly value-add partner though the process. As an example, we discussed tariffs. This is a team that can go out and partner with our customers on-property to explain what's happening in the market and to help them with their budgets through the course of the year. So, while we do see the transactions moving online in some cases, that partnership and identifying the right products to make sure that the properties run properly is stronger than ever.

Operator

Thank you, and our next question comes from Julian Mitchell, Barclays.

Jason Makishi

Hi guys, this is Jason Makishi on Julian. Just talking about -- referring to the monthly sales deceleration that occurred later in the quarter and in November, you highlighted that particularly in November, there was some of that wildfire impact, but given the continued strength that you've specifically called out in the non-residential end markets, could you talk a little bit more about any other pockets of slowdown that you might have seen and give a little bit more detail around those?

Evan Levitt

So, the month of November, we did see some impact from the wildfires in California as well as wet weather in the Northeast and Midwest, and we think that impacted our November sales for the Construction and Industrial business by about 100 basis points. Also, keep in mind that comps for November were particularly difficult. The comps for November for Construction and Industrial were 16.4%, so if you look at the two-year stack comps that we delivered, we've been delivering pretty consistent in the Construction and Industrial business – 23% to 25% two-year stack comps.

Jason Makishi

And just following up on a previous line of questioning, you mentioned how Facilities Maintenance, you were expecting an improvement in the operating leverage. Could you quantify what you expect that to step up to be, either in the core operating leverage or just the net of all the noise, whichever one is easier to quantify?

Evan Levitt

We don't provide specific guidance by business, but for the last two quarters, as we expected and as we originally planned, the operating leverage for Facilities Maintenance was below 1 for a variety of reasons, including some difficult comps as well as some pressure on freight and labor costs and the continuing $3 million a quarter investment. In the fourth quarter, we do expect to lever the Facilities Maintenance results at 1 or above, and then we expect to continue to improve that in 2019.

Jason Makishi

And is there any sort of similar trajectory of improvement in C&I, or has the performance there been strong enough that you expect it to keep up levels into 2019?

Evan Levitt

We've been pleased with the operating leverage of the Construction and Industrial business throughout the year. Now, again, I will point out that that holiday shift will put some pressure on Construction and Industrial's leverage in the fourth quarter since they will be closed for two days that they were open last year.

Operator

And our next question comes from Evelyn Chow of Goldman Sachs.

Evelyn Chow

Maybe just starting on the tariff impact from 301, helpful to understand the actions you're taking on price. Could you just help us bridge your comments previously, thinking about three quarters of that private label business in FM being produced in China versus what you've shared with us today about the relatively minimal impact from 301?

Evan Levitt

First, Evelyn, we haven't seen a lot of that cost roll through yet because the 301 tariffs went into place at the end of September, so it does take some time for that to roll through the supply chain. As you pointed out, about 75% of our private label product does come from China today. Not all of that is impacted by the Section 301 tariffs -- not even half of that is impacted by the Section 301 tariffs -- so we will see some impact there, but as Brad indicated, our first priority is to offset that increase in tariff through negotiation of better pricing with our partners in our factories in China. So, when you talk about a 10% tariff, the actual cost increase that we will take will be substantially less than 10%, but we do intend to pass along the cost increase that we can't avoid. We tried to quantify that with the 100 to 150 basis points. We think that level of price is sufficient to cover the cost increase that will roll through in the current tariff environment.

Evelyn Chow

Evan, I actually wanted to clarify some remarks you made on FM's EBITDA rate for the quarter. So, if I heard correctly, gross margins in FM were flat. I think EBITDA margins were down about 70 bps. I know the accelerated investments are continuing, but not really increasing year over year, so what else drove the deleverage this quarter?

Evan Levitt

The accelerated investment -- that $3 million is about half of that 70 basis points, and the other half is primarily freight and labor costs, more so labor than freight. We did have a difficult comparison from last year, and we are working on cost containment in both of those areas, but our comparable get easier going forward as well, so we are confident that we will better leverage those results going forward in the fourth quarter and 2019, and I just do want to point out that we did expect this is. This is what we initially planned, this is what we initially guided to back in March, as well as our most recent comments that we made in September.

Evelyn Chow

And maybe just to follow-up on that point, it sounds like SG&A leverage will benefit from some easing comps. What other visibility do you have into improving that, whether it's on wage inflation, freight inflation, or other aspects of the bridge that you're seeing?

