HD Supply Holdings, Inc. (HDS) CEO Joseph DeAngelo on Q4 2018 Results - Earnings Call Transcript

About: HD Supply Holdings, Inc. (HDS)
by: SA Transcripts
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Earning Call Audio

HD Supply Holdings, Inc. (NASDAQ:HDS) Q4 2018 Results Earnings Conference Call March 19, 2019 8:00 AM ET

Company Participants

Charlotte McLaughlin - IR

Joseph DeAngelo - CEO

Evan Levitt - CFO

Conference Call Participants

Jason Makishi - Barclays

Deane Dray - RBC Capital Markets

Ryan Merkel - William Blair

Evelyn Chow - Goldman Sachs

Patrick Baumann - JPMorgan

David Manthey - Baird

Robert Barry - The Buckingham Research

Mario Cortellacci - Macquarie

John Inch - Gordon Haskett


Good day, ladies and gentlemen and welcome to the HD Supply Fourth Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. [Operator Instructions]. As a reminder, this call is being recorded.

I would now like to introduce your host for today's conference, Charlotte McLaughlin, Investor Relations. Please go ahead.

Charlotte McLaughlin

Thank you, Christie. Good morning, ladies and gentlemen, and welcome to the HD Supply Holdings 2018 fourth quarter and fiscal year-end 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 to update these statements. Reconciliations of certain non-GAAP financial metrics with their corresponding GAAP measures are available at the end of our slide presentation and in our 2018 fourth quarter and fiscal year-end earnings release, both of which are available on our IR website at www.hdsupply.com.

Joe DeAngelo, our CEO will lead today's call; while Evan Levitt, our CFO will provide additional color on our recent financial performance and our expectations for 2019. There will be an opportunity for Q&A at the end of the call. 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 now turn over the call over to Joe DeAngelo.

Joseph DeAngelo

Well, thank you, Charlotte. Good morning, everyone. Thank you for joining us today for our 2018 fourth quarter and fiscal year-end earnings call. As always it's my privilege to share our company's results with you, on behalf of the 11,500 HD Supply associates who work hard every day, as one team, driving customer success and value creation.

I'm extremely proud of our team and the performance in 2018. We outperformed on our top-line throughout 2018 by taking advantage of favorable market conditions and focused execution. We delivered strong profitable growth and enhanced the capabilities of both businesses throughout the year.

Turning to Page 3, I will begin by discussing our fourth quarter and full year 2018 performance. We delivered 22% sales growth for the fourth quarter of fiscal 2018 and a 7% sales growth on an organic basis excluding the impact of the A.H. Harris acquisition, and net of the change in selling days. We estimate that this represents growth of approximately 400 basis points in excess of market.

Our earnings performance continued to be substantial. We saw 23% adjusted EBITDA growth while generating strong free cash flow. In the fourth quarter, we completed our second share repurchase authorization and began to utilize our third repurchase authorization announced in December. And we'll discuss this in more detail later.

For the full year, we delivered 18% sales growth or 9% on an organic basis, net of the change in selling days. We estimate that this represents growth of approximately 500 to 600 basis points in excess of market. Our adjusted EBITDA grew 19% versus prior year.

On Page 4, we highlight our core 2018 achievements. I will begin by discussing Facilities Maintenance which demonstrated strong performance in 2018. The fourth quarter of 2018 was the final quarter for accelerated investment program. And we believe we are in the early stages of seeing the returns from these investments.

During the quarter, we rolled out our new Facilities Maintenance website, which now offers customers more streamlined interface for interacting with HD Supply. We listen attentively to the voice of our customer. Regularly releasing improvements to our website which becomes even easier to do business with.

2018 also saw the release of our new sales console which provides our field associates with dynamic customer and product data, deepening our ability to be helpful and collaborative with our customers, and provide the best solutions for their specific needs. We will continue to enhance the sales console, enabling our sales associates to problem solve with our customers, ensuring their success.

Other notable full service features of our Facilities Maintenance business include our property improvement business, which provides a compelling service to our customers, enabling them to not only maintain but also renovate their investment properties over their life cycle.

I would like to congratulate Brad Paulsen and his team on a great performance. And I look forward to an even better 2019. I am pleased to announce that in 2019 we'll be opening our new Atlanta distribution center. At over 1 million square feet, this will be our largest, most advanced distribution center, supporting our continued growth and enabling us to improve our already best-in-class customer service not only in Atlanta but also throughout the Southeast. This new facility will showcase our new technologies and provide a blueprint for best practice across the wider network.

Moving to our Construction & Industrial business unit, John Stegeman and his team continued to gain market share throughout the year while integrating the A.H. Harris acquisition which is now substantially complete. The realization of anticipated synergies is on track and we look forward to accelerating growth with HD Supply’s high performance, high growth sales culture.

I couldn't be more pleased with the enthusiasm and hard work of our associates as we complete this integration.

81% of our core C&I white cap ranges are now performing at a double-digit EBITDA rate of 3 percentage points versus prior year. 67 of our C&I white cap ranges including a number of the acquired A.H. Harris locations, now at in-store contractor purchases, making up 40% or more of their sales, generating higher gross margins at a lower cost to serve and keeping them connected with our loyal customer base. In some of our best performing districts, we saw year-over-year core sales growth exceeding 16%.

Additionally, we opened three new locations in priority districts, New York City, Los Angeles and San Diego. 2018 was another great year for our Construction & Industrial business.

Turning to our capital market accomplishments, 2018 saw us refinance our debt obligations, reducing the cost of our debt, extending maturities and fixing the interest rate on close to 70% of our outstanding debt to reduce our sensitivity to future interest rate changes.

