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Edited Transcript of HDS earnings conference call or presentation 10-Sep-19 12:00pm GMT

Q2 2019 HD Supply Holdings Inc Earnings Call

Atlanta Sep 19, 2019 (Thomson StreetEvents) -- Edited Transcript of HD Supply Holdings Inc earnings conference call or presentation Tuesday, September 10, 2019 at 12:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Charlotte McLaughlin

HD Supply Holdings, Inc. - IR Officer

* Evan J. Levitt

HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer

* Joseph J. DeAngelo

HD Supply Holdings, Inc. - Chairman & CEO

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Conference Call Participants

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* Christopher M. Dankert

Longbow Research LLC - Research Analyst

* David John Manthey

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

* Deane Michael Dray

RBC Capital Markets, LLC, Research Division - Analyst

* John George Inch

Gordon Haskett Research Advisors - MD & Senior Analyst of Multi-Industrials

* Keith Brian Hughes

SunTrust Robinson Humphrey, Inc., Research Division - MD

* Michael Lawrence McGinn

Wells Fargo Securities, LLC, Research Division - Associate Analyst

* Nigel Edward Coe

Wolfe Research, LLC - MD & Senior Research Analyst

* Patrick Michael Baumann

JP Morgan Chase & Co, Research Division - Analyst

* Robert Douglas Barry

The Buckingham Research Group Incorporated - Research Analyst

* Ryan James Merkel

William Blair & Company L.L.C., Research Division - Research Analyst

* Stephen Edward Volkmann

Jefferies LLC, Research Division - Equity Analyst

* Takeheiko Makishi

Barclays Bank PLC, Research Division - Research Analyst

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the HD Supply Second Quarter Earnings Conference Call. (Operator Instructions) As a reminder, this conference is being recorded.

I would now like to turn the conference over to Charlotte McLaughlin of investor relations. You may begin.

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Charlotte McLaughlin, HD Supply Holdings, Inc. - IR Officer [2]

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Thank you, Sonia. Good morning, ladies and gentlemen, and welcome to the HD Supply Holdings 2019 Second Quarter Earnings Call.

As a reminder, some of our comments today may be forward-looking statements based on management's beliefs and assumptions and information currently available to management at this time. These beliefs are subject to known and unknown risks and uncertainties, many of which may be beyond our control, including those detailed in our periodic SEC filings. Please note that the company's actual results may differ materially from those anticipated, and we undertake no obligation to update these statements.

Reconciliations of certain non-GAAP financial metrics with their corresponding GAAP measures are available at the end of our slide presentation and in our 2019 second quarter earnings release, which is available on our IR website at www.hdsupply.com.

Joe DeAngelo, our CEO, will lead today's call, while Evan Levitt, our CFO, will provide additional color on our recent financial performance and on our expectations for the remainder of 2019. There will be an opportunity for Q&A. (Operator Instructions)

Thank you for your continued interest in HD Supply. And with that, I will turn the call over to Joe DeAngelo.

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [3]

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Well, thank you, Charlotte. Good morning, everyone. Thank you for joining us today for our second quarter 2019 earnings call. As always, it is my privilege to share our company's results with you on behalf of the over 11,500 HD Supply associates who work hard every day as one team, driving customer success and value creation.

Turning to Page 3. Although we navigated a difficult environment, the team and I were disappointed with our performance in the second quarter of fiscal 2019. We delivered 1.5% sales growth and saw adjusted EBITDA decline 1% in the period. Despite this, we generated net income per diluted share growth of 11% and adjusted net income per diluted share growth of 9%, and we continue to generate strong free cash flow of $562 million on a trailing 12-month basis.

We put this cash to work by executing on our capital allocation strategy, opportunistically repurchasing our shares and acquiring Presto Maintenance Supply subsequent to the end of the quarter. Presto Maintenance Supply is a Houston metro area distributor of MRO products to the multifamily industry. I want to take this opportunity to welcome the new associates from Presto into the HD Supply family. We are excited for you to join the team.

