HD SUPPLY HOLDINGS, INC. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
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 ("MRO") andSpecialty Construction . Through approximately 270 branches and 44 distribution centers, in theU.S. andCanada , we serve these markets with an integrated go-to-market strategy. We have more than 11,000 associates delivering localized, customer-tailored products, services and expertise. We serve approximately 500,000 customers, which include contractors, maintenance professionals, 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.
Impact of COVID-19 on Our Business
The COVID-19 pandemic has resulted, and is likely to continue to result, in significant economic disruption and has and will likely continue to adversely affect our business. As of the date of this filing, significant uncertainty exists concerning the magnitude of the impact and duration of the COVID-19 pandemic and the magnitude of the impact of the pandemic on our sales, operations, and supply chain and our customers, suppliers, vendors, and business partners.HD Supply was deemed an essential business in all areas in which we operate. As a result, we continue to service our customers. However, our customers have been impacted by various factors related to the pandemic, including the response of governmental and other regulatory authorities to the pandemic, such as "shelter-in-place," "stay-at-home" orders, mandatory quarantine orders, travel restrictions, and restrictions on landlord remedies. These factors resulted in a slowing of our sales to the affected customers. Many of Facilities Maintenance's hospitality customer locations were closed or operating at a meaningfully diminished capacity, which negatively impacted sales beginning in the last half of the first quarter and may negatively impact sales until the response to the COVID-19 pandemic moderates. Similarly, our Construction & Industrial facilities continue to operate, but we initially restricted public access to our branches and showrooms, and instead serviced our customers through customer pickup areas in the front of our locations, as well as continued job-site deliveries and direct deliveries. Many of the markets in which we operate have begun to ease restrictions that were in place earlier in the year, subject to change depending on the scope and nature of the continuing pandemic. With respect to liquidity, we are continuously evaluating our cash positions and have taken actions to reduce costs and spending across our organization. This includes reducing hiring activities, adjusting pay programs, negotiating rent payment deferrals at our leased facilities, and limiting discretionary spending. We have also reduced anticipated spending on certain capital investment projects and chose to not repurchase any shares under theMarch 2020 authorized share repurchase program, instead focusing on enhancing our liquidity position. In addition, we may choose and currently have the ability to access available credit facilities and have capacity to do so. See "Liquidity and capital resources - External Financing" of this Item 2 of this quarterly report on
Form 10-Q for further information. We will continue to actively monitor the situation and may take further actions that alter our business operations as may be required by federal, state or local authorities or that we determine are in the best interests of our employees, customers, suppliers, and shareholders. Alternatively, we may reverse some of the actions previously taken as we deem appropriate, including repurchasing shares under theMarch 2020 authorized share repurchase program. 27 Table of Contents
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND HD SUPPLY RESULTS OF 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, the Company's consolidated financial results include Corporate. Corporate incurs costs related to the Company's centralized support functions, which are comprised of finance, information technology, human resources, legal, supply chain and other support services. All Corporate overhead costs are allocated to the reportable segments. Eliminations include the adjustments necessary to eliminate intercompany transactions. Discontinued Operations
OnAugust 10, 2020 , the Company entered into a definitive agreement to sell its Construction & Industrial business to an affiliate of Clayton, Dubilier & Rice. The purchase price of$2.9 billion is payable in cash at closing and may be adjusted for certain purchase price adjustments, as defined in the Transaction Agreement. The Company expects to receive approximately$2.5 billion of net proceeds after taxes and transaction costs. The transaction is expected to close in the third quarter of fiscal 2020 subject to customary regulatory approvals. In accordance with ASC 205-20, "Discontinued Operations," the Company will reflect the Construction & Industrial business as a discontinued operation in its financial statements beginning in the third quarter of fiscal 2020. For additional information, see "Note 14 - Subsequent Event," in the Notes to Consolidated Financial Statements within Item 1 of this quarterly report on
Form 10-Q. Acquisitions
We enter into strategic acquisitions from time to time to expand into new markets, new platforms, and new geographies in an effort to better service existing customers and attract new ones. In accordance with the 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 acquisition forward.
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 YearHD Supply's fiscal year is a 52- or 53-week period ending on the Sunday nearest toJanuary 31 . The fiscal years endingJanuary 31, 2021 ("fiscal 2020") andFebruary 2, 2020 ("fiscal 2019") both include 52 weeks. The three months endedAugust 2, 2020 ("second 28 Table of Contents
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND HD SUPPLY RESULTS OF OPERATIONS
quarter 2020") and
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.
