HDS May Consolidate Before It Springs Into Action

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About: HD Supply (HDS)
by: Badsha Chowdhury
Summary

HDS’s primary value drivers are stable-to-strong.

Recent tariff hike increases costs, which is driving up prices for its offerings.

The company is investing in a technology-based distribution channel.

Strong shareholder returns through share repurchase programs.

Revenue and margin may fall in Q4, but look to recover in 2019.

HDS: Short term versus long term

HD Supply Holdings (HDS) distributes industrial distributors to the contractors, maintenance professionals, homebuilders, industrial businesses, and government entities in North America. I expect the low unemployment rate and foreclosure rate to push HDS’s sales growth in 2019 unless the economy is hit by unforeseen events. The current headwinds for HDS are the tariff hike-linked cost inflation, which can erode its operating margin in the near term.

Some geographic regions in the U.S. witnessed weak new home construction in the past years, which can result in lower revenues in the short term. I expect limited upside in HDS’s stock price given these challenges but should consolidate and strengthen in the medium to long run. In the past year, HD Supply’s stock price has gone down by 5%, while the SPDR S&P 500 ETF (SPY) declined by nearly 8%.

What are the facets of HDS’s business?

HD Supply Holdings’ primary activities include providing construction, maintenance, repair and operations (or MRO) and specialty construction services. Through the Facilities Maintenance business unit, it serves multifamily, hospitality, healthcare, and institutional customers. These facilities typically require maintenance as well as repair and remodeling activities. Its business model is distribution center-based. The MRO-based business provides stable demand, particularly in a challenging economic environment, when new construction tends to decrease. So, it demands we throw some light on the construction market – the primary driver in this segment.

According to data provided by the U.S. Census Bureau, new privately-owned housing units increased 6.2% in 2017 from 2016. The number of units was relatively weak until August 2018 but has improved since then until November. According to edzarenski.com, non-residential buildings construction spending is expected to remain muted in 2019, increasing by 0.4% compared to 2018. In 2020, it is likely to grow by 9.4%. Residential construction spending for 2018 was recently revised down and starts for 2019 are expected flat to down slightly.

The multi-year downturn in the homebuilding industry has resulted in a substantial reduction in demand for HDS’s products and services. During this period, the mortgage markets experienced disruption and reduced availability of mortgages for potential homebuyers due to more restrictive standards to qualify for mortgages.

This, in turn, has had a significant adverse effect on HDS’s business and operating results during fiscal years 2008 to 2017. Although the housing construction market is exhibiting improvement, it was still below 51% in 2017 compared to its 2005 peak, according to HDS’s FY2017 10-K. On the positive side, HDS’s customer base is extensive. It has ~5,000 customers, which reduces its reliance on any significant customer.

Multi-year low unemployment rate to drive sales

The key factors that have historically affected the housing and construction market, and can continue to influence it, include higher unemployment levels, mortgage delinquency and foreclosure rates, mortgage availability issue, home improvement financing, and lower housing turnover. In 2018, U.S. unemployment has seen the lowest rates since 2008, according to data provided by the U.S. Bureau of Labour Statistics.

According to Atom Data Solutions, the U.S. foreclosure activity in Q3 2018 was 36% below the pre-recession average between Q1 2006 and Q3 2007. This indicates foreclosure risk associated with the problem mortgages has faded. Lender repossession of properties in the U.S. dropped to record lows in Q3 2018, down 24% from Q2 and down 8% from Q3 2017. So, with improved construction market, low unemployment rate and significantly low foreclosure rates, the medium-to-long-term industry drivers for HDS are robust.

In the U.S., HDS’s Construction & Industrial segment serves the U.S. market through the branch distribution network and its branches in Canada. In March 2018, HDS acquired A.H. Harris Construction Supplies, a leading specialty construction distributor. The acquisition expanded HDS's market presence in the northeastern United States.

New growth initiatives

On top of its traditional sales force-based delivery model, HDS has also adopted technology-based sales push including e-commerce site and mobile application, supply chain, and data analytics. Although investment in this category is at the early stage, such new investments resulted in 5% sales growth more than the market in Q3. The company’s management expects the FY2019 capital expenditure to be ~2% of FY2019 sales (1.7% in 9M 2018), which suggests it plans to invest in new channels of distribution.