I want to start today's call by providing an update on our a new Facilities Maintenance Atlanta distribution center that opened in May. As we previously shared, we experienced issues with a vendor-delivered automated solution, resulting in delays in fulfilling customer orders. We turned off the automation and returned to legacy methods of fulfilling orders through much of the summer. This enabled us to resume next-day deliveries, a significant improvement from May. We communicated with our customers throughout the process, assuring them that we can deliver with the same reliability and quality that they expect from HD Supply. Customer reaction has been favorable, and we believe we are regaining our customers' confidence and business in this important market.

Additionally, our IT and supply chain teams work continuously with our vendor partner. And in late August, we relaunched the Atlanta distribution center material handling automation. This was a regimented and measured process, supported by live data from the parallel operation of our legacy processes and systems. The automated solution is now working as intended, and we are confident that we'll deliver the efficiency and quality that we originally expected. Evan will share more details, but I want to take this opportunity to recognize the team who has been working tirelessly to ensure our customers operating in the Atlanta area and throughout the Southeast receive exceptional customer service from HD Supply.

When we walked at the facility last week, I was especially proud and impressed by the flexibility and precision that the team was executing to support our customers in Florida, Georgia and the Carolinas as they prepared for and recovered from Hurricane Dorian. While the opening of our new Atlanta distribution center got off to a difficult start, we continue to believe in the improved service capabilities and efficiency anticipated when we initiated the investment.

As we look at the second half of 2019, the environment remains uncertain with a new round of tariffs having gone into effect September 1, an increase in tariff rates planned for October 1 and additional round of tariffs planned for December 15. We believe we are better prepared to manage the changing tariff environment than many of our competitors. The investments that we made in pricing and analytical tools during 2017 and 2018 have significantly increased our visibility into the competitive landscape and elasticity of demand, enabling us to modify pricing with precision on a SKU-by-SKU basis.

As we shared previously, our initial response to any increase in input cost is to avoid or offset as much of the increase as possible through negotiation and productivity. Then as markets allow, we pass on unavoidable cost increases through price. We continue to believe in our ability to execute unavoidable cost increase pass-through with excellence. However, we may see some compression in gross margin rate.

Now turning to Construction & Industrial. During the second quarter, we saw project delays from unfavorable weather year-over-year and lack of skilled construction labor. We do see significant activity in the nonresidential construction market with many large multiyear jobs continuing. However, it does appear that the year-over-year growth rates are moderating. Additionally, the residential construction markets, which make up a comparatively smaller portion of our business, continue to underperform relative to expectations.

Consistent with external data sources, we have updated our view of the construction end markets, which Evan will discuss shortly. Despite the slowing end market growth rates, we see significant new large multiyear construction projects that are scheduled to begin in the second half of 2019, including large multifamily complexes, major DOT and other infrastructure projects and mixed-use developments.

The first half of 2019 underperformed our expectations. However, with major operational difficulties behind us, we are confident in our ability to perform going forward as we help our customers succeed. I'll provide some closing comments following Q&A.

I will now turn the call over to Evan, who will provide an update on the key areas of investor interest.

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [4]

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Thank you, Joe, and good morning, everyone.

On Page 4, I begin with areas of recent investor focus. First is the Section 301 tariffs on Chinese imports. September 1 saw a new round of 15% tariffs implemented on over $110 billion of Chinese imports. October 1 is the planned increase in tariff rates from 25% to 30% on approximately $250 billion of Chinese imports. And December 15 is the planned date for another round of 15% tariffs on an approximately additional $160 billion of Chinese imports. Much of the increase in these most recent round of tariffs won't be felt until fiscal 2020 as it takes some time for these costs to work their way through our supply chain.

As Joe indicated, our initial reaction to any increase in costs is to avoid as much of the increase as possible by negotiating lower pricing based on the strength of the U.S. dollar or overall market competitiveness, evaluating alternative sourcing and identifying additional productivity opportunities. We continue to believe that we can pass along the unavoidable cost increase through price so that we maintain our gross margin dollars earned, but we may see some compression in gross margin rate. Pricing actions taken to date to offset tariff-related cost increases have been relatively modest and comprise approximately 1% of our Facilities Maintenance sales.