We ship products to customers by internal fleet and by third-party carriers. Net sales are recognized from product sales when control of the products 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 profit may not be comparable to those of other companies, as other companies may include all of the costs related to their distribution networks 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), outbound freight, rent, insurance, utilities, repair and maintenance and professional fees. In addition, operating expenses include depreciation and amortization and restructuring charges.
Adjusted EBITDA, Adjusted net income, and Free cash flow
Adjusted EBITDA, Adjusted net income, and Free cash flow are not recognized terms under generally accepted accounting principles inthe United States of America ("GAAP") and do not purport to be alternatives to Net income or, in the case of Free cash flow, operating activities 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, Adjusted net income, and Free cash flow 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. We believe that Free cash flow provides investors a better understanding of the Company's liquidity position. 29 Table of Contents
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND HD SUPPLY RESULTS OF OPERATIONS
Adjusted EBITDA is based on ''Consolidated EBITDA,'' a measure which is defined in our 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 restrictive 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 (both as defined in the SeniorABL Facility agreement). Adjusted EBITDA is defined as Net income (loss) less Income from discontinued operations, net of tax, plus (i) Interest expense and Interest income, net, (ii) Provision for income taxes, (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 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 quarterly report on Form 10-Q. 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 our annual report on Form 10-K for the fiscal year endedFebruary 2, 2020 . 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. Effective with second quarter 2020 reporting, we modified the definition of Adjusted net income to remove the exclusions of the tax provision and amortization of acquisition-related intangible assets (other than software) and addition of cash tax payments. We believe this revised presentation is more useful since we have exhausted our federal net operating loss carryforwards and become a regular taxpayer. All periods presented have been revised to reflect the modified definition. Free cash flow is defined as operating activities
less capital expenditures. We believe that Adjusted EBITDA, Adjusted net income, and Free cash flow are frequently used by securities analysts, investors and other interested parties in their evaluation of companies, many of which present an Adjusted EBITDA, Adjusted net income, and Free cash flow 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, Adjusted net income , and Free cash flow 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, Adjusted net income , and Free cash flow 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.
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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND HD SUPPLY RESULTS OF OPERATIONS
The following table presents a reconciliation of Net Income, the most directly comparable financial measure under GAAP, to Adjusted EBITDA for the periods presented (amounts in millions):
Three Months Ended Six Months Ended
August 2, 2020 August 4, 2019 August 2, 2020 August 4, 2019
Net income $ 131 $ 135 $ 203 $ 242
Interest expense, net 24 28 49 56
Provision for income taxes 43 48 67 83Depreciation and amortization(1) 30 27 59 54 Restructuring and separation charges(2) 4 - 10 (2) Stock-based compensation 5 5 12 12 Acquisition and integration costs(3) -
- - 1
Other 1 1 1 1
Adjusted EBITDA $ 238 $ 244 $ 401 $ 447
(1) Depreciation and amortization includes amounts recorded within Cost of sales
in the Consolidated Statements of Operations.
Represents the costs related to separation activities and personnel changes,
primarily severance and other employee-related costs, and costs related to (2) deferring certain projects during the separation preparations. For the six
months ended
of the lease for its former corporate headquarters.
(3) Represents the costs incurred in the acquisition and integration of business
acquisitions, including A.H. Harris Construction Supplies .
The following table presents a reconciliation of Net Income, the most directly
comparable financial measure under GAAP, to Adjusted net income for the periods
presented (amounts in millions):
Three Months Ended Six Months Ended
August 2, 2020 August 4, 2019 August 2, 2020 August 4, 2019
Net income $ 131 $ 135 $ 203 $ 242Plus: Restructuring and separation charges(1) 4 - 10 (2) Plus: Acquisition and integration costs(2) - - - 1 Plus: Tax benefit for adjustments(3) (1)
- (2) -
Adjusted Net Income $ 134 $ 135 $ 211 $ 241
Represents the costs related to separation activities and personnel changes,
primarily severance and other employee-related costs, and costs related to (1) deferring certain projects during the separation preparations. For the six
months ended
of the lease for its former corporate headquarters.
(2) Represents the costs incurred in the acquisition and integration of business
acquisitions, including
Adjustments to Net income have been tax effected at the Company's combined (3) annual federal and state statutory tax rates of 25.8% for the three and six
months ended August 2, 2020 and 25.7% for the three and six months ended
August 4, 2019 .