Across our business, we continue to deploy capital, the highest return opportunities available. During the fourth quarter of 2018, financial markets were extremely volatile, and the stock market declined significantly.

As we indicated previously, we executed share repurchase program on an opportunistic basis and accelerated our repurchase activities in the fourth quarter. We've repurchased nearly 11 million shares of our outstanding stock in the fourth quarter, bringing our total purchases for the year to 15.5 million shares.

Additionally, we believe that quality M&A is a key value creation lever and we will continue to opportunistically pursue acquisitions with compelling value. Also, we held our first Investor Day in our Atlanta Leadership Development Center. And I was proud to share our strategy, execution, winning culture, and most importantly, our talented frontline and support associates with the investment community.

To summarize our overall full year 2018 performance, we delivered 18% sales growth or 9% organic growth net of the change in selling days, 19% adjusted EBITDA growth and 47% adjusted net income per diluted share growth versus 2017. Our strategic execution delivered sales growth in excess of our market estimate of approximately 500 basis points for 2018 and that translated into double-digit earnings growth.

We also delivered $469 million of free cash flow in 2018 and finished the year with net debt-to-adjusted EBITDA ratio of 2.6 times. Despite the slow start to 2019 impacted by harsh February weather, we remain confident and look forward to continuing to deliver strong results in 2019 as we focus on our customer success within our market leading businesses.

I'm proud of the performance of each of our 11,500 HD Supply associates who work hard every day to deliver on our promises to our customers, fellow associates and shareholders.

I will provide some closing comments following Q&A. We'll now turn the call over to Evan.

Evan Levitt

Thank you, Joe. And good morning, everyone. I'll begin on Page 5 where we highlight areas of recent investor focus. First is winter weather. As we’ve stated in the past, weather can have a significant impact on our results as unusually cold, wet and wintery weather can impact outdoor construction activities and our ability to safely deliver products.

This February, the first month of our fiscal 2019, we saw significant parts of the country experience unusually severe weather, including significant rain throughout California and cold and wintery weather with snow and ice in areas such as the Pacific Northwest, the Midwest, and the Northeast, which significantly impacted our Construction & Industrial business.

February is historically our lowest volume month of the year, and therefore, the effect of weather disruptions can have a magnified impact on the monthly sales growth rates.

As the weather improves and we have the opportunity to deliver to job sites, our sales performance will normalize. We remain confident on delivering a strong 2019.

Next is the construction end market. The non-residential construction markets continue to be productive with many existing large multi-billion dollar multi-year projects continuing and several large new projects either in the planning stage or having recently been announced. Areas of particular strength include airports, sports and entertainment complexes, road and bridge work, data centers and distribution centers. These large projects typically spur additional developments and complementary projects in the surrounding areas for years to come and give us confidence that the non-residential construction end market remains strong.

We saw a modest slow down in the pace of residential construction in the fourth quarter as an uncertain interest rate environment led to moderating activity from homebuilders and home affordability continued to be an issue.

As a reminder, about 20% to 25% of our Construction & Industrial business serves customers working on residential construction projects, particularly on the West Coast and Southeast portions of the United States.

Next, the competitive environment. We've not seen a significant change to the competitive environment, which remains intense. As the largest scaled national distributor, focused on the MRO living space market, and by far the largest national distributor for specialty construction projects serving 14 trades, we have a unique understanding of our customers' needs, defined execution strategies and a clear focus free of distractions to improve and evolve the customer experience and to extend our service differentiation.

Next, the tariff environment. As we've previously indicated, the current tariff environment is manageable. As with any increase to our costs, we work hard to offset as much as the cost as possible through supplier negotiations and productivity. Where we are unable to offset cost increases, we do adjust our pricing to pass along the cost increase as markets allow.

We've been dealing with increasing costs in steel rebar since tariffs were first introduced in 2017. We've been successful in passing along all of the cost increases through pricing and earning the same or slightly more gross margin dollars for each unit sold. However, we've been unable to pass along enough of a price increase to maintain our gross margin rate on rebar.

In recent months, rebar pricing has stabilized but the year-over-year cost is still up about 10%. We expect gross margin pressures from rebar to moderate through the first half of 2019.

The 10% Section 301 tariffs that were imposed on Chinese imports in late 2018 have now been in place for several months. As we intended we have offset much of this cost through negotiations and productivity and have raised prices to recover the unavoidable increases in costs. We've seen our competitors take similar actions, and overall, the market is responding well.

Capital allocation. During fiscal 2017, six months earlier than projected, we normalized our capital structure within our targeted 2 to 3 times net debt-to-adjusted EBITDA leverage range. Since that time, we have and expect to continue to generate substantial free cash flow that we are committed to allocating towards the highest return investments. Those investments include organic investments in our business, M&A opportunities and returning cash to shareholders currently through our share repurchase programs.

During the fiscal 2018, we accelerated approximately $12 million of investment in our Facilities Maintenance business. We acquired A.H. Harris Construction Supplies for $362 million, and we repurchased 15.5 million shares of our outstanding common stock for a total price of $585 million for an average price of $37.78 per share. Approximately 70% of the fiscal 2018 share repurchases or $406 million was completed during the recent market downturn in the fourth quarter of fiscal 2018.

Now, before we review the fourth quarter results on Page 6, I'd like to remind you that the fourth quarter of fiscal 2018 contains an extra week as compared to fiscal 2017. This extra week occurs within our fiscal calendar once every five or six years. Also during the fourth quarter of fiscal 2018, we experienced a holiday calendar shift whereby Christmas Eve and New Year's Eve fell on a Monday. In fiscal 2017, Christmas Eve and New Year's Eve fell on a Sunday. Our Construction & Industrial business was closed on Christmas Eve and New Year's Eve in fiscal 2018, resulting in two fewer selling days. Facilities Maintenance was open but experienced lower volume than normal. We refer to the extra week in fiscal 2018, net of these impacts of our Construction & Industrial business closing for Christmas and New Year's eves as the change in net selling days.