Next, the Atlanta distribution center. As Joe stated, the Atlanta market continues to improve but lagged the company average during the second quarter as a result of the automation issue in the Atlanta distribution center. We believe the Atlanta distribution center created an unfavorable impact to Facilities Maintenance second quarter sales of approximately 100 to 150 basis points. Our most recent data shows that our performance in the Atlanta market and the broader Southeast continues to recover.

Next is HVAC performance. As we previously indicated, cooler weather has unfavorably impacted our HVAC business during the second quarter. Populated weighted cooling degree days, as reported by the National Oceanic and Atmospheric Administration, were down approximately 8% year-over-year in our fiscal second quarter. HVAC, an important category for us during the spring and summer months, was our worst-performing category of the second quarter with a high single-digit negative comp. We estimate that HVAC negatively impacted our second quarter sales at Facilities Maintenance by approximately 50 to 100 basis points.

Next, the construction end markets. The nonresidential construction markets continue to be productive with many large multiyear projects continuing. Growth rates year-over-year, however, appear to be slowing in part because the cooler weather spring and summer and a lack of skilled construction labor. Given this and the continued weakness in the residential construction market, as seen in the reduction in year-over-year single-family housing starts, we have lowered our market guidance for the full year of 2019. I will give more color around this later in the guidance section.

Turning to Page 5, I will review our second quarter results. We delivered sales of $1.6 billion, an increase of $24 million or 1.5% over the second quarter of 2018. Our gross margin rate of 39% was up 10 basis points from the second quarter of 2018. I will discuss the components of gross margin shortly. Adjusted EBITDA for the second quarter of 2019 was $244 million, a decline of $2 million or 0.8% from the second quarter of 2018.

On Page 6, I will discuss the specific performance of our individual business units in more detail. Net sales for our Facilities Maintenance business was $830 million during the second quarter of 2019, up $10 million or 1.2% from the second quarter of 2018. As a reminder, we got off to a slow start in the second quarter, beginning with a negative 2% performance in May, unfavorably impacted by weather and the Atlanta distribution center. Although not yet meeting our expectations, we did improve our sales performance over the course of the quarter to deliver a positive 1.2% growth rate.

Facilities Maintenance gross margins were flat from the second quarter of 2018, benefiting from the mixed impact of lower HVAC sales and sales in excess of the company average in our core multifamily MRO business, partially offset by margin rate pressure from tariffs. Despite good gross margin performance in the second quarter, we believe that rising tariff costs and potential future mix pressures will make holding the gross margin rate flat for the full year difficult.

As I said, we do expect to pass along the unavoidable tariff increase through price as markets allow. However, we do not anticipate raising prices enough to maintain gross margin rate. We now expect to end 2019 with Facilities Maintenance gross margins down 30 to 40 basis points year-over-year. Facilities Maintenance adjusted EBITDA for the second quarter of 2019 was $149 million, a decline of $1 million or 0.7% from the second quarter of 2018.

Net sales for our Construction & Industrial business were $795 million during the second quarter of 2019, up $14 million or 1.8%. We believe that nonresidential construction activity remains strong but that year-over-year growth has slowed due in part to a scarcity of skilled construction labor and less favorable weather conditions than 2018. Although less of an impact to HD Supply and nonresidential construction, we have seen a weakening residential construction market, evidenced by the 3% decline in year-to-date single-family housing starts.

Construction & Industrial gross margins were up 10 basis points year-over-year. Rebar unfavorably impacted our gross margins by about 10 basis points, while continued strength in larger construction projects also has put pressure on our gross margins. We have now reached the point where year-over-year rebar costs are no longer unfavorable and our average inventory cost is consistent with current spot prices. Therefore, we do not anticipate future gross margin pressure at current rebar pricing levels. Construction & Industrial's adjusted EBITDA for the second quarter of 2019 was $95 million, down $1 million or 1%.

