Overview
This Management's Discussion and Analysis of Financial Condition and Results of Operations is combined for two registrants:HD Supply Holdings, Inc. andHD Supply, Inc. Unless the context indicates otherwise, any reference in this discussion and analysis to "Holdings" refers toHD Supply Holdings, Inc. , any reference to "HDS" refers toHD Supply, Inc. , the indirect wholly-owned subsidiary of Holdings, and any references to "HD Supply ," the "Company," "we," "us" and "our" refer to Holdings together with its direct and indirect subsidiaries, including HDS.HD Supply is one of the largest industrial distributors inNorth America . We believe we have leading positions in the two distinct market sectors in which we specialize: Maintenance, Repair &Operations and Specialty Construction . Through approximately 270 branches and 44 distribution centers, in theU.S. andCanada , the Company serves these markets with an integrated go-to-market strategy. We have approximately 11,500 associates delivering localized, customer-tailored products, services and expertise. We serve approximately 500,000 customers, which include contractors, maintenance professionals, home builders, industrial businesses, and government entities. Our broad range of end-to-end product lines and services include approximately 600,000 stock-keeping units ("SKUs") of quality, name-brand and proprietary-brand products as well as value-add services supporting the entire lifecycle of a project from construction to maintenance, repair and operations. Description of segments
We operate our Company through two reportable segments: Facilities Maintenance and Construction & Industrial.
Facilities Maintenance. Facilities Maintenance distributes MRO products, provides value-add services and fabricates custom products. The markets that Facilities Maintenance serves include multifamily, hospitality, healthcare and institutional facilities. Products include electrical and lighting items, plumbing supplies, HVAC products, appliances, janitorial supplies, hardware, kitchen and bath cabinets, window coverings, textiles and guest amenities, healthcare maintenance and water and wastewater treatment products. Construction & Industrial. Construction & Industrial distributes concrete accessories and chemicals, specialized hardware, tools, engineered materials and safety products to non-residential and residential contractors. Products include tilt-up brace systems, forming and shoring systems, hand and power tools, cutting tools, rebar, ladders, safety and fall arrest equipment, specialty screws and fasteners, sealants and adhesives, drainage pipe, geo-synthetics, erosion and sediment control equipment and other engineered materials used broadly across all types of non-residential and residential construction. Construction & Industrial also includes Home Improvement Solutions which offers light remodeling and construction supplies, kitchen and bath cabinets, windows, plumbing materials, electrical equipment and other products, primarily to small remodeling contractors and trade professionals. In addition to the reportable segments, our consolidated financial results include "Corporate and Eliminations" which incurs costs related to our centralized support functions, which are comprised of finance, information technology, human resources, legal, supply chain and other support services, and removes inter-segment transactions. All Corporate operating overhead costs are allocated to the reportable segments. Interest expense, interest income, other non-operating income and expense, and provision for income taxes are not allocated to the reportable segments. The Company does not allocate Corporate assets to its reportable segments.
Acquisitions
We enter into strategic acquisitions from time to time to expand into new markets, net platforms, and new geographies in an effort to better service existing customers and attract new ones. In accordance with the
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acquisition method of accounting under Accounting Standards Codification ("ASC") 805, Business Combinations, the results of the acquisitions we completed are reflected in our consolidated financial statements from the date of the acquisition forward. OnMarch 5, 2018 , our Construction & Industrial business acquiredA.H. Harris Construction Supplies ("A.H. Harris") for a purchase price of approximately$359 million in cash, adjusted for the final working capital settlement received in the second half of fiscal 2019. A.H. Harris is a leading specialty construction distributor serving the northeast and mid-Atlantic regions. This acquisition expands Construction & Industrial's market presence in the northeasternUnited States . For additional detail related to the acquisition of A.H. Harris, see "Note 2, Acquisitions," in the Notes to the Consolidated Financial Statements within "Part II. Item 8. Financial Statements and Supplementary Data" of this annual report on Form 10-K.
Discontinued operations
InAugust 2017 , the Company completed the sale of its Waterworks business. Including the final working capital settlement of approximately$29 million inJanuary 2018 , the Company received cash proceeds of approximately$2.4 billion , net of$38 million of transaction cost payments. Including the final working capital settlement, the Company recognized a gain on sale of the Waterworks business of approximately$732 million , net of tax of$197 million . In accordance with ASC 205-20, Discontinued Operations, the results of the Waterworks operation and the gain/loss on the sale and disposal of the business are classified as discontinued operations. The presentation of discontinued operations includes revenues and expenses of the discontinued operations and gain on the sale of the business, net of tax, as one line item on the Consolidated Statements of Operations and Comprehensive Income. All Consolidated Statements of Operations and Comprehensive Income presented have been revised to reflect this presentation. For additional detail related to the results of operations of the discontinued operations, see "Note 3, Discontinued Operations," in the Notes to the Consolidated Financial Statements within "Part II. Item 8. Financial Statements and Supplementary Data" of this annual report on Form 10-K. Seasonality In a typical year, our operating results are impacted by seasonality. Historically, sales of our products have been higher in the second and third quarters of each fiscal year due to favorable weather and longer daylight conditions during these periods. Seasonal variations in operating results may also be significantly impacted by inclement weather conditions, such as cold or wet weather, which can delay construction projects.
Fiscal Year
Our fiscal year is a 52- or 53-week period ending on the Sunday nearest toJanuary 31 . The fiscal year endedFebruary 2, 2020 ("fiscal 2019") included 52 weeks. The fiscal year endedFebruary 3, 2019 ("fiscal 2018") included 53 weeks. The fiscal year endedJanuary 29, 2018 ("fiscal 2017") included 52 weeks.
Key business metrics
Net sales
We earn our Net sales primarily from the sale of construction, maintenance, repair and operations, and renovation and improvement-related products and our provision of related services to approximately 500,000 customers, including contractors, government entities, maintenance professionals, home builders and industrial businesses. We recognize sales, net of sales tax and allowances for returns and discounts, when an identified performance obligation is satisfied by transfer of the promised goods or services to the customer. Net sales in certain business units fluctuate with the price of commodities as we seek to minimize the effects of changing commodities prices by passing such increases in the prices of certain commodity-based products to our customers. 41
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We ship products to customers by internal fleet and third-party carriers. Net sales are recognized from product sales when control of the product and services are passed to the customer, which generally occurs at the point of destination. We include shipping and handling fees billed to customers in Net sales. Shipping and handling costs associated with inbound freight are capitalized to inventories and relieved through Cost of sales as inventories are sold. We account for shipping and handling costs associated with outbound freight as a fulfillment cost. Such costs are included in Selling, general and administrative expenses. Gross profit Gross profit primarily represents the difference between the product cost from our suppliers (net of earned rebates and discounts) including the cost of inbound freight and the sale price to our customers. The cost of outbound freight, purchasing, receiving and warehousing are included in Selling, general and administrative expenses within operating expenses. Our Gross profits may not be comparable to those of other companies, as other companies may include all of the costs related to their distribution network in Cost of sales.
Operating expenses
Operating expenses are primarily comprised of selling, general and administrative costs, which include payroll expenses (salaries, wages, employee benefits, payroll taxes and bonuses), rent, insurance, utilities, repair and maintenance and professional fees. In addition, operating expenses include depreciation and amortization, and restructuring charges.