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Consolidated results of operations
Dollars in millions
Percentage Percentage
Three Months Ended Increase Six Months Ended Increase
August 2,2020 August 4,2019 (Decrease) August 2,2020 August 4,2019 (Decrease)
Net sales $ 1,552 $ 1,624 (4.4) % $ 2,947 $ 3,117 (5.5) %
Gross Profit 596 633 (5.8) 1,146 1,218 (5.9)
Operating expenses:Selling, general, and administrative 366
396 (7.6) 762 788 (3.3) Depreciation and amortization 28 26 7.7 55 51 7.8 Restructuring and separation 4 - * 10 (2) * Total operating expenses 398 422 (5.7) 827 837 (1.2) Operating Income 198 211 (6.2) 319 381 (16.3) Interest expense 24 28 (14.3) 49 56 (12.5)
Income Before Provision for Income Taxes 174
183 (4.9) 270 325 (16.9)
Provision for income taxes 43 48 (10.4) 67 83 (19.3)
Net Income $ 131 $ 135 (3.0) $ 203 $ 242 (16.1)
Non-GAAP financial data:
Adjusted EBITDA $ 238 $ 244 (2.5) $ 401 $ 447 (10.3)
Adjusted net income $ 134 $ 135 (0.7) $ 211 $ 241 (12.4)
* Not meaningful
% of Net Sales % of Net Sales
Three Months Ended Basis Point Six Months Ended Basis Point
August 2, August 4, Increase August 2, August 4, Increase
2020 2019 (Decrease) 2020 2019 (Decrease)
Net sales 100.0 % 100.0 % - 100.0 % 100.0 % -
Gross Profit 38.4 39.0 (60) 38.9 39.1 (20)
Operating expenses:Selling, general, and administrative 23.5 24.4
(90) 25.9 25.4 50
Depreciation and amortization 1.8 1.6 20 1.9 1.6 30
Restructuring and separation 0.3 - 30 0.3 (0.1) 40
Total operating expenses 25.6 26.0 (40) 28.1 26.9 120
Operating Income 12.8 13.0 (20) 10.8 12.2 (140)
Interest expense 1.6 1.7 (10) 1.6 1.8 (20)Income Before Provision for Income Taxes 11.2 11.3
(10) 9.2 10.4 (120)
Provision for income taxes 2.8 3.0 (20) 2.3 2.6 (30)
Net Income 8.4 8.3 10 6.9 7.8 (90)
Non-GAAP financial data:
Adjusted EBITDA 15.3 15.0 30 13.6 14.3 (70)
Adjusted net income 8.6 8.3 30 7.2 7.7 (50)
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Highlights Second quarter 2020 results were negatively impacted by the response of governmental and other regulatory authorities, including "shelter-in-place" and "stay-at-home" orders to the COVID-19 pandemic put into place during the three months endedMay 3, 2020 ("first quarter 2020"). WhileHD Supply was deemed an essential business in all areas in which we operate, the impact to our customers by the various factors related to the pandemic resulted in a slowing of our sales. These economic impacts generally began inmid-March 2020 , which is the middle of our first quarter 2020. During second quarter 2020, many of the markets in which we operate began easing responses and restrictions that were in place at the beginning of the period. Net sales in second quarter 2020 decreased$72 million , or 4.4%, as compared to second quarter 2019. Operating income in second quarter 2020 decreased$13 million , or 6.2%, as compared to second quarter 2019. Net income in second quarter 2020 decreased$4 million , or 3.0%, to$131 million as compared to second quarter 2019. Adjusted EBITDA in second quarter 2020 decreased$6 million , or 2.5%, as compared to second quarter 2019. Adjusted net income in second quarter 2020 decreased$1 million , or 0.7%, as compared to second quarter 2019. As ofAugust 2, 2020 , our total liquidity was$995 million , an increase of$367 million since the end of fiscal 2019. See "Liquidity and capital resources - External Financing" of this Item 2 of this quarterly report on Form 10-Q
for further information. Net sales Net sales in second quarter 2020 decreased$72 million , or 4.4%, compared to second quarter 2019 and$170 million , or 5.5%, in the first six months of fiscal 2020 as compared to the same period in fiscal 2019. Both of our reportable segments experienced a decrease in Net sales in second quarter 2020 and in the first six months of fiscal 2020 as compared to the same periods in fiscal 2019. The Net sales decreases were primarily due to a decrease in volume related to the response by governmental and other regulatory authorities to the COVID-19 pandemic during first quarter 2020 with moderate improvement in sales volume as the markets in which we operate began easing restrictions during second quarter 2020. Average year-over-year daily sales changes for the fiscal 2020 months of February, March, April, May, June, and July were an increase of 8.8%, an increase of 0.5%, a decrease of 22.6%, a decrease of 7.3%, a decrease of 4.8%, and a decrease of 2.0%, respectively. There were 20 selling days in February, 20 selling days in March, 25 selling days in April, 19 selling days in May, 20 selling days in June, and 24 selling days in July in both fiscal 2020 and fiscal 2019. Gross profit