Now in terms of fourth quarter highlights, we delivered sales of $1.446 billion, an increase of $263 million or 22.2% over the fourth quarter of 2017. Our organic sales during the fourth quarter, adjusted for net selling days, increased 7.4% over the fourth quarter of 2017.

Gross profit increased $104 million or 22.2% to $572 million. Our gross margin rate of 39.6% was flat compared with the fourth quarter of fiscal 2017. The A.H. Harris acquisition had an unfavorable impact to gross margin rate of approximately 40 basis points.

Adjusted EBITDA for the fourth quarter of 2018 was $187 million, up $35 million or 23%. Adjusted EBITDA as a percentage of sales for the fourth quarter was 12.9%, up 10 basis points over the prior year.

Turning to Page 7, we review the full year of fiscal 2018. Net sales grew to $6.47 billion, an increase of $926 million or 18.1% versus fiscal 2017. Our organic sales adjusted for net selling days grew 9.2% over fiscal 2017. Gross profit increased $342 million or 17% versus prior year.

As a percent of net sales, our gross margin rate was 39.3%, a decrease of 40 basis points versus 2017. The A.H. Harris acquisition and rebar pricing unfavorably impacted gross margin rate by 40 basis points and 10 basis points respectively.

Adjusted EBITDA for the full year of fiscal 2018 was $871 million, up $140 million or 19.2%, up 10 basis points versus 2017.

On Page 8, I will discuss the specific performance of each of our individual business units in more detail.

Net sales for our Facilities Maintenance business was $736 million during the fourth quarter of 2018, up $94 million or 14.6% from the fourth quarter of 2017. On a 13-week basis, net sales increased 6.4% over the fourth quarter of fiscal 2017.

We estimate that the MRO market grew approximately 2% in the fourth quarter of 2018.

For fiscal year 2018, revenue for Facilities Maintenance was $3.089 billion, up to $242 million or 8.5%. On a 52-week basis, net sales increased 6.6% over fiscal year 2017. We estimate that the MRO market grew approximately 2% for the full year of 2018.

Facilities Maintenance gross margin improved 80 basis points in the fourth quarter of 2018 from the fourth quarter of 2017, reflecting strong category management performance and favorable business mix, led by our multi-family vertical.

For the full year 2018, our Facilities Maintenance gross margin rate is up approximately 40 basis points from fiscal year 2017. This improvement is on the high-end of our expectations and reflects exceptional execution by our category management team. As we've said in the past, we believe a flat gross margin in this environment is strong performance.

Facilities Maintenance adjusted EBITDA for the fourth quarter of 2018 was $124 million, an increase of $22 million or 21.6% from the fourth quarter of 2017. As a percent of sales, adjusted EBITDA in the fourth quarter of fiscal 2018 was 16.8%, an improvement of 90 basis points.

For the full year of fiscal 2018, adjusted EBITDA was $546 million, up $47 million or 9.4%. Adjusted EBITDA as a percent of sales for the full year of fiscal 2018 was 17.7%, an improvement of 20 basis points.

Net sales for our Construction & Industrial business were $711 million during the fourth quarter of 2018, up $169 million or 31.2%. On an organic basis, adjusted for net selling days, our Construction & Industrial business grew 8.5%. We estimate the overall market was up approximately 4% for the quarter.

For fiscal year 2018, revenue for Construction & Industrial was $2.961 billion, up $682 million or 29.9%. On an organic basis, adjusted for net selling days, our Construction & Industrial business grew 12.4%. We estimate the Construction & Industrial market was up approximately 500 basis points for the year.

During the fourth quarter and full year of fiscal 2018, Construction & Industrial's gross margin declined approximately 40 basis points and 50 basis points respectively. In both periods, the acquisition of A.H. Harris unfavorably impacted gross margin by 30 basis points and rebar unfavorably impacted gross margin by 20 basis points.

Construction & Industrial's adjusted EBITDA for the fourth quarter was $63 million, up $13 million or 26%. Adjusted EBITDA as a percent of sales for the fourth quarter of fiscal 2018 was 8.9%, down 30 basis points from the fourth quarter of 2017.

As expected, Construction & Industrial results were unfavorably impacted by the holiday shift and resulting closures of branches on Christmas Eve and New Year's Eve. For the full year, adjusted EBITDA was $325 million, up $93 million or 40.1% Adjusted EBITDA as a percent of sales for the full year of fiscal 2018 was 11%, up 80 basis points from fiscal 2017.

Turning to Page 9, during the fiscal year 2018, we generated $469 million of free cash flow. Free cash flow was impacted by the reduction in purchase price of A.H. Harris from the original contracted price of $380 million to $362 million because of less working capital being delivered at closing and targeted. The short fall in working capital was released by the purchase of additional inventory after acquisition.

Cash flow was also impacted by the decision to carry some additional inventory at year-end buying around tariffs and the Chinese New Year. We invested $36 million in capital expenditures in the fourth quarter of 2018 and $115 million or approximately 1.9% of sales for the full year of fiscal 2018.

We estimate our ongoing annual capital expenditure requirements to be approximately 2% of annual sales.

During fiscal year 2018, we paid cash taxes of approximately $13 million, primarily associated with the Canadian taxes and US State taxes. We will continue to benefit from our federal net operating loss carryforwards, which along with other federal tax credits, are expected to fully offset our federal income tax liability through the first half of 2019.