Now turning to taxes and cash flow on Page 7. We invested $28 million in capital expenditures in the second quarter of 2019, in line with our ongoing annual capital expenditure plan of approximately 2% of annual sales. In the second quarter of 2019, we paid cash taxes of approximately $6 million.

We have now exhausted our federal net operating loss carryforwards and will become a regular federal income taxpayer in the third quarter. We now expect to pay approximately $24 million to $25 million of cash taxes in the third quarter of 2019 and approximately $53 million to $58 million of cash taxes in the full year of fiscal 2019. We estimate our ongoing GAAP tax rate will be approximately 26%.

In the last 12 months, we generated $562 million of free cash flow. We expect full year 2019 free cash flow generation to be between $500 million and $525 million, including the impact of becoming a regular cash taxpayer in the second half of the year.

During the second quarter of 2019, we repurchased approximately 1.7 million shares of common stock for a total of $69 million at an average price of $39.55. Following the quarter close and through September 6, 2019, we repurchased approximately 3.2 million additional shares of our common stock for $121 million at an average price of $38.12.

As of September 6, 2019, we had approximately $177 million remaining under our share repurchase authorization. Including the completion of our 2 previous $500 million share repurchase authorizations, we reduced our outstanding share count by over 18% since the first quarter of 2017. We will continue to opportunistically repurchase shares.

As of the end of the second quarter of 2019, our net debt to adjusted EBITDA ratio was 2.4x, comfortably within our targeted range of 2 to 3x. Our capital allocation strategy remains the same. We will opportunistically deploy capital to the most attractive return opportunities available. These include organic investments in the business, selective bolt-on or tuck-in acquisitions such as the Presto acquisition that closed after the quarter and a return of cash to shareholders currently through our existing share repurchase authorization.

On Page 8, we provide second quarter 2019 monthly sales trend performance as well as the 2018 comparable. In May 2019, we delivered sales of $464 million, an increase in average daily sales of approximately 0.2% versus May 2018. In June 2019, we delivered sales of $521 million, an increase in average daily sales of approximately 1.9% versus June 2018. In July 2019, we delivered sales of $639 million, an increase in average daily sales of approximately 2.1% versus July 2018.

In 2019, there were 19 selling days in May, 20 selling days in June and 24 selling days in July. In 2018, there were 20 selling days in May, 19 selling days in June and 24 selling days in July. August of 2019 ended September -- Sunday, September 1, which was the first month of our fiscal 2019 third quarter, and we have provided our annual preliminary sales results.

We will now provide information on August results beyond sales. August sales were $521 million, which represents average daily sales growth of approximately 1.6% versus 2018. Average daily sales growth versus prior year by business was approximately 1.2% for Facilities Maintenance and approximately 2% for Construction & Industrial. There were 20 selling days in both August 2019 and August 2018.

On Page 9, we updated our end-market outlook for 2019. We believe the MRO market will continue to grow approximately 1% to 2%. We view the nonresidential construction end-market estimate as up low single digits, and the residential construction market will remain flat or decline low single digits. These specific end-market estimates imply an approximate 1% to 2% end-market growth estimate for HD Supply's end markets in 2019.

Turning to Page 10. We begin by updating our full year fiscal 2019 guidance, which has been revised, taking into account a continued weaker economic environment and increased tariff expectations. We now believe net sales will be in the range of $6.1 billion to $6.2 billion. This translates to a 3% growth rate at the midpoint, adjusted for the impact of the 53rd week in fiscal 2018. Adjusted EBITDA to be in the range of $855 million and $885 million. This translates to a 1% growth rate at the midpoint, adjusted for the impact of the 53rd week in fiscal 2018. 2019 net income per diluted share, calculated in accordance with GAAP, to be in the range of $2.68 and $2.81.