Gross profit decreased
Gross profit as a percentage of Net sales ("gross margin") decreased
approximately 60 basis points to 38.4% in second quarter 2020 as compared to
39.0% in second quarter 2019 and approximately 20 basis points to 38.9% in the
first six months of fiscal 2020 as compared to 39.1% in the same period in
fiscal 2019. Facilities Maintenance experienced a decline in gross profit in
both periods while Construction & Industrial experienced a slight increasein gross profit in both periods. Operating expenses
Operating expenses decreased
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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND HD SUPPLY RESULTS OF OPERATIONS
Selling, general, and administrative expenses decreased in both periods of fiscal 2020 as compared to the same periods in fiscal 2019 primarily due to decreases in variable costs including personnel, travel and other controllable costs. During the first six months of fiscal 2020, these decreases were partially offset by an increase in insurance claims, fixed facility and equipment costs, and charges for expected credit losses. Depreciation and amortization expense increased in both periods due to investments in facilities and technology during fiscal 2019. Restructuring and separation expenses in second quarter 2020 and the first six months of fiscal 2020 were primarily due to professional fees incurred to execute the separation of the Company's planned separation of its Facilities Maintenance and Construction & Industrial businesses, and, to a lesser extent, severance and other employee-related costs and the costs of deferring certain projects during the separation preparations. Restructuring and separation expenses in the first six months of fiscal 2019 included the reversal of$2 million of restructuring expenses incurred in fiscal 2018. The reversal resulted from the favorable termination of the lease associated with the Company's former corporate headquarters, which was exited in fiscal 2018.
Operating expenses as a percentage of Net sales decreased approximately 40 basis points to 25.6% in second quarter 2020 as compared to second quarter 2019 and increased approximately 120 basis points to 28.1% in the first six months of fiscal 2020 as compared to the same period in fiscal 2019. Selling, general, and administrative expenses as a percentage of Net sales, decreased approximately 90 basis points to 23.5% in second quarter 2020 as compared to second quarter 2019. The decrease in second quarter 2020 as compared to second quarter 2019 was primarily due to the decrease in personnel costs, including travel and other controllable costs, partially offset by an increase in fixed facility and equipment costs as a percentage of Net sales. Selling, general, and administrative expenses as a percentage of Net sales increased approximately 50 basis points to 25.9% in the first six months of fiscal 2020 as compared to the same period in fiscal 2019. The increase was primarily a result of the decline in net sales at both of our reportable segments. Beginning inmid-March 2020 , the economic impact of the response to the COVID-19 pandemic was swift and significant. As a result, the initial reduction in Net sales outpaced our efforts to reduce fixed costs. Restructuring and separation expenses as a percentage of Net sales increased approximately 30 basis points in second quarter 2020 as compared to second quarter 2019 and 40 basis points in the first six months of fiscal 2020 as compared to the same period in fiscal 2019. Operating income
Operating income decreased$13 million , or 6.2%, during second quarter 2020 as compared to second quarter 2019 and$62 million , or 16.3%, during the first six months of fiscal 2020 as compared to the same period in fiscal 2019. The decrease in both periods was due to the decline in gross profit as a result of the decrease in Net sales, partially offset by the decrease in operating expenses. Operating income as a percentage of Net sales decreased approximately 20 basis points to 12.8% during second quarter 2020 as compared to second quarter 2019 and approximately 140 basis points to 10.8% during the first six months of fiscal 2020 as compared to the same period in fiscal 2019. The decrease in second quarter 2020 as compared to second quarter 2019 was due to the decline in gross margins, partially offset by the decline in operating expenses as a percentage of Net sales. The decrease in the first six months of fiscal 2020 as compared to the same period in fiscal 2019 periods was primarily due to the increase in operating expenses as a percentage of Net sales, and to a lesser extent, the decline in gross margins. Interest expense