Adjusted EBITDA and Adjusted net income
Adjusted EBITDA and Adjusted net income are not recognized terms under generally accepted accounting principles in theU.S. ("GAAP") and do not purport to be alternatives to Net income as a measure of operating performance. We present Adjusted EBITDA and Adjusted net income because each is a primary measure used by management to evaluate operating performance. In addition, we present Adjusted net income to measure our overall profitability as we believe it is an important measure of our performance. We believe the presentation of Adjusted EBITDA and Adjusted net income enhances our investors' overall understanding of the financial performance of our business. We believe Adjusted EBITDA and Adjusted net income are helpful in highlighting operating trends, because each excludes the results of decisions that are outside the control of operating management and that can differ significantly from company to company depending on long-term strategic decisions regarding capital structure, the tax jurisdictions in which companies operate, age and book depreciation of facilities and capital investments. Adjusted EBITDA is based on "Consolidated EBITDA," a measure which is defined in HDS's Senior Credit Facilities and used in calculating financial ratios in several material debt covenants. Borrowings under these facilities are a key source of liquidity and our ability to borrow under these facilities depends upon, among other things, our compliance with such financial ratio covenants. In particular, both facilities contain covenants that can restrict our activities if we do not maintain financial ratios calculated based on Consolidated EBITDA. Our SeniorABL Facility requires us to maintain a minimum fixed charge coverage ratio of 1:1 if our specified excess availability (including an amount by which our borrowing base exceeds the outstanding amounts) under the SeniorABL Facility falls below the greater of$100 million and 10% of the lesser of (A) the Borrowing Base and (B) the Total Facility Commitment (each, as defined in the SeniorABL Facility ). Adjusted EBITDA is defined as Net income less Income from discontinued operations, net of tax, plus (i) Interest expense and Interest income, net, (ii) Provision (benefit) for income taxes, and (iii) Depreciation and amortization, and further adjusted to exclude loss on extinguishment of debt, non-cash items and certain other adjustments to Consolidated Net Income, including costs associated with capital structure enhancements, permitted in calculating Consolidated EBITDA under our Senior Credit Facilities. We believe that presenting Adjusted EBITDA is appropriate to provide additional information to investors about how the covenants in those agreements operate and about certain non-cash and other items. The Term Loan Facility and SeniorABL Facility permit us to make certain 42
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additional adjustments to Consolidated Net Income in calculating Consolidated EBITDA, such as projected net cost savings, which are not reflected in the Adjusted EBITDA data presented in this annual report on Form 10-K. We may in the future reflect such permitted adjustments in our calculations of Adjusted EBITDA. These covenants are important to the Company as failure to comply with certain covenants would result in a default under our Senior Credit Facilities. The material covenants in our Senior Credit Facilities are discussed in "Part II. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity, capital resources and financial condition - External Financing."
Adjusted net income is defined as Net income less Income from discontinued operations, net of tax, further adjusted for loss on extinguishment of debt and certain non-cash, non-recurring, non-operational, or unusual items, net of tax.
We believe that Adjusted EBITDA and Adjusted net income are frequently used by securities analysts, investors and other interested parties in their evaluation of companies, many of which present an Adjusted EBITDA or Adjusted net income measure when reporting their results. We compensate for the limitations of using non-GAAP financial measures by using them to supplement GAAP results to provide a more complete understanding of the factors and trends affecting the business than GAAP results alone. Because not all companies use identical calculations, our presentation of Adjusted EBITDA and Adjusted net income may not be comparable to other similarly titled measures of other companies.
Adjusted EBITDA and Adjusted net income have limitations as analytical tools and should not be considered in isolation or as substitutes for analyzing our results as reported under GAAP. Some of these limitations are:
? Adjusted EBITDA and Adjusted net income do not reflect changes in, or cash
requirements for, our working capital needs;
? Adjusted EBITDA does not reflect our interest expense, or the requirements
necessary to service interest or principal payments on our debt;
? Adjusted EBITDA does not reflect our income tax expenses or the cash
requirements to pay our taxes;
Adjusted EBITDA and Adjusted net income do not reflect historical cash
? expenditures or future requirements for capital expenditures or contractual
commitments; and
although depreciation and amortization charges are non-cash charges, the assets
? being depreciated and amortized will often have to be replaced in the future,
and Adjusted EBITDA does not reflect any cash requirements for such replacements. 43 Table of Contents
The following table presents a reconciliation of Net income and Income from continuing operations, the most directly comparable financial measures under GAAP, to Adjusted EBITDA for the periods presented (amounts in millions):
Fiscal Year Ended
February 2 ,February 3 ,
2020 2019 2018 2017 2016 Net income $ 452 $ 394 $ 970 $ 196$ 1,472 Less income from discontinued operations, net of tax 1 3 803 130 272 Income from continuing operations 451 391 167 66 1,200 Interest expense, net 110 129 164 269 394 Provision (benefit) for income taxes(i) 162 135 193 51 (1,170) Depreciation and amortization(ii) 113 106 90 88 100 Loss on extinguishment & modification of debt(iii) - 69 84 179 100 Restructuring and separation charges(iv) 8 9 6 7 8 Stockbased compensation 23 26 26 20 16 Acquisition and integration costs(v) 5 6
1 - - Other 1 - - - 2 Adjusted EBITDA $ 873 $ 871 $ 731 $ 680 $ 650 During the fiscal year endedJanuary 31, 2016 , the Company recorded a
tax benefit for the reduction in unrecognized tax benefits as a result of
and state audit settlements.
(ii) Depreciation and amortization includes amounts recorded within Cost of sales
in the Consolidated Statements of Operations.
Represents the loss on extinguishment of debt, including the premium paid
to repurchase or call the debt, as well as the write-off of unamortized (iii) deferred financing costs, original issue discount, and other assets or
liabilities associated with such debt. Also includes the costs of debt
modification. Represents the costs incurred for separation activities and strategic
alignment of workforce. For additional information, see "Note 15, (iv) Restructuring and Separation Activities" in the Notes to the Consolidated
Financial Statements within "Part II. Item 8. Financial Statements and
Supplementary Data."
(v) Represents the costs incurred in the acquisition and integration of business
acquisitions, including A.H. Harris. 44 Table of Contents
The following table presents a reconciliation of Net income and Income from continuing operations, the most directly comparable financial measures under GAAP, to Adjusted net income for the periods presented (amounts in millions):
Fiscal Year Ended February 2, February 3, January 28, January 29, January 31, 2020 2019 2018 2017 2016 Net income $ 452 $ 394 $ 970 $ 196$ 1,472 Less income from discontinued operations, net of tax 1 3 803 130 272 Income from continuing operations 451 391 167 66 1,200 Plus: Provision (benefit) for income taxes(i) 162 135 193 51 (1,170) Less: Cash income taxes(ii) (53) (13) (16) (13) (16) Plus: Amortization of acquisitionrelated intangible assets (other than software) 23 22 12 12 12 Plus: Loss on extinguishment & modification of debt(iii) - 69 84 179 100 Restructuring and separation charges(iv) 8 9 6 7 8 Acquisition and integration costs(v) 5 6
1 - - Other - - - - 1 Adjusted Net Income $ 596 $ 619 $ 447 $ 302 $ 135
During the fiscal year ended
tax benefit for the reduction in unrecognized tax benefits as a result of
and state audit settlements.
Cash paid for income taxes in the fiscal year ended
business unit.
Represents the loss on extinguishment of debt, including the premium paid
to repurchase or call the debt, as well as the write-off of unamortized (iii) deferred financing costs, original issue discount, and other assets or
liabilities associated with such debt. Also includes the costs of debt
modifications. Represents the costs incurred for separation activities and strategic
alignment of workforce. For additional information, see "Note 15, (iv) Restructuring and Separation Activities" in the Notes to the Consolidated
Financial Statements within "Part II. Item 8. Financial Statements and
Supplementary Data."