Around mid-year 2019, we expect our net operating loss carryforwards and other federal income tax credits to be fully utilized, at which time we will become a regular federal income tax payer. We currently expect to pay about $65 million to $75 million in income taxes during fiscal year 2019.

Fiscal 2020 will be the first year in which we are a regular taxpayer for the full year. Our expectations through 2020 for annual free cash flow continue to be in excess of $500 million despite becoming a regular cash taxpayer. Our ongoing GAAP tax rate will be approximately 26%.

As I previously indicated, during the fiscal 2018, we've repurchased 15.5 million shares of common stock for a total of $585 million at an average price of $37.78. Approximately 70% of the repurchases were $406 million, and 10.8 million shares were repurchased during the fourth quarter. We had approximately $375 million remaining under this authorization at the end of fiscal 2018.

Including the completion of our two previous $500 million share repurchase authorizations, we've reduced our outstanding share count by over 16% since the first quarter of 2017. We will continue to opportunistically repurchase shares.

As of the end of fiscal 2018, our net debt-to-adjusted EBITDA leverage was 2.6 times, comfortably within our targeted range of 2 to 3 times.

On Page 10 we provide fourth quarter 2018 monthly sales trend performance as well as the 2017 comparable. In November 2018, we delivered sales of $426 million, an increase in average daily sales of approximately 14% versus November 2017. Organic sales growth in the same period was 6.8%.

In December 2018, we delivered sales of $455 million, an increase in average daily sales of approximately 16.7% versus December 2017. Organic sales growth in the same period was 9.5%.

In January 2019 we delivered sales of $565 million, an increase in average daily sales of approximately 10.3% versus January 2018. Organic sales growth net of selling days was 4.3%. In both years, there were 18 selling days in November and 27 days in December. There were 28 selling days in January 2019 compared to 23 in January 2018 because of the additional week.

February 2019, which ended March 3rd was the first month of our fiscal first quarter 2019 and we have provided our preliminary sales results. We will not provide information on February results beyond sales.

February sales were approximately $423 million, which represents average daily sales growth of approximately 8.1% versus 2018. Organic sales growth for February was 2.2%. Average daily sales growth versus prior year by business was approximately 6% for Facilities Maintenance and approximately 10.5% for Construction & Industrial. Construction & Industrial’s organic sales for February contracted approximately 2.4%.

As I shared, February sales were unfavorably impacted by wet and wintry weather, particularly in our Construction & Industrial business. Approximately one-third of our Construction & Industrial business is done in the State of California.

On last year's fourth quarter earnings call, we shared that dry conditions in California helped us achieve a 17% growth rate in February 2018. By contrast, in February 2019, the Los Angeles market received rain equal to 40% of its normal total annual rainfall. And the San Francisco area received nearly 40% more rainfall than normal and more than 10 times the amount experienced one year ago.

This year's wet weather along with unusually severe winter weather in the Pacific Northwest, and parts of the Midwest and Northeast contributed to the week February sales. We remain confident in the strength of our construction markets as geographies not impacted by severe weather, such as the Southeast, continued to perform in-line with our expectations.

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

On Page 12 we introduce our guidance log for the full year of 2019. We believe net sales will be in the range of $6,300 million to $6,450 million. Our sales guide begins by subtracting the sales from the extra week in 2018 before building on our 2% to 3% end market growth estimate and market outperformance in excess of our 300 basis point long-term commitment. This translates to a 7% growth rate at the midpoint adjusted for the impact of the 53rd week in fiscal 2018.

We expect adjusted EBITDA to be in the range of $900 million to $950 million. This reflects an 8% growth at the midpoint adjusted for the impact of the 53rd week in fiscal 2018. We also expect full year 2019 adjusted net income per diluted share to be in the range of $3.52 and $3.81. This assumes a fully diluted weighted average share count of $171 million and does not contemplate additional share repurchases.

Our business continues to generate significant free cash flow. In fiscal 2019, despite the increase in cash tax payments as we exhaust our federal net operating loss carryforwards, we estimate free cash flow to be around $550 million.

On Page 13, we share a perspective on our first quarter 2019 guidance. We expect sales to be in the range of $1.465 billion, and $1.515 billion; adjusted EBITDA to be in the range of $192 million and $207 million and adjusted net income per diluted share to be in the range of $0.75 and $0.84.

Our adjusted net income per diluted share range assumes a weighted average diluted share count of 171 million and does not contemplate additional share repurchases. The midpoint of our first quarter 2019 sales growth and adjusted EBITDA growth rates are expected to be 7% and 5% respectively.

On Page 14, we summarize and consolidate our first quarter and fiscal year 2019 outlook views. In summary, we saw strong performance from our teams throughout fiscal 2018 and are now preparing for a successful fiscal 2019.

Thank you for your continued interest in HD Supply. And I'd like to turn the call over to Christie for questions.

Question-and-Answer Session


Thank you. [Operator Instructions]. Our first question is from Julian Mitchell with Barclays. Your line is open.

Jason Makishi

Hi guys. This is Makishi on for Julian. Just looking at the demand backdrop as we sort of head past the Q1 into the back half of the year. How do you think about demand particularly in the residential and construction markets heading into the back half of the year? And does the guidance bake in sort of the significant moderation as you get sort of less visibility out there? I guess what I'm trying to ask, is there any conservatism embedded in here or is this sort of the demand visibility as you have it?