Interest expense decreased$4 million , or 14.3%, during second quarter 2020 as compared to second quarter 2019 and$7 million , or 12.5% during the first six months of fiscal 2020 as compared to the same period in fiscal 2019. The decrease in both periods was primarily due to declining interest rates and
a reduction in indebtedness. Provision for income taxes
The provision for income taxes during the period is calculated by applying an estimated annual tax rate for the full fiscal year to pre-tax income for the reported period plus or minus unusual or infrequent discrete items occurring within the period. The provision for income taxes in second quarter 2020 was$43 million compared to$48 million in second quarter 2019. The provision for income taxes for the first six months of fiscal 2020 was$67 million as compared to$83 million in the first six months of fiscal 2019. The effective rate for second quarter 2020 and the first six months of fiscal 2020 was 24.7% and 24.8%, respectively. The effective rate for second quarter 2019 and the first six months of fiscal 2019 was 26.2% and 25.5%, respectively. 34 Table of Contents
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND HD SUPPLY RESULTS OF OPERATIONS
OnMarch 27, 2020 , the Coronavirus Aid, Relief, and Economic Security Act ("CARES Act") was signed into law. The CARES Act contains significant business tax provisions, including modifications to the rules limiting the deductibility of net operating losses ("NOLs"), expensing of qualified improvement property and business interest in Internal Revenue Code Sections 172(a) and 163(j), respectively. The effects of the new legislation are recognized upon enactment. The Company did not recognize any significant impact to income tax expense for second quarter 2020 or the first six months of fiscal 2020 related to the CARES Act.
We regularly assess the realization of our net deferred tax assets and the need for any valuation allowance. This assessment requires management to make judgments about the benefits that could be realized from future taxable income, as well as other positive and negative factors influencing the realization of deferred tax assets. As ofAugust 2, 2020 , andFebruary 2, 2020 , the Company's valuation allowance on itsU.S. deferred tax assets was approximately$6 million . Adjusted EBITDA Adjusted EBITDA decreased$6 million , or 2.5%, in second quarter 2020 as compared to second quarter 2019 and$46 million , or 10.3%, in the first six months of fiscal 2020 as compared the same period in fiscal 2019. The decrease in Adjusted EBITDA in second quarter 2020 was driven by a$17 million decrease at Facilities Maintenance, partially offset by an$11 million increase at Construction & Industrial. The decrease in the first six months of fiscal 2020 was driven by a$53 million decrease at Facilities Maintenance, partially offset by a$7 million increase at Construction & Industrial. Adjusted EBITDA as a percentage of Net sales increased approximately 30 basis points to 15.3% in second quarter 2020 as compared to second quarter 2019 and decreased approximately 70 basis points to 13.6% in the first six months of fiscal 2020 as compared to the same period in fiscal 2019. The increase in second quarter 2020 as compared to second quarter 2019 was due to the decrease in operating expenses as a percentage of Net sales, partially offset by the decline in gross margin. The decrease in the first six months of fiscal 2020 as compared to fiscal 2019 was due to the decline in Net sales and the increase in operating expenses as a percentage of Net sales. Adjusted net income
Adjusted net income decreased$1 million , or 0.7%, in second quarter 2020 as compared to second quarter 2019 and$30 million , or 12.4% in the first six months of fiscal 2020 as compared to fiscal 2019. The decrease in Adjusted net income in both periods was attributable to the decline in operating income, partially offset by lower interest expense and a decrease in the income tax provision.