(v) Represents the costs incurred in the acquisition and integration of business
acquisitions, including A.H. Harris. 45 Table of Contents
Consolidated results of operations
Percentage Fiscal Year Increase (Decrease) Dollars in millions 2019 2018 2017
2019 vs. 2018 2018 vs. 2017 Net sales$ 6,146 $ 6,047 $ 5,121 1.6 18.1 Gross profit 2,403 2,375 2,033 1.2 16.8 Operating expenses: Selling, general & administrative 1,566 1,543 1,334
1.5 15.7 Depreciation & amortization 106 99 85 7.1 16.5 Restructuring and separation 8 9 6 (11.1) 50.0 Total operating expenses 1,680 1,651 1,425 1.8 15.9 Operating income 723 724 608 (0.1) 19.1 Interest expense 110 130 166 (15.4) (21.7) Interest (income) - (1) (2) * (50.0) Loss on extinguishment & modification of debt - 69 84 * (17.9) Income from continuing operations before provision for income taxes 613 526 360 16.5 46.1 Provision for income taxes 162 135 193 20.0 (30.1) Income from continuing operations 451 391 167
15.3 * Income from discontinued operations, net of tax 1 3 803 (66.7) * Net Income$ 452 $ 394 $ 970 14.7 (59.4) NonGAAP Financial Data: Adjusted EBITDA$ 873 $ 871 $ 731 0.2 19.2 Adjusted net income$ 596 $ 619 $ 447 (3.7) 38.5 * not meaningful 46 Table of Contents % of Net sales Basis Point Fiscal Year Increase (Decrease) 2019 2018 2017 2019 vs. 2018 2018 vs. 2017 Net sales 100.0 % 100.0 % 100.0 % - - Gross profit 39.1 39.3 39.7 (20) (40) Operating expenses:
Selling, general & administrative 25.5 25.5 26.0
- (50) Depreciation & amortization 1.7 1.7 1.7 - - Restructuring and separation 0.1 0.1 0.1 - - Total operating expenses 27.3 27.3 27.8 - (50) Operating income 11.8 12.0 11.9 (20) 10 Interest expense 1.8 2.2 3.2 (40) (100) Interest (income) - - - - - Loss on extinguishment & modification of debt - 1.1 1.7 (110) (60) Income from continuing operations before provision for income taxes 10.0 8.7 7.0 130 170 Provision for income taxes 2.6 2.2 3.8 40 (160) Income from continuing operations 7.4 6.5 3.2
90 330 Income from discontinued operations, net of tax - - 15.7 * * Net Income 7.4 6.5 18.9 90 * NonGAAP Financial Data: Adjusted EBITDA 14.2 14.4 14.3 (20) 10 Adjusted net income 9.7 10.2 8.7 (50) 150 * Not meaningful
Fiscal 2019 compared to fiscal 2018
Highlights
Net sales in fiscal 2019 increased$99 million , or 1.6%, compared to fiscal 2018. Operating income in fiscal 2019 decreased$1 million , or 0.1%, to$723 million during fiscal 2019 as compared to fiscal 2018. Net income in fiscal 2019 increased$58 million to$452 million as compared to fiscal 2018. Adjusted EBITDA in fiscal 2019 increased$2 million , or 0.2%, as compared to fiscal 2018. Adjusted net income in fiscal 2019 decreased$23 million , or 3.7%, as compared to fiscal 2018. As ofFebruary 2, 2020 , our liquidity was$628 million . See "Liquidity, capital resources and financial condition" for further information. OnSeptember 24, 2019 , the Company announced its intention to separate its Facilities Maintenance and Construction & Industrial businesses into two independent publicly traded companies with the separation expected to be completed in the middle of fiscal 2020. In light of the current business environment and in order to begin the establishment of two separate standalone businesses, the Company made personnel changes and began assessing the separation process, resulting in the recognition of$8 million in restructuring and separation charges in fiscal 2019. These charges were primarily related to professional fees incurred to execute the separation, and, to a lesser extent, severance and other employee-related costs. The Company is in the early stages of estimating total costs for the separation of the businesses. Fiscal 2019 included the reversal of$2 million of restructuring expenses originally recognized in fiscal 2018. The reversal resulted from the favorable termination of the lease associated with the Company's previous corporate headquarters, which was exited in fiscal 2018. For additional information, see "Note 15, Restructuring and Separation Activities" in the Notes to Consolidated Financial Statements within "Part II. Item 8. Financial Statements and Supplementary Data."
Net sales
Net sales increased
47 Table of Contents Both of our reportable segments delivered an increase in Net sales during fiscal 2019 as compared to fiscal 2018. The Net sales increases were primarily due to increases in market volume and growth initiatives at each of our businesses and, to a lesser extent, the acquisition of A.H. Harris by Construction & Industrial. Organic sales growth, which excludes A.H. Harris sales in fiscal 2019 throughMarch 4, 2019 (the one-year anniversary of the acquisition), was$75 million , or 1.2%, during fiscal 2019 as compared to fiscal 2018. In addition, fiscal 2019 included 52 weeks as compared to 53 weeks in fiscal 2018. On a 52-week basis, organic sales growth was$179 million , or 3.0%, during fiscal 2019 as compared to fiscal 2018. Growth initiatives contributed approximately$101 million in fiscal 2019. Gross profit
Gross profit increased
Both of our reportable segments delivered an increase in Gross profit in fiscal 2019 as compared to fiscal 2018 due to sales growth from growth initiatives and increased market volume.
Gross profit as a percentage of Net sales ("gross margin") decreased approximately 20 basis points to 39.1% in fiscal 2019 as compared to 39.3% in fiscal 2018. Gross margins declined at both Facilities Maintenance and Construction & Industrial in fiscal 2019 as compared to fiscal 2018.
Operating expenses
Operating expenses increased
Selling, general, and administrative expenses increased$23 million , or 1.5%, during fiscal 2019 as compared to fiscal 2018. The increase was primarily a result of increases in variable expenses due to higher sales volume and increased investments in growth initiatives, primarily facilities. In addition, Selling, general, and administrative expenses included$5 million and$6 million of costs in fiscal 2019 and fiscal 2018, respectively, related to acquisition and integration activities. Depreciation and amortization expense increased$7 million , or 7.1%, during fiscal 2019 as compared to fiscal 2018, primarily due to investments in facilities and technology.
Operating expenses as a percentage of Net sales was flat in fiscal 2019 as compared to fiscal 2018.
Operating income
Operating income decreased$1 million , or 0.1%, to$723 million during fiscal 2019 as compared to fiscal 2018. The increase in Selling, general, and administrative expenses and Depreciation and amortization expense were partially offset by an increase in gross profit and reduction in restructuring and separation charges. Operating income as a percentage of Net sales decreased approximately 20 basis points to 11.8% in fiscal 2019 as compared to fiscal 2018. The decline in gross margin and increased investments in growth initiatives were partially offset by the leverage of fixed costs through sales volume increases.
Interest expense
Interest expense decreased$20 million , or 15.4%, during fiscal 2019 as compared to fiscal 2018. The decrease was primarily due to a decrease in the average effective interest rate, including the impact of lower non-cash amortization of deferred financing costs as a result of refinancing activities in fiscal 2018.