What are HDS’s current drivers?

In Q3 2018, HDS’s revenues from Facilities Maintenance increased by 7% year over year. The segment EBITDA margin, however, decreased by a couple of percentages during the same period. The Construction and industrial segment revenues increased by 30% over the previous year. The increases were primarily due to increases in market volume, HDS’s various growth initiatives, and the acquisition of A.H. Harris. Organic sales growth was $129 million or 9.4% for Q3 2018 as compared to 9.8% a year ago.

The Facilities Maintenance segment accounted for 50% of HDS’s Q3 2018 revenues, while the Construction and industrial segment accounted for the rest 50%. In Q3, the EBITDA margin from the Facilities Maintenance segment was ~18%, while the Construction and industrial segment EBITDA margin were lower (~12%).

What are HDS’s future growth opportunities and its headwinds?

HDS sees strong long-term internal growth opportunities in construction and industrial business unit in the major airport renovations, development of new sports and entertainment complexes, corporate headquarters, data centers, and distribution centers. The company also anticipates non-residential construction end market remaining strong across HDS’s 15 priority districts. The U.S. Census Bureau’s data shows that from November 2017 to November 2018, new privately-owned housing unit growth was the highest in the southern regions among the four geographic regions, clocking a 7.3% rise. On top of that, the A.H. Harris integration was scheduled to be completed in FY 2018, which should add to the performance growth chart.

On the other hand, HDS’s MRO business is likely to see a decline in the coming quarters. In Q3 2018, revenues from the MRO business, which falls under its Facilities Maintenance segment, grew ~2%. The negative growth driver in the MRO business lies in the lower margin hospitality vertical. Partially offsetting this would be the fast growth in the HVAC (Heating Ventilation and Air Conditioning) category.

Which way is the company’s pricing moving?

In Q3 2018, as the economic indicators show a sign of improvements, HDS has gradually started to make price escalations. Its management believes that the current tariff environment will allow the company to maintain gross margin. When tariff-related costs increase, HDS typically passes it along to its customers with a small mark-up to offset the overall loss in margin.

In March 2018, the U.S. imposed Section 232, which meant a 25% tariff on all steel imports and 10% on all aluminum imports into the U.S. The sanction impacts all carbon products, including pipe, fittings, and flanges. In July, Section 301 tariffs have been put into place. On construction spending, the effect of the steel tariff increase may cause average construction inflation of 4.25% to 5.5%.

For the construction and industrial business, rebar cost bears the most considerable tariff impact. This rebar price increase contributed almost 3% sales growth for the Construction and Industrial business segment in Q3 2018. In effect, the overall loss in gross margin was arrested within a 0.3% margin. HDS’s management sees signs of stabilizations in the rebar market and expects the year-over-year impact to diminish over the next few quarters. In the Q3 earnings conference call, HDS’s management commented the following,

“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.”

Management guidance for Q4, FY 2018, and FY 2019

Q4 2018 guidance: HD Supply’s management expects Q4 2018 revenues to be in the range of $1.375 billion-$1.425 billion, which would be 13% lower compared to Q3 at the guidance midpoint. The company’s adjusted EBITDA is expected to be in the range of $173 million-$183 million, which would be ~28% lower compared to its Q3 adjusted EBITDA. HDS’s Q4 adjusted earnings are expected to be in the range of $0.63-$0.86.

FY2018 guidance: HD Supply’s management expects FY 2018 revenues to be in the range of $5.976 billion-$6.026 billion, which would be 17% higher compared to FY2017 at the guidance midpoint. The company’s adjusted EBITDA is expected to be in the range of $857 million-$867 million, which would be ~18% higher compared to its FY2017 adjusted EBITDA. HDS’s FY2018 adjusted earnings are expected to be in the range of $3.33-$3.38.

FY 2019 guidance: In FY2019, the management expects ~3% growth for HDS’s end market compared to FY2018. This is based on an MRO market grow of ~1%-2%, non-residential construction end market growth of low-to-mid-single percentages, and residential construction market growth of low-to-mid-single percentages.