Results of operations by reportable segment
Facilities Maintenance
Three Months Ended Six Months Ended
August 2, August 4, Increase August 2, August 4, Increase
Dollars in millions 2020 2019 (Decrease) 2020 2019 (Decrease)
Net sales $ 761 $ 830 (8.3) % $ 1,443 $ 1,602 (9.9) %
Operating income $ 112 $ 133 (15.8) % $ 189 $ 252 (25.0) %
% of Net sales 14.7 % 16.0 % (130) bps 13.1 % 15.7 % (260) bps
Depreciation and amortization 15 13 15.4 %
30 25 20.0 %
Other 5 3 66.7 % 11 6 83.3 %
Adjusted EBITDA $ 132 $ 149 (11.4) % $ 230 $ 283 (18.7) %
% of Net sales 17.3 % 18.0 % (70) bps 15.9 % 17.7 % (180) bps
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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND HD SUPPLY RESULTS OF OPERATIONS
Net Sales Net sales decreased$69 million , or 8.3%, in second quarter 2020 as compared to second quarter 2019 and$159 million , or 9.9%, in the first six months of fiscal 2020 as compared to the same period in fiscal 2019. The decrease in Net sales in both periods was primarily due to declines in the hospitality and multifamily industries related to the response by governmental and other regulatory authorities to the COVID-19 pandemic. As the markets in which we operate have begun easing these restrictions during second quarter 2020, we have generated improving sales volume. Facilities Maintenance average year-over-year daily sales changes for the fiscal 2020 months of February, March, April, May, June, and July were an increase of 4.1%, a decrease of 0.4%, a decrease of 31.9%, a decrease of 13.4%, a decrease of 9.0%, and a decrease of 4.4%, respectively. For Facilities Maintenance, the most prominent impact of the decline in Net sales was in the hospitality industry, which historically represents approximately 18% of sales. The decline in travel due to the COVID-19 pandemic resulted in the closing of many hotels, with the remaining open hotels experiencing a significant reduction in occupancy. In second quarter 2020 and the first six months of fiscal 2020, hospitality sales decreased approximately 34.6% and 33.7% as compared to the same periods in fiscal 2019. Many of our multifamily customers limited their purchases to emergency repair and maintenance items in order to preserve cash and to keep maintenance professionals from entering tenant units unnecessarily in an attempt to maintain social distancing. Multifamily customers may also be affected by the steps taken by state and local governments to minimize the impact of the COVID-19 pandemic on tenants, including placing moratoriums on evictions and prohibiting late fees for up to three months. Finally, multifamily customers are seeing fewer unit turns as tenants are less likely to move their residence during the pandemic. Fewer turns reduce both maintenance and improvement expenditures. Sales to multifamily customers historically account for approximately 60% of Facilities Maintenance's sales. In second quarter 2020 and the first six months of fiscal 2020, our multifamily sales decreased approximately 4.1% and 6.1%, as compared to the same periods in fiscal 2019. Adjusted EBITDA
Adjusted EBITDA decreased$17 million , or 11.4%, in second quarter 2020 as compared to second quarter 2019 and$53 million , or 18.7%, during the first six months of fiscal 2020 as compared to the same period in fiscal 2019. The decrease in Adjusted EBITDA in both periods was primarily due to the reduction in Net sales. Selling, general, and administrative expenses decreased approximately$22 million and$24 million in second quarter 2020 as compared to second quarter 2019 and in the first six months of fiscal 2020 as compared to the same period in fiscal 2019, respectively. The decrease in both periods was primarily due to a reduction in variable expenses, including freight costs, variable compensation, overtime pay, travel expenses and other controllable costs. In the first six months of fiscal 2020, these decreases were partially offset by increased insurance claims, fixed facility and equipment costs, and an approximately$4 million charge for expected credit losses. Adjusted EBITDA as a percentage of Net sales decreased approximately 70 basis points in second quarter 2020 as compared to second quarter 2019 and approximately 180 basis points in the first six months of fiscal 2020 as compared to the same period in fiscal 2019. The decrease in second quarter 2020 was primarily due to a decrease in gross margin of approximately 120 basis points, partially offset by a reduction in Selling, general, and administrative expenses as a percentage of Net sales. The decrease in the first six months of fiscal 2020 was driven by an increase in Selling, general, and administrative expenses as a percentage of Net sales and a decrease in gross margin of approximately 50 basis points. The decline in gross margins resulted from an increase in sales of lower-margin safety products, appliances, HVAC and janitorial products. We expect gross margin to fluctuate as our customers within different industries recover from the impacts of the COVID-19 pandemic at different rates and with new product requirements. 36 Table of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND HD SUPPLY RESULTS OF OPERATIONS Construction & Industrial Three Months Ended Six Months Ended August 2, August 4, Increase August 2, August 4, Increase Dollars in millions 2020 2019 (Decrease) 2020 2019 (Decrease) Net sales$ 793 $ 795 (0.3) %$ 1,506 $ 1,516 (0.7) % Operating income$ 86 $ 78 10.3 %$ 130 $ 129 0.8 % % of Net sales 10.8 % 9.8 % 100 bps 8.6 % 8.5 % 10 bps Depreciation and amortization 15 14 7.1 %
