We See Growth Building for HD Supply

We think it is an exciting time for

HD Supply traces its roots to Maintenance Warehouse, a maintenance product distribution company founded in 1974. Over the subsequent two decades, Maintenance Warehouse continued to grow and Home Depot eventually acquired it in 1997. In 2007, Home Depot sold HD Supply to private equity investors for $10.3 billion. After operating under private equity ownership for over five years and amassing a significant amount of debt, HD Supply completed its initial public offering in 2013. Since the IPO, HD Supply’s management team has kept a steadfast focus on repairing the balance sheet and has significantly reduced the debt load. On Aug. 1, 2017, HD Supply completed the sale of its $2.6 billion Waterworks segment for a net $2.4 billion. The company intends to use a portion of the proceeds to pay down approximately $2 billion of debt, which will allow it to reach its targeted gross debt/EBITDA ratio of below 3 times. It also purchased $500 million worth of shares and authorized an additional $500 million buyback program.

HD Supply has become one of the largest industrial distributors in North America. It is the market leader in facilities and home improvement maintenance, repair, and operations, water infrastructure, and specialty construction. The company has successfully capitalized on its scale and expanding network of customers and suppliers to consistently grow faster than its end markets. We see a continued growth story for HD Supply over at least the next five years as the company continues to execute its growth strategies to expand its presence in its strengthening end markets. The company’s growth playbook consists of introducing new products and services, increasing customer wallet share, expanding its sales channels and geographic footprint, and increasing its already robust network of customers and suppliers. HD Supply’s free cash flow generation has been improving, and with a rightsized balance sheet, we think the company’s true free cash flow potential will shine through.

Scale and Strong Network Drive Narrow Moat Product distribution can be a tough business; low barriers to entry combined with customer and supplier bargaining power can erode returns on invested capital for industry players. Despite these competitive pressures, HD Supply's superior scale and ability to monetize its strong network of customers and suppliers have allowed the company to earn excess returns, and we expect it to maintain its competitive advantages over at least the next 10 years. As a result, we award HD Supply a narrow economic moat rating, supported by scale-driven cost advantages and a network effect. We believe that both of HD Supply's businesses--facilities maintenance and construction and industrial--benefit from these competitive advantages.

As one of the largest industrial distributors in North America, HD Supply benefits from scale-driven cost advantages over smaller competitors, in our view. Given the amount of product volume it sells, HD Supply is able to take advantage of volume-based rebates and other sales incentives to lower its cost of goods sold and support superior gross profit margins.

HD Supply’s efficient North American distribution network is another source of scale-driven cost advantages. The company uses its scale and technology to cost-effectively compete on the local level across a wide geographic footprint. We believe HD Supply’s technological capabilities, including its e-commerce sales channel, integrated customer workflow solutions, and warehouse automation, drive distribution efficiencies that would be difficult for smaller competitors to replicate. HD Supply’s ability to efficiently provide high-touch services on the local level drives improved customer satisfaction and customer retention.

About 14% of facilities maintenance sales are generated from higher-margin private-label product sales, which compares favorably with wide-moat Fastenal FAST (12%) but lags narrow-moat W.W. Grainger GWW (22% of U.S. sales). HD Supply has a goal to increase private-label sales to over 20% of total sales, which represents a nice margin expansion opportunity. Since private-label brands boost profit margins, we believe distributors that offer such products have a cost advantage over those that do not sell private-label brands.

We believe HD Supply’s product selection and availability, combined with its value-added services, offer customers unmatched convenience and support, which helps strengthen existing customer relationships and win new business. HD Supply’s value-added services include customer training, advanced product and product application knowledge, product fabrication, kitting, onsite inventory management, emergency response, and quick and convenient product delivery options. With its large and expanding customer base and a proven ability to grow faster than its underlying markets, product suppliers see HD Supply as a preferred distribution partner. HD Supply uses its reputation with suppliers and its scale to expand its vendor base and product selection, take advantage of sales incentives and volume rebates, and gain preferential access to supplier training programs and support. These positive attributes allow HD Supply to offer its customers better product selection, pricing, and services. As a key middleman that provides a valuable service to both customers and suppliers, HD Supply has leveraged its market-leading position to create a virtuous cycle, allowing it to sustainably grow faster than its markets.

HD Supply has also proved its ability to monetize its network. We calculate that its average sales per customer has outpaced its customer growth. Since 2013, HD Supply’s average sales per customer increased at over a 3% compound annual growth rate, from $12,800 per customer to $14,000 per customer, while its customer count has grown at a 2% CAGR.

The types of customers served and the level of convenience desired can have a profound impact on product profitability and helps explain the margin differential between HD Supply’s businesses. The facilities maintenance business primarily serves maintenance professionals that require quick and convenient product delivery to address oftentimes unplanned facility issues in a timely manner. Because these end users desire a high level of convenience and probably do not have the time to shop around, the facilities maintenance business is able to charge a nice premium and generates higher returns.

The C&I business primarily serves more price-conscious construction contractors that typically win jobs through a bidding process. During the bidding process, contractors are looking for the most cost-effective solutions, but once construction begins, contractors are focused on completing the job on time and are therefore looking for quick and convenient access to necessary supplies. HD Supply works with contractors to construct a winning bid, which we think can pressure margins; however, once the job is won, HD Supply can provide contractors with frequently replenished consumable products throughout the construction process, which typically have better margins. This segment also utilizes a branch network that attracts higher-margin walk-in business, which drives better segment profitability. In addition, of HD Supply’s businesses, C&I has the least amount of capital deployed (due to limited goodwill) which supports better returns on invested capital.

Leverage Elevated but Improving Although HD Supply's management team has done an excellent job shedding debt over the past couple of years, leverage remains elevated relative to other public industrial distributors. These concerns should subside now that the company has completed the sale of its Waterworks business and will use the proceeds to pay down $1.9 billion of debt.

Some industry observers have speculated that the emergence of Amazon AMZN in industrial distribution is the beginning of the end for many incumbent distributors. Although we think the threat should not be taken lightly, Amazon’s decision to hold low or no inventory and its inability to easily replicate HD Supply’s product expertise and high-touch service offerings will prevent Amazon from gaining significant share in the most profitable industrial distribution segments.

Increased customer and/or supplier bargaining power due to disintermediation and consolidation could have a negative impact on HD Supply’s profitability. However, we think HD Supply has a relatively diverse customer and supplier base that damps bargaining power. HD Supply has approximately 530,000 customers, and the top 10 account for less than 8% of consolidated sales. The company has 9,000 suppliers and seeks multiple vendors for each of the products it carries.

HD Supply’s financial performance is affected by cyclical downturns. Still, the facilities maintenance business offers stability, which can counterbalance the company’s exposure to more cyclical commercial and residential construction markets.