Loss on extinguishment and modification of debt
During fiscal 2018, our debt refinancing and redemption activities resulted in
charges of
OnOctober 22, 2018 , HDS amended its senior secured term loan facility (the "Term Loan Facility"), incurring a modification and extinguishment charge of$5 million , which includes financing fees and other costs of$3 million and the write-off of$2 million of unamortized discount and deferred financing costs. 48 Table of Contents OnOctober 11, 2018 , HDS used the net proceeds from the issuance of the 5.375% Senior Unsecured Notes due 2026 (the "October 2018 Senior Unsecured Notes"), together with available cash and borrowings on HDS's Senior Asset Based Lending Facility due 2022 (the "SeniorABL Facility "), to redeem all of the outstanding$1,000 million aggregate principal of the 5.75% Senior Unsecured Notes due 2024 (the "April 2016 Senior Unsecured Notes"), incurring a$64 million loss on extinguishment of debt, which includes a$56 million make-whole premium and the write-off of$8 million of unamortized deferred financing costs.
See "Liquidity, capital resources and financial condition - External financing" for further information.
Provision (benefit) for income taxes
The provision for income taxes from continuing operations in fiscal 2019 was$162 million compared to$135 million in fiscal 2018. The effective rate for continuing operations for fiscal 2019 was 26.4%, which was primarily impacted by the geographical mix of where income was generated and state income tax law changes. The effective rate for continuing operations for fiscal 2018 was 25.7% which was primarily impacted by the geographical mix of where income was generated. As of the end of fiscal 2019, the minimum amount of future taxable income that needs to be generated to realize the deferred tax assets is approximately$893 million forU.S. state tax purposes. The current level of pre-tax earnings under GAAP is sufficient to generate the minimum amount of future taxable income to realize ourU.S. federal and the majority of our state tax deferred assets prior to their expiration. As of the end of fiscal 2019 and fiscal 2018, the Company's remaining valuation allowance on itsU.S. deferred tax assets was approximately$6 million and$7 million , respectively.
As of
Adjusted EBITDA
Adjusted EBITDA increased$2 million , or 0.2%, in fiscal 2019 as compared to fiscal 2018. Construction & Industrial generated an increase in Adjusted EBITDA in fiscal 2019 as compared to fiscal 2018, while Facilities Maintenance was flat in fiscal 2019 as compared to fiscal 2018. The increase in Adjusted EBITDA was primarily due to the increase in sales volume, partially offset by the increase in Operating expenses. Adjusted EBITDA as a percentage of Net sales decreased approximately 20 basis points to 14.2% in fiscal 2019 as compared to fiscal 2018, primarily due to investments in growth initiatives, increases in certain variable cost rates, and a decline in gross margin. Adjusted net income
Adjusted net income decreased
Fiscal 2018 compared to fiscal 2017
Highlights
Net sales in fiscal 2018 increased$926 million , or 18.1%, compared to fiscal 2017. Operating income in fiscal 2018 increased$116 million , or 19.1%, to$724 million during fiscal 2018 as compared to fiscal 2017. Net income in fiscal 2018 decreased$576 million to$394 million as compared to fiscal 2017 due primarily to an$800 million decrease in Income from discontinued operations, net of tax. Adjusted EBITDA in fiscal 2018 increased$140 million , or 19.2%, as compared to fiscal 2017. Adjusted net income in fiscal 2018 increased$172 million , or 38.5%, as compared to fiscal 2017 due primarily to growth in operations, and to a lesser extent, a decline in interest expense as a result of lower outstanding debt balances. As ofFebruary 3, 2019 , our liquidity was$589 million . See "Liquidity, capital resources and financial condition" for further information. 49 Table of Contents
On
In fiscal 2017, the Company completed the sale of its Waterworks business. The Company recognized a gain on the sale of approximately$732 million , net of tax of$197 million , reflected in Income from discontinued operations, net of tax, in the Consolidated Statement of Operations. For additional information, see "Note 3, Discontinued Operations," in the Notes to the Consolidated Financial Statements within "Part II. Item 8. Financial Statements and Supplementary Data." As a result of the sale of the Waterworks business in fiscal 2017, management evaluated the Company's talent alignment and functional support strategies. Consequently, during the second half of fiscal 2017, management initiated a restructuring plan that included reducing workforce personnel and realigning talent. In addition, the Company relocated its corporate headquarters in fiscal 2018. Management completed the activities under this plan during second quarter 2018, resulting in a total of$15 million in charges incurred during fiscal 2017 and fiscal 2018. For additional information, see "Note 15, Restructuring and Separation Activities" in the Notes to the Consolidated Financial Statements within "Part II. Item 8. Financial Statements and Supplementary Data."
Net sales
Net sales increased
Both of our reportable segments delivered an increase in Net sales during fiscal 2018 as compared to fiscal 2017. The Net sales increases were primarily due to increases in market volume, growth initiatives at each of our businesses, and the acquisition of A.H. Harris by Construction & Industrial. In addition, fiscal 2018 included 53 weeks, as compared to 52 weeks in fiscal 2017, and a reduction in selling days due to the timing of holidays. Organic sales growth, net of change in selling days, was$473 million , or 9.2%, during fiscal 2018 as compared to fiscal 2017. Growth initiatives contributed approximately$285 million in fiscal 2018.
Gross profit
Gross profit increased
Both of our reportable segments delivered an increase in Gross profit in fiscal 2018 as compared to fiscal 2017 due to sales growth from increased market volume, growth initiatives, and the acquisition of A.H. Harris.
Gross margin decreased approximately 40 basis points to 39.3% in fiscal 2018 as compared to 39.7% in fiscal 2017. The acquisition of A.H. Harris contributed to the decline in gross margin, unfavorably impacting gross margin by approximately 40 basis points during fiscal 2018 as compared to fiscal 2017. Gross margin was also unfavorably impacted by organic Net sales growth, net of change in selling days in the lower margin Construction & Industrial business at 12.4% outpacing growth in the higher margin Facilities Maintenance business at 6.6%. These unfavorable impacts were partially offset by an improvement in gross margin of approximately 40 basis points at Facilities Maintenance in fiscal
2018 as compared to fiscal 2017. Operating expenses
Operating expenses increased
Selling, general and administrative expenses increased$209 million , or 15.7%, during fiscal 2018 as compared to fiscal 2017. The increase was primarily a result of the acquisition of A.H. Harris, increases in variable expenses due to higher sales volume and increased investments in growth initiatives, primarily additional personnel and license fees for new technologies. Operating expenses as a percentage of Net sales decreased approximately 50 basis points to 27.3%, in fiscal 2018 as compared to fiscal 2017. Selling, general and administrative expenses as a percentage of Net sales 50
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decreased approximately 50 basis points to 25.5% in fiscal 2018 as compared to fiscal 2017. The decrease was primarily a result of the leverage of fixed costs through sales volume increases, partially offset by increased investments in growth initiatives. Operating income Operating income increased$116 million , or 19.1%, to$724 million during fiscal 2018 as compared to fiscal 2017, primarily due to higher sales volume, including the acquisition of A.H. Harris, partially offset by the increase in Operating expenses. Operating income as a percentage of Net sales increased approximately 10 basis points to 12.0% in fiscal 2018 as compared to fiscal 2017. The leverage of fixed costs through sales volume increases was partially offset by the decline in gross margin and increased investments in growth initiatives.
Interest expense
Interest expense decreased$36 million , or 21.7%, during fiscal 2018 as compared to fiscal 2017. The decrease was due to a lower outstanding balance as a result of using proceeds from the sale of a business to reduce indebtedness, partially offset by an increase in non-cash amortization of deferred financing costs and, to a lesser extent, an increase in variable interest rates.