29 29 -
Other 5 3 66.7 % 12 6 100.0 %
Adjusted EBITDA $ 106 $ 95 11.6 % $ 171 $ 164 4.3 %
% of Net sales 13.4 % 11.9 % 150 bps 11.4 % 10.8 % 60 bps
Net Sales
Net sales decreased$2 million , or 0.3%, in second quarter 2020 as compared to second quarter 2019 and$10 million , or 0.7%, in the first six months of fiscal 2020 as compared to the same period in fiscal 2019. The decrease in Net sales in both periods was primarily due to varying state and local government restrictions on construction-related activities to address the COVID-19 pandemic. These restrictions, which were generally introduced in the middle ofMarch 2020 , resulted in an uneven impact on Net sales across the markets we serve. As the markets in which we operate eased restrictions during second quarter 2020, our sales volume improved. Average year-over-year daily sales changes for the fiscal 2020 months of February, March, April, May, June, and July were an increase of 14.2%, an increase of 1.4%, a decrease of 13.0%, a decrease of 1.4%, a decrease of 0.4%, and an increase of 0.5%, respectively. Adjusted EBITDA
Adjusted EBITDA increased$11 million , or 11.6%, in second quarter 2020 as compared to second quarter 2019 and$7 million , or 4.3% in the first six months of fiscal 2020 as compared to the same period in fiscal 2019. The increase in both periods was primarily due to a reduction in Selling, general, and administrative expenses, and, to a lesser extent, improvements in gross margins. The decrease in Selling, general, and administrative expenses in both periods was primarily due to reductions in overtime pay, travel, and other controllable expenses in response to the COVID-19 pandemic. These decreases were partially offset by increased fixed costs related to new branches recently opened. Adjusted EBITDA as a percentage of Net sales increased approximately 150 basis points in second quarter 2020 as compared to second quarter 2019 and approximately 60 basis points in the first six months of fiscal 2020 as compared to the same period in fiscal 2019. The increase in second quarter 2020 as compared to second quarter 2019 was driven by a decrease in Selling, general, and administrative expenses as a percentage of Net sales and an increase in gross margin of approximately 30 basis points in second quarter 2020. The increase in the first six months of fiscal 2020 as compared to the same period in fiscal 2019 was driven by an increase in gross margin of approximately 50 basis points and a decrease in Selling, general, and administrative expenses as a percentage of Net sales. The increase in gross margin in both periods was primarily due to improved rebar gross margin rates, and an increase in safety product sales which are generally higher gross margin products.
Liquidity and capital resources
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, based on our current business plan, that these sources of funds will be sufficient to meet the operating needs of our business for at least the next twelve months. We are continuously evaluating our cash positions and have taken prudent actions to reduce costs and spending across our organization. This includes reducing hiring activities, adjusting pay programs, negotiating rent payment deferrals at our leased facilities, and limiting discretionary spending. We have also reduced anticipated spending on certain capital investment projects. In addition, we chose not to repurchase any shares under theMarch 2020 authorized share repurchase program, instead focusing on enhancing our liquidity position. We may elect to repurchase shares under this program during the second half of fiscal 2020. 37 Table of Contents
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND HD SUPPLY RESULTS OF OPERATIONS
OnAugust 10, 2020 , the Company entered into a definitive agreement to sell its Construction & Industrial business to an affiliate of Clayton, Dubilier & Rice. The purchase price of$2.9 billion is payable in cash at closing and may be adjusted for certain purchase price adjustments, as defined in the Transaction Agreement. The Company anticipates using the estimated net proceeds of$2.5 billion after tax and transaction costs, to repay debt, finance acquisitions, invest in Facilities Maintenance and return cash to the shareholders, likely through share repurchases. The CARES Act allows employers to defer the payment of the employer share of Federal Insurance Contributions Act ("FICA") taxes for the period fromMarch 27, 2020 and endingDecember 31, 2020 . During the first six months of fiscal 2020, the Company deferred FICA payments of$14 million under the CARES Act and will continue to defer FICA payments throughDecember 31, 2020 . The deferred amount will be payable as follows: (1) 50% of the deferred amount will be dueDecember 31, 2021 and (2) Remaining 50% of the deferred amount will be due December
31, 2022.
During the first six months of fiscal 2020, our cash inflow was primarily driven by cash provided by operations, partially offset by net debt repayments and capital expenditures.