Evan Levitt

Yes, so the guidance that we provided is the best information we have to-date. We did reduce our expectations slightly for the residential construction market. We previously expected that market to grow low to mid single-digits, we're now expecting that market to be flat to up low-single-digits, and that is fully reflected in the guidance. We saw a slight slowdown in the fourth quarter as interest rates crept up. Now interest rates have come down again and growth rates have dropped again, so we'll see whether that spurs further demand in the residential construction market. Homebuilders’ sentiment improved a bit over the last month or two. So we'll see if that translates to a stronger residential construction market.

Keep in mind, residential construction is about 20% to 25% of our Construction & Industrial business. We're really more non-residential construction shop. But we do have some exposure to residential, particularly in California and in the Southeast part of the United States. And we've also increased our guidance range you may have noticed for the full year from $40 million to $50 million, reflecting some of that uncertainty we see in the market place.

Jason Makishi

Understood. And just on the back of that, the EBITDA guidance, could you just talk to any sort of dynamics as you've seen them evolve in terms of operating leverage, particularly on around the Facilities Maintenance business, anything that you've seen as to call out as a tailwind or a headwind that might change, how you’re thinking about these targets?

Evan Levitt

Yes, look, we certainly expect to grow the business profitably. And when we say grow the business profitably that means to continually expand our EBITDA margins. So we did that in 2018, particularly in Facilities Maintenance in the fourth quarter. We were very pleased with that. There will be some variations based on product mix and vertical mix as we grow our business. But we do expect to continue to expand EBITDA margins. And that's reflected in the guidance as well.


Thank you. And our next question is from Deane Dray with RBC Capital Markets. Your line is open.

Deane Dray

Thank you. Good morning, everyone. Hey, I also want to welcome back Charlotte and congrats on her little baby boy.

Charlotte McLaughlin

Thank you, Deane.

Deane Dray

Hey. First question, just to clarify on the February weather event. So we've been through this before. Your expectation on C&I to do a catch-up here. You guys are not in the restaurant business where if you miss a snow day, people will go back and eat two meals. But for C&I, these projects just go into a catch up, is there -- is that the expectation here you'll see over time and how quickly does it typically catch-up?

Evan Levitt

Yes, so Deane we typically do catch-up some of what we lost but some gets just pushed indefinitely. In the construction industry there's only so many daylight hours in the day. So there's only so much work that can be done in any given day, certainly our customers will try to catch-up to the extent possible and we will be there serving them to assist them in any way we can which in some regards create some incremental costs for us as well in terms of overtime, running additional truck routes, so it just put a little pressure on our SG&A rate as we work hard to stay in lockstep with our customers. So there will be a little bit of catch-up which is reflected in the guidance for the balance of the first quarter. And some of the missed time, when you have as much rain in California as we had, some of that just delays projects and everything gets pushed a bit. So I guess the answer to your question is, some slight catch-up and some project push.

Deane Dray

Great. That's the color I was looking for. And then on the wind down on the investment spending, how are you measuring the returns? It looks like you starting to get that, the type of returns both on the website, app that is being accessed. And so how do you measure that? And then what is -- as you ramp down what's the normalized spend in this area so we get a sense of what that delta is? Thank you.

Evan Levitt

Yes. So first on the return on our investment. We internally monitor each individual project that we're investing in and measure its success, and each project has key metrics that we watch, whether it's clicks on the website, conversion of a cart in the website through an order or sales through certain a sales channel. So we watch that project-by-project and work hard to make sure that we get the return that we originally expected. And if not, we'll go back and understand why and work that project if appropriate to realize that return.

Now the returns we're getting on those projects project-by-project also inform where we're going to invest in the future. So where we're seeing good returns, those are areas where we'll continue to invest and continue to work with the customer in understanding what they're looking for, and improve their customer experience in areas where we may be falling short in an investment or areas where we’ll limit our investments going forward.

So that is a very important part of our investment strategy. And I agree with you, we are starting to see some of those benefits. And we think we're in the early stages of seeing some of those benefits.

Now in terms of how much we invest on an ongoing basis and the normal run rate, I think we're at that normal run rate now. So that additional $12 million that we invested last year we don't get that back because that's now baked into our normal SG&A run rate and much of that cost was the cost of additional talent and licensing fees for certain technologies that we acquired. So those costs will continue into the future, but we don't need to step them up again. So the guidance and the SG&A rate and being able to leverage SG&A as we grow is something that’s important to us and we think we've got the right investment cadence now.


Thank you. Our next question is from Ryan Merkel with William Blair. Your line is open.

Ryan Merkel

So my first question is on the first quarter EBITDA guidance 4%, 5% growth. Can you just give us some details on why margins look to be lower in both segments?

Evan Levitt

Yes, good question. And it’s what I alluded to previously. When you do catch-up -- when you are in catch-up phase, you do incur additional costs for overtime contract labor and other incremental costs to ensure that we're available to serve our customers as they try to catch-up.

Now, in addition to that in the month of February, with C&I having sales contracted, when you have a contraction that's not expected, you've got the SG&A cost that you've incurred in the expectation of a normal quarter. So we don't get a lot of warning that it's going to be a rainy month. So we're fully staffed, we're ready to serve the customer. And when the job sites aren’t open because they're flooded or because of significant rain, we incur that incremental costs without the sales. So it does put pressure on our SG&A rate, it’s only temporary but it does put pressure on it.

Ryan Merkel

Got it. So just to summarize, it sounds like it's mostly in the C&I business impacting the first quarter and the FM business for margins is looking a little better, probably some expansion year-over-year. Is that fair?

Joseph DeAngelo

Yes. That is a fair assumption, yes

Ryan Merkel

Okay, great. And then on the FM organic growth, again, really solid performance. Can you just give us some details on the sources of growth, either by geography or initiative or products?