We also expect full year 2019 adjusted net income per diluted share to be in the range of $3.45 and $3.60. Our net income per diluted share range and our adjusted net income per diluted share range assume a full year 2019 fully diluted weighted average share count of 168 million and does not contemplate additional share repurchases.

For the third quarter of fiscal 2019, we anticipate sales to be in the range of $1.620 billion and $1.670 billion; adjusted EBITDA to be in the range of $240 million and $255 million; net income per diluted share, calculated in accordance with GAAP, to be in the range of $0.78 and $0.86; and adjusted net income per diluted share to be in the range of $0.96 and $1.05. Our net income per diluted share range and our adjusted net income per diluted share range assume a third quarter fully diluted weighted average share count of 166 million and do not contemplate additional share repurchases.

In summary, we're disappointed with our quarterly results, and we are taking a cautious approach to the remainder of the year. We will continue to focus on what we can control operationally while navigating an increasingly volatile environment.

Thank you for your continued interest in HD Supply. And Sonia, we are now ready for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Nigel Coe, Wolfe Research.

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Nigel Edward Coe, Wolfe Research, LLC - MD & Senior Research Analyst [2]

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I have a question. First of all, can you maybe just touch on the comment you made about tariffs pressuring gross margins? Couldn't understand that dynamic. Or maybe talk about the many different factors in terms of operational offsets and also any resourcing that you're doing. And then maybe just touch on how your exposure, the 12% of FM sales that come in from China, any resourcing activity that you're undertaking?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [3]

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Yes. So Nigel, obviously, the tariff environment has been very volatile, and we laid out the current expectations for that tariff environment which, of course, are subject to change. We will always attempt to offset any cost increase, tariff or otherwise, as our first course of action, and that starts with good negotiations as part of our overall merchandising process. The U.S. dollar has continued to strengthen against the local Chinese currency, so we certainly look to take advantage of that.

We also look to take advantage of the overall competitiveness of the Chinese factories which -- because the tariffs are becoming less competitive to the rest of the world. We're also seeing, and we were seeing this even before the tariff dispute began, a migration away from China into other low source -- low-cost source countries in Asia and Mexico. We expect that to continue. And if the tariff environment continues, we actually expect that to accelerate, and I think you're already beginning to see that.

Certainly, we look to improve our own productivity through our supply chain and our transportation network and our distribution centers. And then the unavoidable cost increase after we've mitigated as much as we can, we do expect to pass on through price. Now we pass on cost increase through price very surgically on a SKU-by-SKU basis, and that doesn't mean that every dollar of tariff on a given SKU results in a dollar increase in that particular SKU. We look -- we use our pricing analytic tools to understand the price elasticity of the various SKUs and the market dynamics of the pricing of the various SKUs to very surgically adjust pricing SKU by SKU, not category by category but SKU by SKU. And that's been successful for us so far. We've been pleased with our margin performance so far, but as you know, the tariff environment is getting more and more difficult. But we'll continue to navigate that. We think we can do it better than most.

As far as our exposure, 18% of our Facilities Maintenance sales are from our proprietary brands, 2/3 of which are sourced in China, so that's about that 12% that you were referring to. And that's what we're managing. To date, it's been about a 1% increase in overall Facilities Maintenance sales to pass through the unavoidable cost increase. And we'll continue to monitor that and work hard to take cost out to avoid having to raise prices.

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Nigel Edward Coe, Wolfe Research, LLC - MD & Senior Research Analyst [4]

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And then a quick one on the Atlanta DC, obviously, a good recapture intra-quarter. Do you think now that, real-time, you're back to where you should have been in September? Have you recaptured the share of the wallet you lost?

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [5]

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Yes. I think the Atlanta DC is operating exactly the way it should have been in May when we turned it on. I think the team did an incredible job making sure that they were perfect in this launch. And so I feel very good that we're right back on the curve and that we will have that being by far the crown jewel of our network coming into selling season for next year.

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [6]

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Yes. Customer reaction has been favorable. As I indicated, the Atlanta market is still operating slightly below the company average, but it is improving. And Nigel, just a point of clarification there, that's the sales performance, not the operational performance of the Atlanta DC.