As of
Information about our cash flows, by category, is presented in the Consolidated Statements of Cash Flows and is summarized as follows:
Amounts in millions Six Months Ended Net cash provided by (used for): August 2, 2020 August 4, 2019
Increase (Decrease) Operating activities $ 339 $ 286 $ 53 Investing activities (33) (49) 16 Financing activities (269) (234) (35) Free cash flow: Operating activities $ 339 $ 286 $ 53 Less: Capital expenditures (33) (54) 21 Free cash flow $ 306 $ 232 $ 74 Working capital Working capital, excluding cash and cash equivalents, was$755 million as ofAugust 2, 2020 , decreasing$109 million as compared to$864 million as ofAugust 4, 2019 . The change in working capital was primarily driven by declines in Accounts receivable and Inventory due to declining sales and deliberate controls over working capital spending as a result of the COVID-19 pandemic. Operating activities During the first six months of fiscal 2020, cash provided by operating activities was$339 million compared to$286 million in the first six months of fiscal 2019. Cash interest paid in the first six months of fiscal 2020 was$47 million , compared to$53 million in the first six months of fiscal 2019. Cash income taxes paid in the first six months of fiscal 2020 was$36 million , compared to$10 million in the first six months of fiscal 2019. The increase in operating cash flows excluding interest and income tax payments is primarily attributable to efficiency in the use of working capital. 38 Table of Contents
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND HD SUPPLY RESULTS OF OPERATIONS
Investing activities During the first six months of fiscal 2020, cash used by investing activities was$33 million , comprised entirely of capital expenditures. During the first six months of fiscal 2019, cash used by investing activities was$49 million , primarily comprised of capital expenditures. Financing activities During the first six months of fiscal 2020, cash used in financing activities was$269 million , primarily due to net debt repayments of$265 million , tax withholdings on stock-based awards of$4 million , and purchases of treasury shares of$3 million , partially offset by proceeds from employee stock option exercises of$3 million . During the first six months of fiscal 2019, cash used in financing activities was$234 million , primarily due to the payment of the corporate headquarters financing liability of$88 million , purchases of treasury shares of$78 million , net debt repayments of$69 million , and tax withholdings on stock-based awards of$5 million , partially offset by proceeds from employee stock option exercises of$7 million . External financing As ofAugust 2, 2020 , we had an aggregate principal amount of$1,783 million of outstanding indebtedness, net of unamortized discounts and unamortized deferred financing costs of$2 million and$16 million , respectively, and$976 million of additional available borrowings under our SeniorABL Facility (after giving effect to the borrowing base limitations and approximately$24 million in letters of credit issued and including$86 million of borrowings available on qualifying cash balances). From time to time, depending on market conditions and other factors, we may seek to repay, redeem, repurchase or otherwise acquire or refinance all or a portion of our indebtedness. We may make such repurchases in privately negotiated transactions or otherwise.
For additional information, see "Note 2 - Debt," in the Notes to Consolidated Financial Statements within Item 1 of this quarterly report on Form 10-Q.
Critical accounting policies
Our consolidated financial statements have been prepared in accordance with GAAP. Preparation of these statements requires management to make judgments and estimates. Some accounting policies have a significant impact on amounts reported in these consolidated financial statements. The Company's critical accounting policies have not changed from those reported in Management's Discussion and Analysis of Financial Condition and Results of Operations in our annual report on Form 10-K for the fiscal year endedFebruary 2, 2020 , with the exception of the Company's adoption of Accounting Standard Update ("ASU") 2016-13, "Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments" ("ASU 2016-13") onFebruary 3, 2020 (the first day of fiscal 2020). Pursuant to the implementation of ASU 2016-13, the Company establishes an allowance for credit losses using estimations of loss rates based upon historical loss experience and adjusted for factors that are relevant to determining the expected collectability of trade receivables. These estimations and factors require assumptions and judgments regarding matters that are inherently uncertain, including the impact that the COVID-19 pandemic may have on the liquidity, credit, and solvency status of our customers or their industries. For further discussion on the Company's allowances for credit losses, see "Note 8 - Supplemental Balance Sheet and Cash Flow Information" in the Notes to Consolidated Financial Statements within Item 1 of this quarterly report on Form 10-Q.
Recent accounting pronouncements
See "Note 13 - Recent Accounting Pronouncements" in the Notes to Consolidated Financial Statements within Item 1 of this quarterly report on Form 10-Q.
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