Loss on extinguishment and modification of debt
During fiscal 2018, our debt refinancing and redemption activities resulted in
charges of
On
On
During fiscal 2017, our debt refinancing and redemption activities resulted in
charges of
OnDecember 28, 2017 , HDS reduced its borrowing capacity under the SeniorABL Facility by$500 million , incurring a$3 million loss on extinguishment of debt for the write-off of unamortized deferred financing costs. OnSeptember 1, 2017 , HDS redeemed all of the outstanding$1,250 million aggregate principal amount of its 5.25% Senior Secured First Priority Notes (the "December 2014 First Priority Notes"), incurring a$73 million loss on extinguishment of debt, which includes a$62 million make-whole premium and the write-off of$11 million of unamortized deferred financing costs. OnAugust 31, 2017 , HDS amended its Term Loan Facility, incurring a modification and extinguishment charge of$3 million , which includes financing fees and other costs of$1 million and the write-off of$2 million of unamortized original issue discount and unamortized deferred financing costs.
On
On
51
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Loans") incurring a
On
See "Liquidity, capital resources and financial condition - External financing" for further information.
Provision (benefit) for income taxes
The provision for income taxes from continuing operations in fiscal 2018 was$135 million compared to$193 million in fiscal 2017. The effective rate for continuing operations for fiscal 2018 was 25.7% which was primarily impacted by the geographical mix of where income was generated. The effective rate for continuing operations for fiscal 2017 was an expense of 53.6% which was primarily impacted by the enactment of the Tax Cuts and Jobs Act of 2017, excess tax benefits related to shareholder based compensation, and the geographical mix of where income was generated. As of the end of fiscal 2018, the minimum amount of future taxable income that needs to be generated to realize the deferred tax assets is approximately$321 million forU.S. federal tax purposes and$1,364 million forU.S. state tax purposes. The current level of pre-tax earnings under GAAP is sufficient to generate the minimum amount of future taxable income to realize ourU.S. federal and the majority of our state tax deferred assets prior to their expiration. As of the end of fiscal 2018 and fiscal 2017, the Company's remaining valuation allowance on itsU.S. deferred tax assets was approximately$7 million .
As of
Adjusted EBITDA
Adjusted EBITDA increased$140 million , or 19.2%, in fiscal 2018 as compared to fiscal 2017. Both of our reportable segments generated an increase in Adjusted EBITDA in fiscal 2018 as compared to fiscal 2017. The increase in Adjusted EBITDA was primarily due to the increase in sales volume, partially offset by the increase in Operating expenses. Adjusted EBITDA as a percentage of Net sales increased approximately 10 basis points to 14.4% in fiscal 2018 as compared to fiscal 2017, primarily due to the leverage of fixed costs through sales volume increases, partially offset by increased investments in growth initiatives and decline in gross margin.
Adjusted net income
Adjusted net income increased$172 million , or 38.5%, in fiscal 2018 as compared to fiscal 2017. The increase in Adjusted net income was attributable to growth in operations and lower interest expense.
Results of operations by reportable segment
Facilities Maintenance Fiscal Year Increase (Decrease) 2019 2018 2017 2019 vs. 2018 2018 vs. 2017 (Dollars in millions) Net sales$ 3,130 $ 3,089 $ 2,847 1.3 % 8.5 % Operating income$ 474 $ 478 $ 434 (0.8) % 10.1 % % of Net sales 15.1 % 15.5 % 15.2 % (40) bps 30 bps Depreciation and amortization 54 48 45
12.5 % 6.7 % Other 18 20 20 (10.0) % - Adjusted EBITDA$ 546 $ 546 $ 499 - 9.4 % % of Net sales 17.4 % 17.7 % 17.5 % (30) bps 20 bps * not meaningful 52 Table of Contents
Fiscal 2019 compared to fiscal 2018
Net sales increased$41 million , or 1.3%, in fiscal 2019 as compared to fiscal 2018. The 53rd week in fiscal 2018 contributed approximately$53 million in Net sales. On a 52-week basis, Net sales increased$94 million , or 3.1%, in fiscal 2019 as compared to fiscal 2018. The increase in Net sales was driven by growth in the multi-family and institutional industries and growth initiatives, partially offset by the impacts of a slow HVAC season and disruptions during the second quarter at ourAtlanta distribution center unfavorably impacting our service capabilities in theSoutheast U.S. We have since fully restored our service capabilities. The growth initiatives consist of investments in personnel, products, and technology aligned with our selling channels, such as our sales force, e-commerce site and mobile applications, and our enabling functions, such as supply chain and data analytics. Adjusted EBITDA
Adjusted EBITDA was flat in fiscal 2019 as compared to fiscal 2018. The 53rd
week in fiscal 2018 contributed approximately
On a 52-week basis, Adjusted EBITDA increased as a result of the higher sales volume, but was negatively impacted by an increase in Selling, general, and administrative expenses. The increase in Selling, general, and administrative expense was primarily related to facility expansions and inflation on lease renewals and freight. This was partially offset by a decrease in personnel costs as a result of lower incentive compensation, partially offset by inflation in other employee benefits. Adjusted EBITDA as a percentage of Net sales decreased approximately 30 basis points in fiscal 2019 as compared to fiscal 2018. The decrease was driven by a decline in gross margin of approximately 30 basis points, increased facilities and equipment costs as a percentage of Net sales, and increased variable cost rates, offset by a reduction in personnel costs as a percentage of Net sales.
Fiscal 2018 compared to fiscal 2017
Net sales increased$242 million , or 8.5%, in fiscal 2018 as compared to fiscal 2017. Excluding the impact of the 53rd week in fiscal 2018, Net sales increased$189 million , or 6.6%, as compared to fiscal 2017. The increase in Net sales was primarily due to market growth in the multifamily and hospitality industries and growth initiatives. Facilities Maintenance is beginning to see the sales benefits from the accelerated investments in our sales force, selling tools and analytics that began in mid-2017. These growth initiatives consist of investments in personnel, products, and technology aligned with our selling channels, such as our sales force, e-commerce site and mobile application, and our enabling functions, such as supply chain and data analytics. Adjusted EBITDA
Adjusted EBITDA increased
The increase in Adjusted EBITDA was primarily due to increased sales volume as a result of the accelerated investments, partially offset by the cost of such investments and incentive compensation.