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [7]

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Yes. The operational performance is on because when you have events like big hurricanes, you have to be very flexible because you're forward deploying within hour's notice of where the storm is moving. And the precision we saw when we're down there last week was exceptional. The team's very proud of that, and they should be very proud of that.

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Operator [8]

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And our next question comes from Julian Mitchell, Barclays.

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Takeheiko Makishi, Barclays Bank PLC, Research Division - Research Analyst [9]

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This is Jason Makishi on for Julian. Just quickly on margin expectation for the back half of the year, it seems as if the implied profit expectations through the second half are far from heroic. So if there is anything to call out other than sort of tariffs impacting gross margins or any other margin headwinds to call out there, whether it be incremental investments in Facilities Maintenance or anything else besides the 53rd week impact, that would be helpful.

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [10]

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Yes. Look, gross margins, as I said, for Facilities Maintenance, we're now expecting 20 to 40 basis points of decline for the year. And that's all on the tariffs. The gross margin dollars we earn on each unit should be pretty consistent.

Construction & Industrial's gross margin should be about flat where the earnings profile decline is because of the drop in volume, so the ability to leverage fixed cost is reduced as volume drops. We're working hard to take cost out, and we'll continue to work hard to take cost out. And so what we've provided you in the guidance today is based on our current trend and our current expectation, but we're always working to do better.

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Takeheiko Makishi, Barclays Bank PLC, Research Division - Research Analyst [11]

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Understood. And maybe just a quick one on the top line is sort of the moderation that was seen in August. Is this FM growth just purely due to a weakening HVAC environment? Or just wondering if there are any other factors at play there.

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [12]

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The HVAC has been a little weak. There's a little bit of noise between July and August in the calendar shift to where the 1st of the month falls. Best way to look at it is July for Facilities Maintenance was about a 3%, August was about a 1%. I look at the current trend rate of the 2 of them together, so we're trending about 2% right now.

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Operator [13]

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And our next question comes from Ryan Merkel of William Blair.

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Ryan James Merkel, William Blair & Company L.L.C., Research Division - Research Analyst [14]

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So my first question is on the FM business. Can you just talk about the improvement in growth you saw from the weak May? How much of that was sort of the DC coming back online? And how much of that was weather and HVAC getting a little bit better?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [15]

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Yes. So certainly, the impact of the distribution center in the Atlanta marketplace and the Southeast continued to improve over the course of the quarter and then again into August, as I said. Still operating a little -- on the sales line, operating a little below company average in the Atlanta marketplace but closing that gap, and we expect to have that gap closed here in the second half.

Weather -- HVAC was a drag throughout the quarter. May was the worst of it, so that improved somewhat as well, but certainly, the 2 of them didn't improve enough to hit the sales number for the second quarter that we were hoping for as well as our overall performance in other categories.

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Ryan James Merkel, William Blair & Company L.L.C., Research Division - Research Analyst [16]

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All right. Then just sticking with FM, just up 1% here in August. What needs to happen to get us back to that mid-single-digit growth territory?

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [17]

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We just need to continue getting confidence and the customers to buy from us, so it's just staying at it. I think the encouraging thing is that the multifamily core MRO, which is the real business, outperformed the average. And so I feel really good about that. And then making sure that the other business units and lines like property improvement continue to step up. But I think the operational performance is there, and now it's all sales gain.

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Operator [18]

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And our next question comes from Deane Dray of RBC Capital Markets.

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Deane Michael Dray, RBC Capital Markets, LLC, Research Division - Analyst [19]

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This is probably a delicate question, but is there any recourse against the vendor-supplied automation issue here? I'm sure there's always finger-pointing on an insulation about customer changes, but this was a big-enough impact that it raises the question whether there's any recourse.

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [20]

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Yes. I'm probably not going to comment on the call on that.