Evan Levitt

So, inflation -- we do expect to see some wage inflation and freight inflation continue, but certainly, we're taking actions to offset some of those pressures. Particularly in freight, the most important thing that we can do is optimize our usage of freight by using the lower-cost modes of freight versus the higher-cost. The lowest-cost mode is to use our own delivery, move products on our own trucks, and it's using full truckloads versus partial truckloads versus small parcel, so we're working hard on doing that.

Operator

And, the next question comes from Deane Dray of RBC Capital Markets.

Deane Dray

Just to get some more color on the A.H. Harris coming in with lower inventory. I guess it shouldn't be surprising -- since they were being acquired, they didn't replenish inventory -- but what does this mean for the normalized free cash flow generation of the business? How are you thinking about that in terms of what kind of working capital you've had to put in? What would be normalized?

Evan Levitt

Deane, I think you're referring to my comment that originally, the purchase price for A.H. Harris was $380 million. We actually ended up paying $362 million since less working capital was delivered with the company when we acquired it. That was actually good news for us because it's a cash-neutral event, but then we're able to buy the inventory we want, and it's fresh inventory as we roll into the integration of A.H. Harris. The normalized cash flow for 2018 we think is still around $500 million, and we think we'll still do close to that -- between $475 million to $500 million. Now, we are carrying a little more inventory than we normally would today, and we may carry a little more at the end of the year as we navigate through the tariff environment. We are trying to be as opportunistic as possible with buying inventory and how much we carry, and that will continue as we move through the end of the year and even into 2019, as the tariff environment is fluid

Deane Dray

And then, on the outgrowth expectations for 2019, I'm trying to bridge the excellent outgrowth this quarter because of the accelerated investments. You said it was a 500 basis point outgrowth. How much of that is sustainable in terms of the better sales efforts and so forth? Might there be upside when we think about the opportunities in 2019 on that outgrowth?

Evan Levitt

Our commitment is always 300 basis points of outgrowth. Now, as you pointed out, in the most recent quarter, we've successfully grown faster than that, but we will always continue to try to grow faster than that 300 basis points. We do believe there's more upside to the investments that we've made and are making in the business, but our commitment will remain at 300 basis points of outgrowth, and we always try to do better than that.

Deane Dray

And, just one quick clarification; have you actually changed any suppliers at this point with regard to Chinese exposure, or are you just positioning so if you need to, you can change them?

Joseph DeAngelo

To this point, we have made zero changes to our supplier base.

Operator

And our next question comes from Hamzah Mazari of Macquarie.

Hamzah Mazari

My first question is just on C&I. I know you're not seeing a slowdown right now, but how should we think about detrimental margins in C&I, and specifically, how is that business today different than past cycles? It seems like it's pretty different than the last cycle.

Joseph DeAngelo

Hamzah, this was a business that was primarily a majority residential business, but now it's majority a non-residential business, so that's the first big change. It's also one that John and team have made that basically now is a national business that wasn't a complete national business. Certainly, A.H. Harris was the last piece to be able to make that happen, and when you talk about the strength of those 14 trades, our job is to make those 14 trades ubiquitous across the country and under every roof. So, now you have a repeatable business model that enters into basically a great market backdrop -- non-res versus dependent on res -- and very much focused on how I get all the value-added portions of really big project work. So, it is a very different, much better business than when we went through the downturn with much less commodity content. It had a lot of rebar content in there. Now, it's a specialty rebar business versus a primary rebar business in many cases.

Evan Levitt

And Hamzah, we're still very bullish on the non-residential construction environment. We see the non-residential construction environment buoyed by robust corporate earnings growth, real strong corporate cash flows in large part because of tax reform, high employment, we still have historically low interest rates, and there are tax incentives for corporations to invest. So, we like that backdrop for non-residential construction.

Hamzah Mazari

My follow-up question is just on longer-term free cash flow conversion, it seems like you've been running in the low 50% range. Even if you look out to the '19 guidance and make some assumptions, is that the right run rate for this business long-term, or does that step up given any levers on working capital or investments in FM begin to show greater benefits? We're just trying to think about how this business should be looked at on a free cash flow conversion of adjusted EBITDA if we look at that metric longer-term, or is this low 55% range kind of normal?

Evan Levitt

Hamzah, the way to look at free cash flow is 75% of EBITDA is our target for pre-tax, pre-interest cash flow. So, 75% of EBITDA subtract cash interest, which currently is in that $100-110 million range going forward, and then -- that's cash interest, $100-110 million range going forward -- and then cash taxes. Cash taxes this year -- only about $12 million; that's 2018. 2019, $40 million to $50 million, and then, 2020 and beyond, we'll become a full cash-tax payer. We're looking at probably a 24% to 25% cash tax rate on book earnings.

Operator

And our next question comes from Patrick Baumann of J.P. Morgan.

