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Morningstar | HD Supply Raises Full-Year 2018 Guidance Yet Again After Another Strong Quarter; Maintaining $45 FVE

On Sept. 5, HD Supply reported fiscal second-quarter results that beat both management's guidance and consensus estimates. The narrow-moat industrial distributor's second-quarter revenue increased 18% (10% organic) year over year to $1.6 billion, adjusted EBITDA grew 18% to $246 million, adjusted EBITDA margin was flat at 15.4%, and adjusted diluted EPS increased $0.35 versus the year-ago quarter to $0.99. Management raised its guidance for full-year 2018 revenue, adjusted EBITDA, and adjusted EPS for the second consecutive quarter. We're maintaining our $45 per share fair value estimate.

Despite HD Supply's "beat and raise" the stock traded down modestly during intra-day trading on Sept. 5, likely in reaction to the facilities maintenance segment's weak operating leverage (defined as adjusted EBITDA growth divided by revenue growth) during the quarter. That ratio came in at 0.5 for the segment as year-over-year adjusted EBITDA growth of 3.4% lagged a 6.6% increase in segment sales. A 60-basis-point year-over-year decline in EBITDA margin, mainly driven by a mix-shift to lower-margin business (for example, heating, ventilation, and air-conditioning products and property improvement installation services) was to blame for the segment's poor operating leverage. While management expects facilities maintenance gross margin pressure to persist in the third quarter, the team still expects the segment to achieve a "flat to slightly up" full-year gross margin.

The commercial and industrial segment had a very strong quarter. Revenue was up 34% year over year (15% excluding the recently acquired A.H. Harris business), adjusted EBITDA margin expanded 150 basis points to 12.3%, and the segment's operating leverage ratio came in at about 1.6. Strong operating leverage was more than enough for the C&I segment to overcome a 60-basis point gross margin decline, which was driven by the lower gross margin mix associated with A.H. Harris and margin pressure from rebar sales.

Both segments continue to deliver above-market growth. Management estimates that the facilities maintenance segment outperformed its end market by about 5% (7% segment growth versus 1% to 2% end-market growth) and the C&I segment outperformed its end market by 9% on an organic basis and 28% including the A.H. Harris acquisition (15% organic growth and 34% reported growth versus 6% end market growth).

We're not concerned about facilities maintenance margin pressure because that pressure doesn't appear to be the result of aggressive price competition. Rather, the margin pressure can be explained by the timing of lower-margin HVAC sales relative to last year and strong growth from HD Supply's property improvement business, which generates lower margins than the segment's MRO products. The property improvement business, which provides customers with project management and installation and renovation services, achieved double-digit growth during the second quarter. In our view, the property improvement business is a value-added service that differentiates the facilities maintenance segment from web-based competitors (such as Amazon Business) and can drive higher product sales. We think it would be foolhardy for management to pull back the reins on this business for the sole purpose of improving segment margin optics.

Tariffs have caused rebar prices to rise, which has been a headwind for C&I margins. However, rebar sales only account for about 5% of HD Supply's total revenue. Furthermore, management noted it's been successful at passing higher rebar costs along to customers. That said, HD Supply isn't adding a mark-up to tariff-related incremental costs, so C&I gross margins have suffered. Management noted that reduced rebar gross margins accounted for approximately two thirds of the C&I segment's 60-basis-point gross margin decline during the quarter.

In terms of the company's updated fiscal 2018 guidance, management now expects sales of $5.9 billion to $6.0 billion (versus $5.82 billion to $5.94 billion previously), adjusted EBITDA of $845 million to $870 million (versus $832 million to $862 million) and adjusted diluted EPS of $3.22 to $3.35 (versus $3.11 to $3.27).