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Deane Michael Dray, RBC Capital Markets, LLC, Research Division - Analyst [21]

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Oh, so I'll assume that, that means there is a potential for recourse if it's something you can't say. So will you be able to update us later on that, Joe?

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [22]

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Yes, I don't think I'm going to comment on it ever, I mean, so just [work it out]. I mean we work with vendor partners, and we worked very well with this vendor partner to recover. I think we're in a good position. So I mean really our last course of activity is to be fighting with our vendor partners, and our first course is always to make sure that we're putting our customer first and we're delivering the best technology and material handling solutions to be able to get it done, and that's going to be our intent going forward.

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Deane Michael Dray, RBC Capital Markets, LLC, Research Division - Analyst [23]

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Understood. And then, Joe, on your prepared remarks, you talked about some larger projects coming on later this year. Have -- on these large projects, has there been any slippage, push-outs? Are you seeing any hesitation about getting these projects greenlighted? So if you could comment on that.

And then elaborate on the labor shortage. Does that include trades like cement? Or is it concentrated more around electricians? And if you could size for us how much these shortages are impacting the business, that will be a great help.

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [24]

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Yes. I say now that we got through the weather, the shortage is the main constraint out there and it's hitting all skilled levels, including supervisory skills on the job sites. And so this has been on one very site. And you can imagine, if you're supervising skilled construction workers, that is a very tight space also. So people are essentially constrained at the labor force that they can put on.

As far as your first question about any delays in the project start, there really hasn't been -- these are projects that were scheduled to go and will go, but everyone is being very cautious not only in starts but also in bidding relative to the labor force that they have available to them. So I would say the primary impact now is that the labor force is the actual constraint to the demand profile.

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Deane Michael Dray, RBC Capital Markets, LLC, Research Division - Analyst [25]

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And of those, the labor force, is there -- we keep hearing about electricians. Is that still at the top of the list of issues?

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [26]

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More primary concrete. We do service electricians on the site, but I would say universally we haven't found a skilled trade that isn't heavily constrained at the moment.

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Operator [27]

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And our next question comes from Keith Hughes with SunTrust.

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Keith Brian Hughes, SunTrust Robinson Humphrey, Inc., Research Division - MD [28]

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Just another question on nonresidential, your lower forecast. Is there any 1 or 2 specific building types or kind of project types that are -- that you're seeing more profound weakness in?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [29]

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Yes. So Keith, we look a lot at the external data that I'm sure you look at as well as we've got the insight from our local field teams. We continue to see strength in certain areas like a lot of the well-funded infrastructure projects like airports, road and bridge. Distribution centers continue to be strong. Sports entertainment complexes continue to be strong. And that's a bit of a theme, too. If you look at the construction put in place numbers released by the Census Bureau, nonresi construction on a year-to-date basis, they show as up 2.6%, but almost all of the growth is in public construction. Private construction is actually only up 0.6% on a year-to-date basis.

So it's the types of projects that you would imagine to see some weakness in, retail, office space, some of the larger private construction projects, but overall we still feel good about the marketplace. There's a lot of good activity out there. Keep in mind, last year's activity was a lot of activity. It was a strong year. And so while the growth rates have slowed, there still a lot of business to be had out there. So we need to get at it, and we need to win and take market share. It gets a little tougher because when there isn't as much growth to grow, you have to eat off of somebody else's plate. But there's still a lot of whitespace out there for us to do, and that's what we're working hard on doing.

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Keith Brian Hughes, SunTrust Robinson Humphrey, Inc., Research Division - MD [30]

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And within that, you're not seeing projects canceled, is that correct? This is more just a general slowing of growth?

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [31]

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Yes, that is correct. I mean we see a slowing of growth, but the activity, to Evan's point, is very strong. So we're at a high plateau here, so I think it's leveling off. And I do think there is a real labor constraint out there that's causing people not to be able to do road projects.

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Operator [32]

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And our next question comes from Robert Barry of Buckingham Research.

