Description

Trade recommendation: long HD Supply (HDS) common equity with 20-40% upside near-term and strong long-term growth prospects. 

Summary:

HDS is trading cheap to its peers but has more end-markets at cyclical lows, potentially leading to repressed demand snapping back. The Co has long-term ability to increase market share in an unconsolidated market, is the market leader in most of its business lines (scale), and has a base business that is a-cyclical. 

Investment thesis:

HD Supply (HDS) is an industrial distributor trading at ~11x CY14 EBITDA compared to peers at ~12x (actually trading at closer to 10x on consensus EBITDA, which has stale estimates in there) and this is before ascribing any value to large Net Operating Losses (NOLs) that could be worth another 15% of upside (~$3/share). WW Grainger (GWW) is the best comp for HDS and is trading at 12x CY14 EBTIDA.  Longer-term, HDS’ scale gives them the ability to increase their market share in this very fragmented industry – HDS estimates they have 7% market share of the addressable market of $110b, which is dominated by regional and local players.  Further, many of HDS’ end-markets are still in cyclical lows (~20% of EBITDA from non-residential construction end-markets and 10% from residential) while many of their comps’ end-markets have recovered more, thus HDS’ should actually trade at a premium multiple to comps given where they are in the cycle.  

Cyclical downside protection is provided by strong base business of Maintenance, Repair, & Operations (MRO) that is very stable (overall EBITDA declined 30% in 2009 but in MRO actually grew 7%) and counter-cyclical working capital of distributors (working capital release in down-cycle).  MRO was 34% of revenue but 57% of EBITDA in 2012 and historically has the highest incremental margins at ~20%.  The other portions of the business are cyclical and levered to the recovery in both residential and non-residential construction as well as the need to replace the aging infrastructure in the US. 

The biggest risk to the Company is its leverage – it is over-levered right now at 7.5x net debt / TTM EBITDA but should be able grow into the capital structure as EBITDA improves.  The Co has ample liquidity, no near-term maturities, and working capital is counter-cyclical and releases cash in downturns as mentioned above.   

Legacy private equity owners still own 57% of the outstanding equity and could be sellers when their 180 lock-up period ends in late December, creating an overhang on the stock.  However this is unlikely given their estimated cost basis at ~$20/share and they have yet to sell any portion of their ownership – the IPO equity issuance in June diluted them and proceeds were used to pay down debt.  The sponsors may have taken management fees but these are not likely enough to get them to a target return on an LBO (likely 12-15% IRR or more) while given a stock px of $21, the sponsors are only 5% above their costs basis.  However, the specific buyout funds the HDS LBO is in could be winding down and thus could be forced sellers, or alternatively, the sponsors could distribute shares directly to LP’s of the specific buyout funds.

The trade does lack a catalyst and will take time for value to accrete but this is a good long-term Company with scale, ability to grow, and very high returns on capital (high 20%). 

Value Drivers:

• Scale provides a barrier to entry and a key competitive advantage against the mostly local or regional distributors. Customers need to know they can get every SKU needed on a day’s notice and not all regional / local players have the ability to keep / manage such extensive inventory.  Customers essentially use HDS to help manage their inventory and working capital, which requires scale. Further, scale helps HDS in their purchasing, getting discounts from manufacturers when they buy goods.  For example, HDS buys ~25% of Mueller’s volume and gets discounts due to this high volume. 

• Stable base business of MRO with end-markets that grow at GDP.  This business is to keep lights on and replace broken parts for HDS’ customers and thus volumes can’t be deferred very long.  57% of EBITDA and highest margin and incremental margin segment.

• Expected to grow at a multiple of the market, taking market share from the smaller players.  Mgmt estimates 3-5% growth in excess of the market but have historically done much better (conservative estimate by mgmt.).  HDS has 7% market share of a $110b addressable market – plenty of room to grow.

• Low capx requirements at less than 2% of revenue, strong incremental margins of 18-20%, and high return on invested capital of 28-30%.

• Pent-up demand of struggling municipalities or said differently, a way to play the need to replace the aging infrastructure of the US.  US capital stock has grown very slowly in this recovery with growth in 2012 of 1.4% compared to an average recovery exhibiting growth of ~3% in capital stock and thus the eventual rebound could have deferred demand and higher growth rates than normal.

• Along the same lines as the point above, buying at still very depressed part of the non-residential cycle.  Comps, which are generally not in such a depressed part of the cycle given their business mix, are trading at richer multiples.  Non-residential is slightly less than 20% of EBITDA and given the slack demand, has substantial operating leverage.

Weaknesses:

• Cyclical and levered to resi and non-resi recovery.  Residential construction looked to be improving but has moderated in the past couple months and is forecasted to grow 20-25% in 2014 (up to 1.2m housing starts).  Non-residential recovery is historically 12-18months behind the residential improvement but has yet to materialize.  Alcoa thinks non-resi construction market grows 3-4% in 2014 and then 4-5% in 2015 and 2016 – not that they are the best prognosticators but a good sanity check.

