It’s been an eventful couple of months for industrial distributor HD Supply Holdings, Inc.
A recent revised outlook for the balance of fiscal 2019 sent shares moderately lower. This was follow by an announcement that it was splitting up into two separate publicly traded entities.
With the coming split, an aggressive stock buyback program, and insider buying, HD Supply merited further investigation.
Be civilized. Grudges are for Neanderthals.
- Hubert Humphrey
Today we look at a construction/housing-related firm that is splitting into two entities in an attempt to unlock shareholder value. The stock saw a large insider buy in September, prompting analysis. That research follows in the paragraphs below.
Based in Atlanta, Georgia, HD Supply Holdings, Inc. (HDS) is one of the largest industrial distributors in North America. The company leverages its relationships with over 7,000 specialty suppliers to offer over 650,000 SKUs to ~500,000 business customers through its 270 branches and 44 distribution centers in the U.S. and Canada.
HD Supply was founded as Maintenance Warehouse in 1974 and has been a bonanza for investment bankers ever since Home Depot (HD) bought it in 1997. After being integrated with the (then) recently purchased Hughes Supply in 2006, HD Supply was sold to three private equity firms in 2007. It subsequently made its IPO in 2013, raising net proceeds of $1.0 billion at $18 per share.
After simplifying its corporate structure in 2017 with the sale of its Waterworks division to private equity for $2.5 billion, the company announced on September 24, 2019 that it intends to split into two separate publicly traded businesses, each representing the two distinct market sectors in which it specializes: Facilities Maintenance and Construction & Industrial (C&I). HD Supply currently trades near $41 a share and commands a market cap of ~$6.8 billion. The company operates on a fiscal year (FY) ending the Sunday closest to January 31st.
In its six-plus years as a public entity, HD Supply has enjoyed success, with its stock price up ~120%. The company ranked number 3 in sales on Industrial Distribution’s 2018 Big 50 list (behind W.W. Grainger (GWW) and Airgas (OTCPK:AIQUF)). However, citing its two divisions’ market leadership positions, scale, and relative independence from each other owing to a lack of customer and operational overlap, the company has decided to go forward as two independent corporations.
The Facilities Maintenance (a.k.a. maintenance, repair, and operations (MRO)) segment supplies electrical and lighting items, plumbing, kitchen & bathroom cabinets, HVAC products, janitorial supplies, appliances, textiles, water and wastewater treatment products, amongst others, to multifamily, hospitality, and healthcare facilities. This operation is supported by 44 distribution centers and 5,500+ employees, of which 900+ are delivery drivers. It sells primarily through its 1,000+ marketing agents, ecommerce, and print catalogs. MRO was responsible for TTM revenue (ending August 4, 2019) of $3.1 billion and Adj. EBITDA of $556 million (17.7%).
Although the ~$55 billion North American MRO market is highly fragmented, HD Supply’s MRO competes with industry leaders W.W. Grainger, MSC Industrial (MSM), Fastenal (FAST), Watsco (WSO), as well as Home Depot (HD) and Lowe’s (LOW) in-house efforts.
C&I distributes power tools, rebar, ladders, safety equipment, forming and shoring systems, concrete chemicals and many other tools, hardware, and engineered materials to non-residential and residential contractors. It serves its customers through a branch network of 270 locations in 39 states and 6 Canadian provinces run by 5,500+ employees. This segment accounted for TTM revenue (ending August 4, 2019) of $3.0 billion and Adj. EBITDA of $326 million (10.8%).
Like MRO, C&I competes in a fragmented market (valued at ~$30 billion) with large players such as Fastenal (FAST), MSC Industrial, as well as the in-house divisions of Home Depot and Lowe’s.
2QFY19 Results and FY19 Outlook
HD Supply’s 2QFY19 results and FY19 revised outlook provide some insight into the impetus for the breakup.
On September 10, 2019, the company reported 2QFY19 Adj. Net Income of $1.08 per share on revenue of $1.62 billion compared to 2QFY18 Adj. Net Income of $0.99 a share on revenue of $1.60 billion, representing 9.1% and 1.5% increases, respectively. These metrics were in line with Street expectations. Also, 2QFY19 Adj. EBITDA dropped $2 million to $244 million and 40 basis points to 15.0% as a percentage of net sales versus the prior-year period.
From a business unit perspective, MRO generated 2QFY19 Adj. EBITDA of $149 million on revenue of $830 million, representing a $1 million decrease from and a $10 million increase (+1.2%) over the prior-year period, respectively. As a percentage of revenue, Adj. EBITDA dropped 30 basis points to 18.0% versus 2QFY18.
