Description

Summary:  HD Supply (HDS) is a large industrial distributor.  The company recently announced its agreement to sell its lower margin, cyclical White Cap Construction & Infrastructure business to Clayton, Dubilier & Rice for $2.9 billion.  The sale is expected to close in October 2020 and should give the company cash proceeds equivalent to ¼ of the market cap.  After the completion of this sale, the remaining HDS will be a simplified, higher margin, less cyclical business that should produce 50% upside to the equity from here.   

Business Overview:  HD Supply currently operates 2 segments, which are each about $3 billion in annual revenue:  

• Facilities Maintenance is a Maintenance, Repair, and Operations (MRO) business for “living space” professionals.  It has approximately 300,000 customers, ⅔ of which are in the multifamily space, 20% in hospitality.   It sells 200,000 SKUs in things like plumbing, hardware and janitorial supplies.  

• Construction & Industrial operates under the brand White Cap.  It sells concrete accessories, specialty construction and safety products to the general contractor space. It has approximately 200,000 customers, 75% non-residential, 25% residential.  

Key Pillars of the Thesis:

1.  Simplified business with less cyclicality and higher margins.  Since going public, the management team has sold off business lines, paid down debt and reduced the share count.  With this sale, only the less cyclical, higher margin Facilities Maintenance segment will remain.

2.  Balance sheet should improve.   The after-tax proceeds from this sale will be equivalent to the gross debt outstanding and ¼ of the company’s market cap.  It will provide management with significant opportunity to return capital to shareholders while also reducing financial leverage.

3. Bounce back in the FM business and resilience in an economic slowdown.  The Facilities Maintenance business has recently suffered heavily from sales declines related to Covid shutdown. We expect sales to bounce back in the coming months while the economics of the business should show resilience in the face of an economic downturn.  

4. Insulation from potential competition. 

5. Attractive Valuation.  

#1.  Simplified business with less cyclicality and higher margins.  When HDS came public in 2013, it had 4 operating segments and was levered 11x.  Since then the management team has sold $4 billion worth of businesses (prior to the C&I sale), reduced debt to under 3 turns, simplified the business down to 2 operating segments, improved the margin profile, and bought back 20% of the stock since 2017.  

The remaining business, Facilities Maintenance, is (theoretically) less cyclical than the C&I business.  The Facilities Maintenance business operating margin has bounced between 16% and 17% over the past few years.  By contrast, the C&I business hovers more around 10%.  For over a year, the management team had discussed plans to separate these businesses so that they could be valued properly.  

#2. Balance sheet should improve and capital returned to shareholders.   The C&I business is being sold to Clayton, Dubilier for $2.9 billion gross.  Net of taxes and fee leakage, HDS should realize $2.5 billion in proceeds.  This is above the $2.0 billion in gross/$1.9 billion net debt ($2.6 billion/$2.4 billion if including capital leases) on the business and just under a quarter of the market cap.  

The company has not yet given specific guidance as to how they will use the proceeds of the sale, other than to say they will use some of it for debt paydown, some for m&a, and some to return capital to shareholders.  In the past, management has indicated its preference for 2-3x leverage on each segment, implying $1.0-1.5 billion in debt on the remaining FM business.  In theory, this leaves $1.0+ billion for the company to return to shareholders.  We expect to get an update on this topic later this week on the company’s 2q20 earnings call.  

#3.  Bounce-back from Covid and evidence of growth in a slower economy.  These have been hard hit by Covid with FM sales down 12% y/y in 1q20, though we expect a rebound in the back of this year and into next.  In this business, there is a baseline level of demand for facilities maintenance and capex.  Some of it has certainly been deferred with the slowdown in hospitality and investment in multifamily properties.  We believe that ultimately spending in these segments will rebound, helping HDS to regain revenue momentum in this segment.  

In the event of a continued overall economic slowdown, we believe there are 2 factors at play that can help to limit downside: 

Evidenced ability to perform in a downturn:

For some context, we looked back to the 2008/09 recession to see how Facilities Maintenance performed.  While there are a lot of moving parts and the company is not exactly the same, the revenue in the reported segment was slightly down, though largely flat at $1.6 billion in sales and operating income from $160-180 million during the period 2007 to 2009.  By contrast, the White Cap business saw revenues decline from $1.5 billion to $872 million during that period.  Operating income declined from $4 million to a loss of $76 million.  

Flexible nature of the distribution model:

One of the attractions of a distributor model for us is this cyclical relationship:  during good times, EBITDA rises, but the company needs to invest in working capital.  In bad times, EBITDA might take a hit, but they tend to be able to manage working capital to generate more cash flow.  

#4.  Insulation from competition.  Yes, in theory, Amazon could decide to tackle this business.  We believe, though, that there are limits to the inroads that more low-touch, generalist competitors could make.  Many of the maintenance professionals are looking for a one-stop shop with a broad array of products and consult with knowledgeable sales reps (FM has 1,000).   FM also has 900 dedicated delivery drivers and 44 distribution centers across the US so they can provide timely, next-day delivery to customers.   

 #5.  Attractive Valuation.  The remaining Facilities Maintenance business should trade for a higher multiple, as it is higher margin and less cyclical.  The stock currently trades just under 15x 2020 (Jan 2021) consensus earnings of $2.67 and 11x EBITDA.  Adjusting for the $2.5 billion in proceeds from the sale of the C&I business results in a multiple of 12x EBITDA (since the FM business is underearning).  

If the company can continue to grow sales in the Facilities Maintenance business at 4-5% per year the next several years and maintain margins in the FM segment, they should be able to generate approximately $600 million in EBITDA.  Adjusting for the build in cash/buyback/debt paydown on the balance sheet, 15x FY2023 earnings yield a $62 stock, up 55% from here.  

Catalyst

• Closing sale of White Cap
• Capital deployment - buybacks and debt paydown
• Pick up in sales at remaining business