Patrick Baumann

Maybe following up on Deane's question, that FM sales growth has been really strong versus the market, but you've also said a couple times here that you're in the early stages of realizing the full benefits of all those investments. Is there any way you could give us any color on what full realization would mean? Any pilots you have in specific markets or technologies where you're seeing even more top-line pickup?

Evan Levitt

As we said previously, we're going to keep our commitment to 300 basis points of outgrowth, always trying to do as much as we can. The investments that we're making -- we highlighted a number of those during our Investor Day, and Joe referred to a number of them on the call. First, the dynamic information that we're providing our sales associates through the sales console, so they've got better and better information about their customers and about the products their customers need at their fingertips. The new websites or the new web platforms that are being rolled out make it easier for customers to interact with us and free up our sales folks' time to do more solutions selling, more value-added selling rather than processing transactions for our customers. So, these investments -- we're going to continue to enhance these investments. There is also what we call our sales enablers, which are analytics -- pricing analytics, supply chain improvement so we continue to get our products to our customers faster, more accurately, at lower cost. These are all the investments that we're working on that we do expect to improve our ability to gain share going forward, but as I said, right now, we're going to keep our commitment to 300 basis points of outgrowth.

Patrick Baumann

On the tariffs, you guys talked about an additional 100 to 150 basis points of top-line overtime from price as these work their way through. Is this mostly at FM? Also, as a follow-up to that, given the inventory strategies you alluded to that's impacting free cash this year, will there be any short-term benefit to operating leverage, or how should we think about timing lag related to this stuff?

Evan Levitt

So the 100 to 150 basis point comment on price was relevant to Facilities Maintenance. The Construction and Industrial business is actually seeing quite a bit of price right now -- 300 basis points from tariff-impacted rebar cost increase year over year, which is where their biggest impact is today. Certainly, both businesses are managing through the tariff environment, and we think it is manageable. I'm sorry; I didn't hear the second half of your question.

Patrick Baumann

The inventory strategies you guys talked about as impacting free cash flow for 2018 -- is there going to be any short-term benefit to operating leverage as you take in more of this inventory early, or how should we think about time -- is there any timing lag on price versus cost to keep in mind?

Evan Levitt

Yes, we certainly are being as opportunistic as we can with purchasing inventory and navigating the tariff environment. Our first goal is always to avoid cost increases, whether that means changing our buying or our negotiations, and we do think we can pass along those unavoidable cost increases. As to whether that's additional opportunity for operating leverage, we're certainly going to always -- through our category management initiatives -- try to improve our operating leverage, but at this point, we're still committing to a flat gross margin. We do think flat gross margin -- particularly in this environment now -- is very good performance.

Patrick Baumann

Are your own customers trying to buy ahead of price increases at all?

Evan Levitt

We have not seen that. Most of our customers have very limited storage space, and that's part of the value that we add. We guarantee delivery next-day in local markets for the products that they need that they don't have room to store themselves on-premise.

Patrick Baumann

And then, last one for me, just on C&I, you mentioned the 300 basis points of tariff impact from rebar. How does that play out -- that was in the third quarter, I guess. How does that play out in the fourth quarter? When do you lap those numbers from a rebar price impact to C&I top line perspective?

Evan Levitt

We have seen rebar pricing begin to stabilize, certainly over the last several months. Right now, assuming the prices remain stable, we will lap that in the summer of 2019, with that 300 basis points of outgrowth in sales and 30 basis points of margin compression diminishing between now and the second half of next year.

Operator

And our next question comes from Ryan Cieslak of Northcoast Research.

Ryan Cieslak

The first question I had -- I wanted to go back to the tariff comments, and I know you said that you see limited impact so far to date with some of the costs still having to roll through, but of the costs that actually have rolled through and some of the pricing that you've actually implemented to date related to that, can you just give some colors on how that's flowed through? Has it actually been able to maintain the margin rate on those types of price increases and cost inflation? Secondly, what is your FY19 guidance -- I know it's not really guidance, but more of a framework -- the 9% to 10% EBITDA growth? What is it assuming as it relates to the overall impact from the tariffs?

Bradley Paulsen

I'll take the first half of that question. As I mentioned earlier in the call, real credit to our sales team in partnering with our customers to explain the tariffs, the product-level impact that they would experience at the property, and again, assisting them with their budgets as they plan for 2019. The pass-through has come through in the form of price, and up to this point, we've been able to hold our margin rates, and that's the plan, as we mentioned, moving forward. We'll see what happens with the most recent announcement from this weekend on the 90-day trade truce, if you will. Our teams have been working for months to develop scenario planning around how we would attack that, and again, continued to deliver value back to our customers.