C&I generated 2QFY19 Adj. EBITDA of $95 million on revenue of $795 million, representing a $1 million decrease from and a $14 million increase (+1.8%) over the prior-year period, respectively. Adj. EBTIDA margin dropped 40 basis points from 12.3% to 11.9%.
Even though these numbers were in line with Street consensus, the company blamed an automation issue at its Atlanta distribution facility - allegedly now fixed - and cooler weather (i.e., less HVAC sales) for the "meh" performance of the MRO segment and the non-beat overall.
The real disappointment came when the company revised its outlook for the balance of FY19. HD Supply lowered its FY19 Adj. EPS guidance 2% from $3.61 to $3.53 and its revenue guidance 2% from $6.3 billion to $6.15 billion, based on range midpoints. Citing slower growth in the non-residential market due to a dearth of skilled construction workers, a reduction in year-over-year housing starts, and tariffs possibly compressing margins, management was compelled to make these downward revisions.
On the back of this news, shares of HDS drifted 7% lower over the subsequent two weeks. Then came the announcement of the split.
The rationale for the separation (besides what was offered in the press release) is two-fold. One motivation is to unlock the value of the Facilities Maintenance division, which generates a higher EBITDA margin (~18% versus ~11%) on a steadier revenue stream than its more cyclical C&I counterpart. Management believes that investors are assigning a more cyclical (i.e., lower) multiple to the entire company because of C&I. The revised outlook was a case in point: it was based on business cycle (or C&I) concerns (save tariffs), whereas the reason offered for not beating 2QFY19 consensus was based on temporary phenomena (a facility issue and weather) in the otherwise more consistent MRO segment.
The second reason is to create two companies that could be takeover targets for other players in their respective industrial distribution segments. For example, with HD Supply’s MRO separated from C&I, it may become more appealing to a pure-play MRO like Grainger.
The separation is scheduled to take place in mid-FY20, with both companies maintaining headquarters in Atlanta. Both balance sheets are expected to carry high, non-investment grade credit ratings. Facilities Maintenance will retain the HD Supply name, CEO, CFO and CAO. C&I will have a to-be-determined moniker, with its current president ascending to the CEO role.
Balance Sheet and Analyst Opinion
The current combined entity has ~$2.1 billion of debt and a leverage ratio (net debt/TTM Adj. EBITDA) of 2.4x. HD Supply generates plenty of free cash flow ($562 million for the TTM ending August 4, 2019) but does not pay a dividend. Instead, HD Supply has been an aggressive buyer of its own stock, acquiring ~18.7 million shares over the past two years (since August 2017), and has ~$300 million remaining under its current authorization.
Between its downwardly revised outlook and separation news, there was plenty of analyst commentary on HD Supply during September 2019 - the majority of it negative. Four downgrades - two after earnings and two after the breakup announcement - hit in short order. Today, SunTrust Robinson posted the first analyst commentary since late September. They reiterated a Buy rating but lowered their price target a buck a share to $49.
In addition to the board’s incessant repurchasing, one of its members, Lauren Taylor Wolfe, representing the interests of activist investor Impactive Capital, purchased 600,000 shares on September 27, 2019, which is a ~$23 million stake in HD Supply.
News of the split has bumped shares slightly higher, but all the analyst negativity has kept a lid on any optimism to date. Using crude back-of-the-envelope calculations, W.W. Grainger, which resembles HD Supply’s MRO division, currently trades at 18.2x 2019E Adj. EPS of $17.58 . HD Supply currently trades at 12x its FY19E Adj. EPS of $3.51. Considering MRO is responsible for 63% of the Adj. EBITDA line at HD Supply - owing to its higher margins - assigning a Grainger multiple to its share of the Adj. EPS (18.2 x ($3.51 x 63%)) would value this segment at below the current level of the stock, with the C&I tossed in for free as well.
It remains to be seen if the MRO valuation (or any buyouts) will come to pass, but the above exercise demonstrates that there is likely more upside than downside in shares of HD Supply. With solid cash flow and an aggressive share buyback plan in place, this is a reasonable name for those who want more exposure to this space. Although it could take some time for value to be realized, obviously analysts have not bought into the shares being substantially undervalued yet, even as one insider apparently believe it is so.
However, I already have several similar holdings in my portfolio, such as Builders FirstSource (BLDR), whose value I find more compelling. Therefore, I am passing on any recommendation on HDS Supply at this time.
A talent for forgetting is necessary to maintain civility.”
- Matthew De Abaitua, "If Then"
Bret Jensen is the Founder of and authors articles for the Biotech Forum, Busted IPO Forum, and Insiders Forum
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Disclosure: I am/we are long BLDR. 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.