On top of the end-market growth, the company expects FY2019 revenues to exceed FY2018 revenues by 3%. It also plans to deliver 9%-10% adjusted EBITDA growth. Free cash flow is expected to be approximately $500 million.

HDS’s debt level is manageable

In the past three quarters of 2018, HDS generated $126 million in cash flow from operations (or CFO). In 2018, the company added to its inventory, which it found economically meaningful given the higher input cost based on the increased tariff. It may continue to do so in 2019 if the tariff environment remains volatile.

In October, HDS replaced $1 billion of old debt which was set to redeem in October with the proceeds from the new debt issuance as well as from its revolving credit facility. Again, in October, it refinanced two term loans with maturity dates in 2021 and 2023 with a new loan of $1.07 billion with a maturity date in 2023. As of October 28, 2018, HDS’s total liquidity was $920 million. As a result of the refinancing, 75% of HDS’s debt is effectively fixed, reducing its exposure to future increases in interest rates.

In the past three quarters of 2018, HDS has spent $79 million in capex. On November 30, 2018, the company’s Board authorized a new share repurchase program of $500 million of its common stock. Investors may note that HDS has already been repurchasing shares since August 2017 under a $500 million share buyback plan. With the available liquidity (cash balance and revolving credit facility), and at the current cash flow generation run rate plus no debt repayment obligations in the near term, HDS does not have short-term financial risks. But, its debt-to-equity ratio (1.35x) is higher than its competitors’ average (0.75x). Its competitors include Fastenal Company (FAST), WESCO International (WCC), and DXP Enterprises (DXPE).

HDS’s indebtedness can increase further if it finds inorganic growth opportunities. In the Q3 2018 earnings conference call, the company’s management commented,

“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.”

Stable management: Joseph J. DeAngelo has been serving as HDS’s CEO since 2005. He is also the Chairman of HDS’s board. Evan Levitt has been its CFO since December 2013.

What does HDS’s relative valuation say?

HDS is currently trading at an EV to adjusted EBITDA multiple of ~9.8x. Based on sell-side analysts’ estimates in the next four quarters, as pulled from Thomson Reuters, HDS’s forward EV/EBITDA multiple is lower, which implies higher EBITDA in the next four quarters. Between FY2013 and FY 2018, HDS’s EV/EBITDA multiple was 13.6x. So, HDS is currently trading at a discount to its past six-year average.

HDS’s forward EV to EBITDA multiple contraction versus its adjusted trailing twelve months EV/EBITDA is less steep than the industry peers’ average multiple compression, as noted in the table above. This is because HDS is expected to improve EBITDA less sharply compared to the rise in the peers’ average in the next four quarters. This would typically reflect in a lower current EV/EBITDA multiple compared to the peers’ average. HDS’s TTM EV/EBITDA multiple is lower than its peers’ (FAST, DXPE, and WCC) average of 10.5x.

Analysts’ rating on HDS

According to data provided by Seeking Alpha, 13 sell-side analysts rated HDS a “buy” in January, while five of the sell-side analysts rated HDS a “hold.” None of them rated HDS a “sell.” The analysts’ consensus target price for HDS is $47.3, which at HDS’s current price yields ~26% returns.

What’s the take on HDS?

HDS’s primary value drivers are going strong. While the new privately-owned house units have started to steady, the low unemployment rate and foreclosure rate should pave the way for sharper growth in HDS’s sales in 2019, unless the economy is hit by unforeseen events. The A.H. Harris integration, once complete, should also lead to a top-level and operating margin expansion for HDS. HDS’s cash flow is steady, and its debt level is manageable.

The headwinds for HDS are the tariff hike-linked cost inflation, which can erode its operating margin in the near term. Also, when the higher cost is passed on to customers with higher pricing, HDS’s customers may turn to lower-priced offerings from its competitors. Geographically, the U.S. midwest and west regions witnessed weak new home construction in the past years, which can result in lower revenues in the near term. I expect HDS’s stock price to remain stable, or can get slightly weak from the current level given the near-term challenges, but should consolidate and strengthen in 2019 as the economic drivers get stronger.

Disclosure: I/we 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.