Joseph DeAngelo

Yes. We're seeing strong growth across the country and in particular in the Facilities Maintenance business in the fourth quarter. We were very pleased with our multi-family vertical. Now the multi-family business was strong, that also contributed to the strong margin performance in the fourth quarter. The multi-family vertical is a stronger margin vertical than say hospitality. So normally when we talk about headwinds we talk about hospitality grow faster than multi-family. Multi-family had a strong quarter. So we were very pleased with that.


Thank you. Next question is from Evelyn Chow with Goldman Sachs. Your line is open.

Evelyn Chow

Just returning to the FM operating leverage and margin performance in the fourth quarter; obviously great to see. Maybe just to clarify one aspect, I know mix has been a headwind for you in the earlier part of the year and you called out strengthened mix in 4Q. Beyond multi-family being strong, is there anything else driving that? And secondly, for fiscal '19, would you expect that mix continues to be a positive?

Evan Levitt

The other mix there Evelyn that benefited us in the fourth quarter was property improvement which we call out as a headwind in quarters two and three. Property improvement grew about the same as the company, slightly less. And so property improvement is a lower margin category or a lower margin business as well. And so that improved our performance on overall margins.

Also keep in mind in the fourth quarter property improvement is out of season, so the big seasons for property improvement are the second quarter and the third quarter generally over the summer months when folks are moving. So it’s always lighter in the fourth quarter but didn't grow -- it grew but not as quickly as the balance of the business. And that business also is going to be a little more uneven in the core business just because it's project based. So as those projects come we have a big property improvement quarter when we’re anniversarying a big project, quarter will have a light property improvement quarter. So that'll be a little uneven.

Evelyn Chow

That all make sense, Evan. And then maybe just trying to non-res, it sounds like outside of the splits in February you feel pretty good about the end market and you’re starting a number of areas where projects continue to be strong. It’s a little at odds with the Dodge data we have been seeing where I think in the past three or four months, it's actually been down year-over-year. So I wanted just to get a little bit more context from what you're seeing to give you that confidence in the strength?

Evan Levitt

Yes, there's certainly mixed data point out there, when you look at the economic data. And so we look at all those data points as well. And as you said, the top Dodge data has been a little weak. If you look at the construction put in place data for non-res that’s been published by the US Census Bureau, it's been quite good. So there is that that variance in third-party data. Like I said, we look at it all as well as having conversations with our vendors and our customers. But the best data that we get surveying on our own people in each of our markets in which we operate and we see a lot of product -- a lot of project activity. There's half a dozen major airport expansions and renovations occurring across the country, multiple large sports and entertainment complexes or stadiums being built, datacenters and distribution centers, corporate headquarters. So these are all big projects that as I said in the prepared remarks, not only do we get the benefit of those big projects, but we get the benefit of all the small projects and the construction activity that occurs around those areas of development. So we feel good about the non-residential construction market.

Joseph DeAngelo

Yes, we had World Concrete at the end of January, and I had the opportunity to meet with hundreds of customers, suppliers, hundreds of our own associates, and universally the non-res construction markets for all 15 priority districts look very solid.


Thank you. Our next question is from Patrick Baumann with JPMorgan. Your line is open.

Patrick Baumann

A couple -- maybe I'll just start off on the free cash flow guide for '19 which looked a little bit better than you are expecting. Is there anything unusual to highlight for the year along the lines of the dynamics you talked about impacting 2018, any pluses or minuses to highlight?

Evan Levitt

The only thing or unusual item or new item is becoming a cash taxpayer. So we now expect to pay $65 million to $75 million in cash taxes in 2019 versus $13 million that we paid in 2018. So that, that is certainly a headwind. But some of the framework we've given in the past on free cash flow is to take EBITDA subtract cash interest, which call it $105 million, $110 million, subtract 2% of sales for CapEx, $65 million to $75 million in taxes. And then we estimate about 18% of sales growth for working capital investment. And that should get you pretty close.

Patrick Baumann

Okay, so nothing along the lines of the puts and takes that were unusual for '18 that are going to impact ‘19 apart from those.

Evan Levitt

No other impact.

Patrick Baumann

Yes, fair enough. In terms of your gross margin outlook for '19, should I assume you continue to view stable as the benchmark? And just along those lines, how do you think pricing is going to develop for the year, what your expectations are?

Evan Levitt

We still continue to believe that a flat gross margin is good performance, that's our target. If we can we can make out 10 basis points here and there of improvement, that's great. If we go backwards by 10 or 20 basis points in any given quarter, that's not unexpected either. And in terms of the pricing environment as I shared we did take up some prices reflecting some increases in cost inputs that we saw late in 2018. We'll continue to monitor the market, continue to manage our costs and the expectation is that we have additional cost increases. We work hard to offset them and then we'll pass along anything we can’t offset in price as the market allows. And as of now looks like our competitors are taking a similar approach.

Patrick Baumann

Got it. And then just last one for me. In terms of C&I, a bunch of questions on this already, but -- so down 2% in February. It looks like, for total company, you're still expecting mid-single-digit organic growth for the quarter. And I guess I'm just wondering what kind of visibility you have to have or what gives you confidence that you can pick back up to kind of get there after the weather impacted the C&I business in Feb?

Evan Levitt

Yes obviously the guide reflects an improved March and April. And that's our expectation based on improving weather and the break of spring. So -- and what gives us the confidence in that is the areas where we've not seen significantly bad weather like the Southeast, like from the Texas markets, our growth and very good very much in line with our expectations in our recent trends.


Thank you. Our next question is from David Manthey with Baird. Your line is open.