Adjusted EBITDA as a percentage of Net sales increased approximately 20 basis points in fiscal 2018 as compared to fiscal 2017. The increase was primarily driven by an improvement in gross margin of approximately 40 basis points, partially offset by an increase in Selling, general and administrative expenses as a percentage of Net sales as a result of investments in growth initiatives including personnel and license fees for new technologies. 53 Table of Contents Construction & Industrial Fiscal Year Increase (Decrease) 2019 2018 2017 2019 vs. 2018 2018 vs. 2017 (Dollars in millions) Net sales$ 3,019 $ 2,961 $ 2,279 2.0 % 29.9 % Operating income$ 249 $ 246 $ 174 1.2 % 41.4 % % of Net sales 8.2 % 8.3 % 7.6 % (10) bps 70 bps Depreciation and amortization 59 58 45
1.7 % 28.9 % Other 19 21 13 (9.5) % 61.5 % Adjusted EBITDA$ 327 $ 325 $ 232 0.6 % 40.1 % % of Net sales 10.8 % 11.0 % 10.2 % (20) bps 80 bps * not meaningful
Fiscal 2019 compared to fiscal 2018
Net sales increased$58 million , or 2.0%, in fiscal 2019 as compared to fiscal 2018. On an organic basis, sales growth was 1.1% in fiscal 2019 as compared to fiscal 2018. The 53rd week in fiscal 2018 contributed approximately$51 million in organic Net sales. On a 52-week basis, organic Net sales increased$85 million , or 2.9%, in fiscal 2019 as compared to fiscal 2018. Growth initiatives contributed to the increase in Net sales in fiscal 2019 driven by our Managed Sales Approach (''MSA''), new locations, and direct marketing initiatives. MSA is a structured approach to drive revenue at a regional level through analysis, tools and sales management. In addition, Net sales were positively impacted by end-market improvement in the non-residential market. Adjusted EBITDA Adjusted EBITDA increased$2 million , or 0.6%, in fiscal 2019 as compared to fiscal 2018. The 53rd week in fiscal 2018 contributed approximately$3 million in Adjusted EBITDA. The increase in Adjusted EBITDA in fiscal 2019 as compared to fiscal 2018 was primarily driven by increased sales volume, partially offset by increased Selling, general and administrative costs related to inflation on lease renewals and increased personnel expenses. Adjusted EBITDA as a percentage of Net sales decreased approximately 20 basis points in fiscal 2019 as compared to fiscal 2018. The decrease was driven by an approximately 10 basis points decrease in gross margin and an increase in Selling, general and administrative expenses as percentage of Net sales. Selling, general and administrative expenses as a percentage of Net sales increased primarily due to inflation on real estate and equipment lease renewals and employee benefit costs.
Fiscal 2018 compared to fiscal 2017
Net sales increased$682 million , or 29.9%, in fiscal 2018 as compared to fiscal 2017. On an organic basis, excluding the sales of recently acquired A.H. Harris, and excluding the impact of a net change in selling days due to the 53rd week and change in holiday timing during the fourth quarter of fiscal 2018, Net sales increased$282 million , or 12.4%, as compared to fiscal 2017.
Growth initiatives contributed to the increase in Net sales in fiscal 2018 driven by our MSA, new locations, and direct marketing initiatives. MSA is a structured approach to drive revenue at a regional level through
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analysis, tools and sales management. In addition, Net sales were positively impacted by end-market improvement in the non-residential housing market.
Adjusted EBITDA
Adjusted EBITDA increased
The increase in Adjusted EBITDA in fiscal 2018 as compared to fiscal 2017 was primarily driven by the acquisition of A.H. Harris, growth initiatives and market volume. The increase was partially offset by increased Selling, general and administrative costs related to variable expenses and the hiring of additional associates to support the expanding business and future growth. Adjusted EBITDA as a percentage of Net sales increased approximately 80 basis points in fiscal 2018 as compared to fiscal 2017. The increase was driven by a decrease in Selling, general and administrative expenses as percentage of Net sales due to the leverage of fixed costs through sales volume increases, partially offset by a decline in gross margins of approximately 50 basis point. The acquisition of A.H. Harris negatively impacted gross margin by approximately 30 basis points in fiscal 2018 as compared to fiscal 2017. In addition, rebar gross margins declined in fiscal 2018 due to an increase in steel costs driven by tariffs and duties. We increased our pricing of rebar to recover the increase in rebar costs, but not enough to maintain our gross margin rate, negatively affecting our overall margin rate by approximately 20 basis points in fiscal 2018 as compared to fiscal 2017.
Liquidity, capital resources and financial condition
Sources and uses of cash
Our sources of funds, primarily from operations, cash on hand, and, to the extent necessary, from readily available external financing arrangements, are sufficient to meet all current obligations on a timely basis. We believe that these sources of funds will be sufficient to meet the operating needs of our business for at least the next twelve months.
During fiscal 2019, the Company's use of cash was primarily driven by net repayments of debt, purchase of treasury shares, and capital expenditures. These uses were substantially offset by cash provided by operations.
As ofFebruary 2, 2020 , our combined liquidity of approximately$628 million was comprised of$34 million in cash and cash equivalents and$594 million of additional available borrowings (excluding$4 million of borrowings on available cash balances) under our SeniorABL Facility , based on qualifying inventory and receivables.
Information about the Company's cash flows, by category, is presented in the Consolidated Statements of Cash Flows and is summarized as follows:
Fiscal 2019 Fiscal 2018
Fiscal 2017
Amounts in millions Net cash provided by (used for): Operating activities $ 677 $ 584 $ 502 Investing activities (112) (477) 2,329 Financing activities (569) (627) (2,348) Free cash flow: Operating activities $ 677 $ 584 $ 502 Less: Capital expenditures (106) (115) (94) Free cash flow $ 571 $ 469 $ 408 55 Table of Contents Working capital Working capital, excluding cash and cash equivalents, was$815 million as ofFebruary 2, 2020 , increasing$13 million as compared to$802 million as ofFebruary 3, 2019 . Working capital increased as a result of business growth that resulted in increases in Receivables and Inventory, offset by increases in Accounts Payable. The change in working capital also included an increase of$110 million for the Current portion of lease liabilities due to the adoption of ASC 842, Leases, on the first day of fiscal 2019 offset by a decrease of$87 million in Other current liabilities for the payment of the corporate headquarters financing liability. Additionally, working capital increased as a result of a decline in Accrued compensation and benefits due to timing of payments.
Operating activities
During fiscal 2019 cash provided by operating activities was$677 million compared to$584 million in fiscal 2018. Cash interest paid in fiscal 2019 was$105 million , compared to$121 million in fiscal 2018. Cash flows from operating activities included payments of$4 million of original issue discounts related to the extinguishment of a portion of the Term Loans in fiscal 2018. Excluding the cash interest payments in both periods and original issue discounts paid, cash flows from operating activities for continuing operations increased approximately$73 million in fiscal 2019 as compared to fiscal 2018. The increase in operating cash flows excluding interest and original issue discount is primarily attributable to growth in earnings and efficiency in use of working capital, partially offset by cash tax payments. During fiscal 2018 cash provided by operating activities was$584 million compared to$502 million in fiscal 2017. Cash interest paid in fiscal 2018 was$121 million , compared to$159 million in fiscal 2017. Cash flows from operating activities included payments of$4 million and$6 million of original issue discounts related to the extinguishment of a portion of the Term Loans in fiscal 2018 and fiscal 2017, respectively. Cash flows provided by operating activities for discontinued operations were zero and$27 million in fiscal 2018 and fiscal 2017, respectively. Excluding the cash interest payments in both periods and original issue discounts paid, cash flows from operating activities for continuing operations increased approximately$69 million in fiscal 2018 as compared to fiscal 2017. The increase in operating cash flows excluding interest, original issue discount, and discontinued operations is primarily attributable to growth in earnings of continuing operations, partially offset by investments in working capital for business growth.
Investing activities
During fiscal 2019, cash used by investing activities was
During fiscal 2018, cash used by investing activities was
During fiscal 2017, cash provided by investing activities was$2,329 million , primarily comprised of$2,421 of cash proceeds from the sales of businesses, partially offset by$94 million of capital expenditures.
Financing activities
During fiscal 2019, cash used in financing activities was
During fiscal 2018, cash used in financing activities was$627 million , primarily due to net debt repayments of$19 million including premiums to redeem debt prior to maturity, purchases of treasury shares of$596 million , and payments of debt issuance costs of$19 million , partially offset by net proceeds from employee stock-based awards activities of$6 million . 56
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During fiscal 2017, cash used in financing activities was$2,348 million , primarily due to net debt repayments of$1,783 million , including premiums to redeem debt prior to maturity, purchase of treasury shares of$584 million , and payments for debt issuance costs of$26 million ; partially offset by net proceeds from employee stock-based awards activities of$41 million .