• Over-levered right now with debt / EBITDA of 7.7x but mitigated by:
  • distributors can be levered b/c their counter-cyclical cash flows (working capital unwinds when volumes fall).  In 2008-2009, working capital was a source of cash of over $300m
  • low fixed costs – SG&A at 21-22% of revenue and mgmt. indicates that more than half of this is variable.  Gross margins stable at 27-29% in last 5yrs
  • high equity valuations – peers trade at > 12x 2013e EBITDA and thus there is value through the debt. 
  • Good liquidity of $946m ($109m of cash and balance on ABL) and no maturities until 2017 – this will allow the Co to grow into their capital structure

• Consensus well-liked Company – sell-side mostly have buy-ratings on the equity; estimates need to come down as the consensus number has a lot of stale estimates in there.  Current consensus has incremental margin assumptions of 18%, which is Co guidance and is likely too high. 

• Large, legacy private equity holders that will not likely be long-term holders.  Lock-up period ends in late December but not likely to sell given they have not made money on the trade and end-markets are still at troughs.  Their holdings are more liquid with the IPO but have yet to harvest the investment and could opt to distribute shares directly to LP holders. 

• Lacks a catalyst and will likely be a longer-term investment to reap the benefits of taking market share and the eventual cyclical recovery.
• Municipal exposure: estimate it at ~40% of revenue in 2012 
• Fuel prices – do not hedge and might not be able to pass-through px increases to their customers

Business Description:

HD Supply is one of the largest industrial distributors in the US and Canada with 600 locations (roughly 50 owned and 550 leased) across 46 US states and nine Canadian provinces.  The Company has ~500,000 customers, which include contractors, government entities, maintenance professionals, home builders, and industrial businesses.  These customers are served by 15,000 associates (less than 1% unionized), delivering over 1 million SKUs and value-add services. 

HDS spun out of Home Depot (HD) in August 2007 in an LBO by Bain, Carlyle, and Clayton Dubilier, & Rice with HD retaining a 12.5% ownership stake.  The PE consortium paid $8.2b of cash and HD retained $325m, valuing HDS at $8.5b or 8.6x trailing EBITDA (peak EBITDA).  The Company went public in June 2013, raising $1.1b and subsequently used these proceeds to pay down debt.  Home Depot remains HDS’ largest customer at ~4% of FY12 net revenue.

End-Markets:

Three distinct markets served: 1) Maintenance, Repair, & Operations (MRO) 2) infrastructure & Power 3) Specialty Construction (resi and non-resi).  I estimate that ~40% of revenue is tied to municipalities in FY12.

The Company reports in four segments: Facilities & Maintenance, Waterworks, Power Solutions, and White Cap. 

Facilities Maintenance:

58% of  EBITDA, highest margin segment, and most stable earnings. This is the base of the HDS business and provides downside cyclical protection, end-markets grow roughly at GDP and distributing products that customers need to keep operations running if something breaks.  Distributes MRO supplies to owners and managers of multifamily, hospitality, healthcare, and institutional facilities.  Products include replacement light-bulbs, pipes/valves, janitorial supplies, HVAC products. 

WW Grainger (GWW) is the best comp for this segment (and HDS overall).  GWW has more international exposure, a pristine balance sheet, stable growth over the last decade, has a private label offering (22% of revenue from private-label products with Grainger brands), but has lower margins than HDS. 

Estimated that HDS has 4% of the $48b addressable market.  In 2008, revenues declined ~15% but this was offset by improved EBITDA margins that resulted in EBTIDA growing 13% y/y.

Waterworks:

Waterworks (22% of EBITDA) has been hardest hit segment due to its exposure to resi and non-resi construction and the segment is still well below previous peaks, leaving a lot of room for recovery and operating leverage that means incremental margins should be very high.  The segment distributes pipes, valves, water and wastewater transmission products, fire protection, and related products to public and private utilities as well as contractors serving municipal, residential, and commercial markets. Roughly 50% municipal end-markets, 25% residential, and 25% non-residential. 

FY12 EBITDA of $137m is well below the peak of 2006 when it was over $330m (trough was in FY10 at $94m).  Beyond cyclical recovery, mgmt highlights positive proposed legislation for water infrastructure that could add to growth.  Estimated that HDS has 20% market share of the $10b addressable market.

Power Solutions:

Power Solutions (11% of EBITDA) distributes products / solutions for distribution, transmission, and generation of electric power.  The segment is the largest distributor to utilities in the US and Canada with estimated that HDS has 5% market share of a $35b addressable market. Customers are utilities, municipalities, and contractors for both maintenance and project-based capx. End-markets are ~80% infrastructures (muni and utilities) and 20% non-resi.  This segment will benefit when utilities upgrade aging power infrastructure.

White Cap:

White Cap (13% of EBITDA).  Distributes specialty hardware, tools, materials, and safety products for contractors in resi and non-resi markets.  Estimated to have 6% market share in $19b addressable market. Demand is mostly driven by single and multifamily, commercial, municipal, and repair/remodel construction spending – 75% non-resi and 25% resi.

The addressable market for industrial distributors in US and Canada is $110b, mostly dominated by local and regional companies with HDS estimating their market share at 7% of the total.

Mgmt is targeting growth 3-5 percentage points greater than the market and 2011 showed good results.  

Recent Events:

• Cut guidance on end-market growth: In May 2013, HDS was forecasting non-resi +6% in 2013, municipal +4%, and power infrastructure +2%.  All these were cut to flat growth y/y after earnings in September. 

Misc:

• NOLs don’t start expiring until 2029 and more likely used up in the next few years as Co starts to free-cash flow.  These are $787m on a tax-effected basis.
• Report on a January-end fiscal year.
• All market / pricing data is as of market close Nov 26, 2013. 

Catalyst