David Manthey

First off, could you put a finer point on the price increases? Evan, what are your expectations for each of the two segments?

Evan Levitt

So for Facilities Maintenance, like I said, we did institute some price increases, not overly significant, I'd say it'd be less than a 100 basis points worth of price increases on total company. But we look at it very methodically category-by-category, SKU-by-SKU, looking at where we're priced relative to where the competition is priced, relative to any cost pressures we see and price appropriately to remain competitive and to continue to ensure that, that we're providing compelling value to the customer. We think we can do that and maintain gross margins.

On the Construction & Industrial basis, a little different business for Construction & Industrial since it’s a bid-based business. So every bid is different and every bid is very competitive. So we have to stay priced sharp in order to win those bids. And then we work hard to maintain and develop relationships with our contractors to get them to visit us, to get them to come into our branch locations where we can sell them the consumables for the job, the saw blades, to drill bits, the work gloves, the things that keep the job running that aren't necessarily bid and tend to have a little higher margin. So we do think flat gross margins in this environment is good and we do think we can execute on that.

David Manthey

Okay. So it sounds like low single-digit should be the expectation there may be in both segments?

Evan Levitt

For price increases?

David Manthey


Evan Levitt

I'd say that, that would be on the highest -- that'd be higher than our expectation.

David Manthey

Flat to low single-digits?

Evan Levitt

Flat to low single-digits is fine, yes.

David Manthey

Got it. Okay. And then on the new distribution center, could you talk about the financial dynamics there, is that leased or owned and how does the operating costs, depreciation whatever flow through the P&L here in fiscal '19? And then if you could also talk about the working capital drain. I would assume there'll be a ramp up of inventory there and how does that look on the balance sheet this year?

Evan Levitt

Yeah, so all good questions. So first in terms of the structure of that facility, that is a long-term operating lease. So we generally like to lease those large facilities with 10 to 20 year leases and then options beyond that period so that we control the facility for quite some time as it is a big investment for us. And so that rolls through the P&L as rent expense. As far as our investment in facility in terms of leasehold improvements, racking equipment, that is part of the CapEx, the 2% CapEx -- or 2% of sales for CapEx that I shared. And that gets depreciated for book purposes over the life of the asset. For tax purposes some of that can be depreciated immediately and deducted on our 2019 return. Some of it gets deferred and is depreciated over time for tax purposes.

As far as rent expense, it does put a little pressure on rent expense. Any time that we move into a new larger facilities like that or renew a lease on a long-term facility, we typically see an increase in rent. And the accounting rules are such that the -- we expense the average rent over the initial lease term. So if it's a 10 year lease, even if it's got rent escalations over the course of the year, you expense the average rental costs for that 10 year period each year. So that when you renew it 10 years later, you're getting a step up to market value 10 years later. And so that does put some pressure on rent expense, and it’s baked into the guidance, but those are those are costs that we have to overcome as we grow and that's not unique for 2019. That happens every year.

David Manthey

Okay. And then the working capital drain, anything you can discuss there?

Evan Levitt

Yes, so the working capital, as we move into that facility and open that facility, we may carry slightly more inventory for a short period. But actually over time, we hope that that gives us the ability to reduce working capital. By better managing inventory not only in Atlanta throughout the Southeast, as we were in line hauls between Atlanta and several other smaller markets in the Southeast enables us to be a little more efficient with our inventory and the additional space.


Thank you. Our next question is from Robert Barry with Buckingham Research. Your line is open.

Robert Barry

Congrats on the solid finish to the year. So back in 3Q you were talking about EBITDA growing a 9% to 10% and now it's growing 8%. I think the math is maybe like $12 million less. Is that all to weather in February or is there other factors affecting that?

Evan Levitt

Yes, less so. It's the slow start to the year in February, and the weather, and obviously you can see the guide for Q1 reflects that as well. And we could take the resi construction market expectation down slightly. But then we -- as you -- as we also talked about, we brought into the range for EBITDA, we're certainly not giving up on that 9% to 10%, we are going to work hard for it. But we're calling it the way we see it right now and midpoint is our best expectation.

Robert Barry

Got it. And do you have an estimate for how much weather impacted growth in Feb?

Evan Levitt

Yes, so we think in our Construction & Industrial in the month of February, probably $14 million to $15 million is what our expectation is for -- just for C&I.

Robert Barry

And any in FM?

Evan Levitt

At FM it would be minimal. But we did have some disruptions, particularly in markets like Seattle where we saw significant hikes and couldn’t run trucks. But generally we were able to catch-up pretty well. So while it may have had a modest impact it’s not something that we specifically call out.

Robert Barry

Got it. Just lastly, could you just say what -- if you put aside rebar, what price cost was in the quarter? And maybe just differentiate between kind of pure price versus product cost and more broadly pricing productivity versus inflation, freight, labor, et cetera? Thank you.

Evan Levitt

So excluding rebar and A.H. Harris, our gross margins for the total company would have been about flat up to about 10 basis -- I think up 10 basis points is where we have landed for the year. So price and costs pretty well balanced outside of a A.H. Harris, which is more of a mix issue than anything else. And the rebar exposure which is diminishing as we start to anniversary that increasing costs.


Thank you. Our next question is from Hamzah Mazari with Macquarie. Your line is open.

Mario Cortellacci

Hi, guys. This is actually Mario Cortellacci calling in for Hamzah, how are you?

Joseph DeAngelo

Good. How are you?

Mario Cortellacci

Just quick on your FM business, can you give us a sense as the business is different structurally versus prior cycles? Maybe, for example, it gets more critical mass and starting verticals or maybe you're using more data or maybe you have a tighter go-to-market strategy? Just try to see if there's any changes versus prior cycles and maybe what that looks like longer term as well.