External financing
As ofFebruary 2, 2020 , HDS had an aggregate principal amount of$2,067 million of outstanding debt, net of unamortized original issue discounts and unamortized deferred financing costs of$3 million and$18 million , respectively, and an additional$598 million of available borrowings under its SeniorABL Facility (after giving effect to the borrowing base limitations and approximately$24 million in letters of credit issued and including$4 million of borrowings available on qualifying cash balances). We may from time to time repurchase or otherwise retire or extend our debt and/or take other steps to reduce our debt or otherwise improve our financial position. These actions may include open market debt repurchases, negotiated repurchases, other retirements of outstanding debt, and/or opportunistic refinancing of debt. The amount of debt that may be repurchased or otherwise retired or refinanced, if any, will depend on market conditions, trading levels of our debt, our cash position, compliance with debt covenants and other considerations. Our affiliates may also purchase our debt from time to time, through open market purchases or other transactions. In such cases, our debt may not be retired, in which case we would continue to pay interest in accordance with the terms of the debt, and we would continue to reflect the debt as outstanding in our consolidated statements of financial position.
For additional information, see "Note 6, Debt," in the Notes to the Consolidated Financial Statements within "Part II. Item 8. Financial Statements and Supplementary Data."
Commodity and interest rate risk
Commodity risk
We are aware of the potentially unfavorable effects inflationary pressures may create through higher asset replacement costs and related depreciation, higher interest rates and higher material costs. In addition, our operating performance is affected by price fluctuations in the commodity-based products that we purchase and sell, which contain commodities such as steel and refrigerants. We are also exposed to fluctuations in petroleum costs as we deliver a substantial portion of the products we sell by truck. We seek to minimize the effects of inflation and changing prices through economies of scale in purchasing and inventory management, resulting in cost reductions and productivity improvements, as well as price increases to maintain reasonable gross margins.
As discussed above, our results of operations were impacted by fluctuating commodity prices based on our ability or inability to pass increases in the costs of certain commodity-based products to our customers through price increases. Such commodity price fluctuations have from time to time produced volatility in our financial performance and could do so in the future.
Interest rate risk related to debt
We are subject to interest rate risk associated with our debt. While changes in interest rates impact the fair value of the fixed-rate debt, there is no impact to earnings and cash flow. Alternatively, while changes in interest rates do not affect the fair value of our variable-rate debt, they do affect future earnings and cash flows.
HDS's Senior
The Senior
denominated loans, either at LIBOR or the Prime Rate, at the option of the
Company, plus applicable borrowing margins and (ii) in the case of Canadian
? dollar denominated loans, either at the BA Rate or the Canadian Prime Rate, at
the option of the Company, plus applicable borrowing margins. The borrowing
margins are defined by a pricing grid, as included in the ABL Facility
agreement, based on average excess availability for the previous quarter.
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The Term B-5 Loans bear interest at the applicable margin for borrowings of
? 1.75% for LIBOR borrowings and 0.75% for base rate borrowings, with a LIBOR
floor of zero.
OnOctober 24, 2018 , we entered into an interest rate swap agreement with a notional amount of$750 million , designated as a cash flow hedge in accordance with ASC 815, Derivatives and Hedging, to hedge the variability of cash flows in interest payments associated with our variable-rate debt. The interest rate swap agreement swaps a LIBOR rate for a fixed rate of 3.07% and matures onOctober 17, 2023 . The swap effectively converts a portion of the Company's Term B-5 Loans from a rate of LIBOR plus 1.75% to a 4.82% fixed rate. After giving effect to our interest rate swap agreement, a 1% increase in interest rates on our variable-rate debt would increase our annual forecasted interest expense by approximately$6 million based on our outstanding borrowings as ofFebruary 2, 2020 . See "Part 1. Item 1A. Risk Factors - Risks Relating to Our Indebtedness - Increases in interest rates would increase the cost of servicing our debt and could reduce our profitability."
Off-balance sheet arrangements
Prior to our adoption of ASC 842, Leases, in fiscal 2019, our operating leases were not reflected in Consolidated Balance Sheets.
Contractual obligations
The following table discloses aggregate information about our contractual obligations as ofFebruary 2, 2020 and the periods in which payments are due (amounts in millions): Payments due by period Fiscal Fiscal Fiscal Fiscal years Total 2020 2021 - 2022 2023 - 2024 after 2024 Long-term debt$ 2,067 $ 11 $ 282$ 1,024 $ 750 Interest on long-term debt(i) 471 97 185 120 69 Operating leases 588 132 225 129 102 Purchase obligations(ii) 224 217 7 - -
Total contractual cash obligations$ 3,350 $ 457 $
699
The interest rates for the Senior
debt includes the effect of the interest rate swap agreement.
Purchase obligations include various commitments with vendors to purchase (ii) goods and services, primarily inventory. These purchase obligations are
generally cancelable, but the Company has no intent to cancel. The Company
has IT service contracts payable through fiscal 2024.
Recent accounting pronouncements
See "Note 1, Nature of Business and Summary of Significant Accounting Policies," in the Notes to the Consolidated Financial Statements within "Part II. Item 8. Financial Statements and Supplementary Data."
Our critical accounting policies include:
Revenue recognition
We recognize revenue, net of allowances for returns and taxes collected from the customer, when an identified performance obligation is satisfied by the transfer of control of promised products or services to the customer. We ship products to customers by internal fleet and third-party carriers. Transfer of control to the customer for products generally occurs at the point of destination (i.e., upon transfer of title and risk of loss of product). Transfer of control to the customer for services occurs when the customer has the right to direct the use of and obtain substantially all of the remaining benefits of the asset that is created or enhanced from the service. 58
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We account for shipping and handling costs associated with outbound freight as a fulfillment costs. Such costs are included in Selling, general and administrative expenses.
Allowance for doubtful accounts
We evaluate the collectability of accounts receivable based on numerous factors, including past transaction history with customers, their credit worthiness and an assessment of our lien and bond rights. Initially, we estimate an allowance for doubtful accounts as a percentage of aged receivables. This estimate is periodically adjusted when we become aware of a specific customer's inability to meet its financial obligations (e.g., bankruptcy filing) or as a result of changes in our historical collection patterns. While we have a large customer base that is geographically dispersed, a slowdown in the markets in which we operate may result in higher than expected uncollectible accounts, and, as a result, the need to revise estimates for bad debts. To the extent historical credit experience is not indicative of future performance or other assumptions used by management do not prevail, the allowance for doubtful accounts could differ significantly, resulting in either higher or lower future provisions
for doubtful accounts. Inventories Inventories consist primarily of finished goods and are carried at the lower of cost or net realizable value. The cost of substantially all of our inventories is determined by the moving or weighted average cost method. We evaluate our inventory value at the end of each quarter to ensure that it is carried at the lower of cost or net realizable value. This evaluation includes an analysis of historical physical inventory results, a review of potential excess and obsolete inventories based on inventory aging and anticipated future demand. Periodically, each location's perpetual inventory records are adjusted to reflect any declines in net realizable value below inventory carrying cost. To the extent historical physical inventory results are not indicative of future results and if future events impact, either favorably or unfavorably, the saleability of our products or our relationship with certain key vendors, our inventory reserves could differ significantly, resulting in either higher or lower future inventory provisions.