Ryan Cieslak

Okay. And, on the FY19 guidance or framework?

Evan Levitt

Ryan, the 2019 framework assumes the current 10% tariff environment. Obviously, we'll give you an update when we speak next, and when we speak next, we may have an update on what to expect with our tariffs.

Ryan Cieslak

For my follow-up, just going back to the comments with regard to operating leverage with FM, it's actually starting to see that improve in the next couple quarters. I wanted to specifically think about FY19. It seems like you go back and you look at the type of growth you're having right now -- historically, you typically have been able to put up operating leverage within FM above 1.5x. You already have some mix headwinds this year. I think the 53rd week in '18 actually was dragging down on the operating leverage. Is there a path -- again, I'm not looking for specific guidance, but is there a path based on those moving pieces that you can get something, again, at least up to 1.5x, if not more here into fiscal '19?

Evan Levitt

Ryan, it's certainly possible, although I'll tell you we are looking at it from the perspective of that 9% to 10% EBITDA growth. So, we're looking at it as profitable growth of EBITDA and conversion to cash flow versus a specific operating leverage target.

Ryan Cieslak

How about if I ask it this way: What would drive upside to that 9% to 10% growth for you guys?

Evan Levitt

Drive upside to 9% to 10% growth would be additional top-line growth -- so, additional share gain.

Ryan Cieslak

Is there anything incremental as it relates to gross margin initiatives or cost opportunities you see into next year as it relates to the EBITDA growth?

Evan Levitt

Look, I think the better operating leverage in cost initiatives gets us to the 9-10% earnings growth. That's what we're working hard at and work hard at every day. Gross margins -- again, we think flat gross margin is really good performance in this environment, so when you're talking about Facilities Maintenance and you're talking about a 1.5x operating leverage, keep in mind the Facilities Maintenance business is an 18% EBITDA business, so if you're talking about a 1.5x operating leverage, that's a 27% contribution margin. That's a pretty hefty contribution margin for each incremental sales dollar.

Operator

And our final question comes from the line of Nigel Coe [ph] of Wolfe Research.

Unidentified Analyst

I just wanted to touch on 2019 guidance here. When you look at the market growth of about 3%, we have seen ready growth like this year to be mid-single. I think you were projecting that to be low-to-mid-single in '19 for both the businesses. Could you give some color on the markets, like if you go through the horn here, like non-res market, what are you thinking? Should we be on the high side of the low-to-mid or the res on the midpoint of the low end? Thanks.

Evan Levitt

The MRO business is a stable business. We continue to leave that growth at about 1% to 2% rate. On the Construction side, as Joe indicated, we're primarily a non-residential construction shop. We've been growing in that 5% to 6% market rate over the last couple of quarters. We've got it called at low-to-mid-single-digit growth rate. So far this year, the market has been on the high end of that range. Going forward, we're still going to call it as low-to-mid-single-digit growth. That's what we see based on the triangulation of third-party data that we look at -- we use third-party economic forecasts. We look at what our customers and our competitors and our vendors are recording, as well as what they're telling us, and then we survey our own field associates. And so, we do feel good about the market. We think it's a good adaptive market. We don't currently see a slowdown in non-residential construction, but we're going to continue to call it at low-to-mid-single-digit.

On the residential side, I think you've probably seen some folks reporting a slight slowdown in residential construction. That is less impactful to HD Supply than non-residential construction, and certainly less impactful than it's been in the past, but we still see growth in residential construction, even if it's at a bit of a slower pace.

Unidentified Analyst

Just a follow-on here on the investments you guys are making in FM. We have Brad here. I just wanted to run through him -- what kind of cadence are we looking for as we look for the payback of these investments? Going through 2019, are they first-half-loaded, second-half-loaded?

Bradley Paulsen

To echo what Evan shared earlier, this is a continuous process for us. Our investments are really focused on two buckets: Our sales channels and our enabling functions. The conversation we have with ourselves is we've got to make sure every investment we make obviously delivers a great return, but also improves either our customer or associate experience. There is not a single answer to your question. Every investment is a little bit different, but we do have a very high sense of urgency to realize that return as quickly as possible.

Operator

And that concludes our question and answer session for today. I'd like to turn the conference back over to Joseph DeAngelo for closing remarks.

Joseph DeAngelo

Well, thank you for your questions. In summary on Page 15, the team is focused and energized to continue to deliver on our customer, associate, and shareholder promises. Thank you for your continued support and interest in HD Supply.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may all disconnect. Everyone have a great day.