Evan Levitt

Well certainly we've got better visibility into the market to our customers and better use of data. We're able to evaluate our pricing relative to the markets and our competitors on a near daily basis by SKU. That is something new over the last couple years. We previously did not have that. Now as the business grows our hospitality vertical is bigger than it was in the past. That’s a newer vertical for us. And so that we continue to grow shares in that vertical faster than in our multi-family vertical.

And beyond that I think the business is pretty similar to where it was in the past. Obviously we're making it better all the time. We're getting closer to our customers and understanding our customer better. Our proprietary brand penetration is a little higher. But -- that's how I would view it.

Joseph DeAngelo

Look, I think structurally the business is the same. I mean we are the leader in the space and we'll continue to expand that leadership via customer experience and now we have a steady state year of investment that we can look forward to kind of forever and we'll just continuously invest that and making sure that we create a customer experience, an extended competitive advantage. So it's going to be a pretty simple story going forward.

Mario Cortellacci

Got it. And then just a quick question on the potential China trade deal. Does that end up being a positive for you? Or because of the work that you've done in managing to the tariff situation, does it end up just being a net neutral if we do get a trade deal?

Evan Levitt

Yes. We're comfortable operating in any environment that that comes at us. We believe we're being the largest in both of our markets that we've got the ability to properly source and price product best for our customer segment. And we can be nimble. So we're not afraid of any environment -- we'll react to it as it occurs. Current environment quite frankly is just fine. We're very pleased with it and are happy to compete and execute in this environment.


Thank you. Our last question is from John Inch with Gordon Haskett. Your line is open.

John Inch

Good morning guys and Charlotte, congratulations. So if these tariffs come off for whatever reason in the future, how does that work? Do you guys have to ultimately reverse and take prices down? Or do you think you can kind of just keep it absorbed like what's your expectation?

Evan Levitt

Yes, so John, as I shared, the price increases we've taken so far, less than a 100 basis points on the total business. So it's not overly significant. And then it all depends on the market and other cost pressures as well, right? The tariffs of one component of cost. We do see other components of costs and beginning to rise as we appear to be entering a more inflationary environment. And over the last month or two of data that's come out has indicated that maybe the inflation fears have been overblown, but I think there's still some inflation out in the marketplace. And so it all depends on the market. As I said, we've got the ability now to be monitoring price SKU-by-SKU where we're priced relative to our competitors. And we're going to remain competitively priced. And we'll offer compelling value to our customers at whatever price that is. So I wouldn't assume that prices come down if tariffs roll off. That could be the outcome. It all depends on other cost inputs and the market dynamics.

John Inch

Yes. And what competitors do. That's fair. Facilities Maintenance core growth in Jan stepped down 6 points. And I'm curious do you guys think that there might have been some pre-buying in December? Did you observe that in the FM business? I'm not quite sure what the context of that would be, but maybe to get ahead of some of the anticipated cost increases or maybe not, I'm not sure. Just what do you think the dynamics were kind of December through January in Facilities Maintenance?

Evan Levitt

Yes, so just December and January, always difficult to measure because of the holiday period. So if you look back historically, we've got significant move between December and January. And so oftentimes, what we'll do is we'll combine the two and look at them combined at the holiday period. So this year, in particular, January was a tough year because of the holiday shift. So Christmas Eve, and New Year's Eve on a Monday this year, Facilities Maintenance was open to making deliveries, but as you can imagine business was light on Christmas Eve and New Year's Eve falling on a Monday. Last year Christmas Eve and New Year's Eve fell on a Sunday, so everybody was closed anyway. So we have had some pretty significant holiday shift. And keep in mind for our fiscal calendar both the Christmas and New Year's eves fell in fiscal January. So that's kind of some of the dynamics around the holidays, while oftentimes, we'll look at December and January together.

Joseph DeAngelo

But John, we did not see anything abnormal relative to folks rushing to buy in the calendar year.

We just didn't see anything like.

John Inch

Well, that would make sense. So I wouldn't understand the context of FM pre-buying. Just lastly, I wanted to go back to the point that someone raised about sort of the mix. I think, Evan, you even said the non-resi stats were mixed. And, it's always easy to look at the positive for non-resi stats versus the more mixed ones or negative ones. And I think you gave a good read on your own customer stat. Maybe you can flush that out a little bit, sort of the pipeline of activity, maybe talk a little bit about like what's book-to-bill and how long do these projects go on for if you never booked any other projects, that mean do you have a two year run ahead of you? Or what gives you the confidence to not be a little bit more cautious at this point in the cycle when debatably there might be a little bit of peaking going on in the macro?

Evan Levitt

Yes so John hard to answer, because some projects do have a two or three year run, others are six months. So certainly as the further out you go right, the less build that you have. But we don't see the slowdown in the activity. We've got the airport in Chicago, O'Hare, hasn't even begun yet. That's an $8.5 billion project over the next eight years. Sea-Tac in Seattle, that project is still in the planning stage. That's going to be a multi-billion dollar project. We've got corporate headquarters that have been announced in the Washington area, significant investments in New York and Austin from some of the big tech players. And these are all just recent announcements, work that is just now beginning or have not yet begun.


Thank you. And that does conclude our Q&A session for today. I'd like to turn the call back over to Mr. Joe DeAngelo for any further remarks.

Joseph DeAngelo

Well, great. Well, thank you for your questions. In summary, on Page 16, 2018 was a fantastic year. The team is focused and energized to continue to deliver for our customers, associates, shareholders and communities. Thank you for your continued support of HD Supply.


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