Consideration received from vendors
We enter into agreements with many of our vendors providing for inventory purchase rebates ("vendor rebates") upon achievement of specified volume purchasing levels. We accrue the receipt of vendor rebates as part of our cost of sales for products sold based on progress towards earning the vendor rebates, taking into consideration cumulative purchases of inventory to date and projected purchases through the end of the year. An estimate of vendor rebates is included in the carrying value of inventory at each period end for vendor rebates to be received on products not yet sold. While we believe we will continue to receive consideration from vendors in fiscal 2020 and thereafter, there can be no assurance that vendors will continue to provide comparable amounts of vendor rebates in the future.
Impairment of long-lived assets
Long-lived assets, including property and equipment, are reviewed for possible impairment whenever events or circumstances indicate that the carrying amount of an asset may not be recoverable. To analyze recoverability, we project undiscounted future cash flows over the remaining life of the asset. If these projected cash flows are less than the carrying amount, an impairment loss is recognized based on the fair value of the asset less any costs of disposition. Our judgment regarding the existence of impairment indicators are based on market and operational performance. Future events could cause us to conclude that impairment indicators exist and that assets are impaired. Evaluating the impairment also requires us to estimate future operating results and cash flows that require judgment by management. If different estimates were used, the amount and timing of asset impairments could be affected. 59
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Business Combinations,
We allocate the purchase price paid for business acquisitions to identifiable tangible and intangible assets acquired and liabilities assumed based on their estimated fair values. The excess of the purchase price paid over the fair values of these identifiable assets and liabilities is allocated to goodwill. The allocation of the purchase price paid requires management to make significant estimates and assumptions, especially with respect to intangible assets. These estimates can include, but are not limited to, timing and amounts of future expected cash flows of acquired customers and trade names from a market participant perspective, estimated revenue growth rates, estimates of useful lives, and discount rates. Management's estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates. During the measurement period, which is up to one year from the acquisition date, we may record adjustments to the assets acquired and liabilities assumed, with the corresponding offset to goodwill. Upon the conclusion of the measurement period, any subsequent adjustments are recorded to earnings.
We periodically assess the carrying value of goodwill by reviewing the fair value of the net assets underlying all acquisition-related goodwill on a reporting unit basis. We assess the recoverability of goodwill in the fourth quarter of each fiscal year.
We also use judgment in assessing whether we need to test goodwill more frequently for impairment than annually given factors such as unexpected adverse economic conditions, competition, product changes and other events. If the carrying amount of a reporting unit that contains goodwill exceeds fair value, a possible impairment would be indicated. We assess each reporting unit qualitatively to determine if it is more likely than not that the fair value of one, or more, of our reporting units is less than its book value. If based on the qualitative analysis, we conclude that it is more likely than not that the fair value of one, or more, of our reporting units fair values is less than its book value, we determine the fair value of the reporting unit, or units, for further testing using a quantitative method.
Quantitatively, we determine the fair value of a reporting unit using a discounted cash flow ("DCF") analysis and a market comparable method, with each method being equally weighted in the calculation.
Determining fair value requires the exercise of significant judgment, including judgment about appropriate discount rates, the amount and timing of expected future cash flows, as well as relevant comparable company earnings multiples for the market comparable approach. The cash flows employed in the DCF analyses are based on the Company's most recent long-range forecast and, for years beyond the forecast, the Company's estimates, which are based on estimated exit multiples times the final forecasted year earnings before interest, taxes, depreciation and amortization. The discount rates used in the DCF analyses are intended to reflect the risks inherent in the future cash flows of the respective reporting units. For the market comparable approach, the Company evaluated comparable company public trading values, using earnings multiples and sales multiples that are used to value the reporting units.
There was no indication of impairment in any of the Company's reporting units in the fiscal 2019, fiscal 2018 or fiscal 2017 annual tests.
The Company's DCF model is based on our expectation of future market conditions for each of the reporting units, as well as discount rates that would be used by market participants in an arms-length transaction. Future events could cause the Company to conclude that market conditions have declined or discount rates have increased to the extent that the Company's goodwill could be further impaired. It is not possible at this time to determine if any such future impairment charge would result.
Income Taxes
Income taxes are determined under the asset and liability method as required by ASC 740, Income Taxes. Income tax expense or benefit is based on pre-tax financial accounting income. Deferred tax assets and liabilities are recognized for the expected tax consequences of temporary differences between the tax
bases of assets and 60 Table of Contents
liabilities and their reported amounts. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. AtFebruary 2, 2020 , the Company'sU.S. operations continued to have cumulative consolidated pre-tax income for the most recent three-year period. Management concluded that as a consequence of the Company's three-year cumulative consolidated pre-tax income, generating taxable income in fiscal 2017, 2018, and 2019, the Company's long NOL carryforward periods, a significant reduction in the Company's recent interest expense, and the Company's business plan for fiscal 2020 and beyond showing continued profitability, that it is more likely than not that substantially all of the Company'sU.S. deferred tax assets will be realized. As a result, the Company concluded that no additional valuation allowance on itsU.S. Federal and state deferred tax assets was necessary. The Company follows the GAAP guidance for uncertain tax positions within ASC 740, Income Taxes. ASC 740 provides guidance related to the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. The standard prescribes the minimum recognition threshold that a tax position is required to meet before being recognized in the financial statements. ASC 740 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosure. Initial recognition, derecognition and measurement is based on management's judgment given the facts, circumstances and information available at the reporting date. We reevaluate uncertain tax positions on a quarterly basis. This evaluation is based on factors including, but not limited to, changes in facts or circumstances, changes in tax law, effectively settled issues under audit, and new audit activity. Such a change in recognition or measurement could result in the recognition of a tax benefit or an additional charge to the tax provision. For the Global Intangible Low-Tax Income ("GILTI") provisions of the Tax Cuts and Jobs Act of 2017, the Company has elected GILTI as a period cost if and
when incurred. Self-insurance We have a high deductible insurance program for most losses related to general liability, product liability, environmental liability, automobile liability, workers' compensation, and we are self-insured for medical claims, while maintaining per employee stop loss coverage, and certain legal claims. The expected ultimate cost for claims incurred as of the balance sheet date is not discounted and is recognized as a liability. Self-insurance losses for claims filed and claims incurred but not reported are accrued based upon estimates of the aggregate liability for uninsured claims using loss development factors and actuarial assumptions followed in the insurance industry and historical loss development experience. To the extent the projected future development of the losses resulting from environmental, workers' compensation, automobile, general and product liability claims incurred as ofFebruary 2, 2020 differs from the actual development of such losses in future periods, our insurance reserves could differ significantly, resulting in either higher or lower future insurance expense. Management estimates Management believes the assumptions and other considerations used to estimate amounts reflected in our consolidated financial statements are appropriate. However, if actual experience differs from the assumptions and other considerations used in estimating amounts reflected in our consolidated financial statements, the resulting changes could have a material adverse effect on our consolidated results of operations, and in certain situations, could have a material adverse effect on our financial condition.
Stock-Based Compensation
Our stock option expense is estimated at the grant date based on an award's fair value as calculated by the Black-Scholes option-pricing model and is recognized as an expense over the requisite service period. The Black-Scholes model requires various highly judgmental assumptions including expected volatility and option life. If any of the assumptions used in the Black-Scholes model change significantly, stock-based compensation 61
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expense may differ materially in the future from that recorded in the current period. In addition, we estimate an expected forfeiture rate on all of our stock-based compensation awards and only recognize expense for those awards expected to vest. We estimate the forfeiture rate based on historical experience. To the extent our actual forfeiture rate is different from our estimate, stock-based compensation expense is adjusted accordingly. See "Note 12-Stock Based Compensation and Employee Benefit Plans" in the Notes to the Consolidated Financial Statements within "Part II. Item 8. Financial Statements and Supplementary Data."
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