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Robert Douglas Barry, The Buckingham Research Group Incorporated - Research Analyst [33]

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So I just wanted to clarify a little bit understanding kind of the changes in the guidance. So the EBITDA came down by 40. I think you only missed your 2Q, as it turns out, by 4, so $36 million weaker in the second half. How does that break down between lower sales and lower second half margins?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [34]

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Yes. So it's predominantly sales. And you're right, we took down our expectations for the second quarter based on the current trajectory and run rate that we see as well as the uncertainties that we're seeing in the marketplace so that we're now expecting about a 3% for the year versus the 5% to 6% that we were thinking about at the beginning of the year.

And so most of it is sales volume, and then there's a bit of the leverage of fixed cost that impacts the EBITDA margins. And again, on gross margin, relatively flat for C&I from the balance of the year is what we're expecting and FM to have some slight margin pressure as a result of passing along the unavoidable cost increases from tariffs but not enough to maintain the margin rate.

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Robert Douglas Barry, The Buckingham Research Group Incorporated - Research Analyst [35]

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Right, right. So then the revenue outlook, I guess, came down by 150. I think you missed the 2Q by about 20. So you took the end-market growth down by 1 point. That's worth about $60 million, so as the other, I don't know, $100 million, $90 million, is that just less outgrowth?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [36]

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It's just -- Yes, just based on our current trend, that's what we're seeing right now. So as I said earlier, we're always going to strive to do more than that, but we want to take a bit of a cautious approach in the second half because that's where we're trending.

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Robert Douglas Barry, The Buckingham Research Group Incorporated - Research Analyst [37]

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So I think it implies that even in the second half, the outgrowth would be below the 3 points that's targeted. Is that right?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [38]

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Yes.

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Robert Douglas Barry, The Buckingham Research Group Incorporated - Research Analyst [39]

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And then just lastly, I guess, on the FM, I think you talked about the gross margin now being down 30 to 40 bps for the year. Is that right in FM?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [40]

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Yes, that's right.

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Robert Douglas Barry, The Buckingham Research Group Incorporated - Research Analyst [41]

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And what's that a quarter ago? Like what were you expecting the FM gross margin to be?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [42]

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So originally we're expecting it to be relatively flat. Relatively flat for me is flat to up or down 10 to 20 basis points. So we're down (inaudible) where we expect it to be at the start of the year.

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Robert Douglas Barry, The Buckingham Research Group Incorporated - Research Analyst [43]

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Got it. So the decline of about 30 bps in the FM gross margin, that's all like weaker price cost?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [44]

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Yes. Well, I guess it depends how you want to define weaker price cost. It's passing along the tariff cost increase but not passing along the margin on top of the tariff.

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Robert Douglas Barry, The Buckingham Research Group Incorporated - Research Analyst [45]

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Got it. I mean, in dollar terms, is price cost -- well, how is price cost tracking? And what's your expectation? Is it neutral in dollar terms on price cost or is it a negative?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [46]

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Yes. Our expectation is to be neutral on dollars earned per unit sold.

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Operator [47]

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And our next question comes from David Manthey of Baird.

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David John Manthey, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [48]

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Evan, your discussion about guidance reduction relative to tariffs, just so I'm clear on that, that's all gross margin, you're not flagging any kind of demand issue relative to tariffs, correct?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [49]

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Yes, that's correct. Obviously, when we adjust pricing, we are looking at the competitive landscape in the marketplace and what the market allows, but that's correct. Our expectation is that we're able to pass along that cost increase, and the sales guidance would include our outlook on demand. Now that is part of what I'll call the uncertainty going forward when we got the question previously on market outgrowth or why expecting the second quarter -- or the second half to be softer. There is a lot of uncertainty out there, and you pointed out one of them.

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David John Manthey, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [50]

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Okay. And then if all the tariffs that you've experienced to date are driving about 1% on the top line and the gross margin impact that you noted, is it safe to say that the incremental tariffs that we're seeing from here forward should lead to a lesser impact in fiscal 2020 relative to fiscal '19?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [51]

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Not necessarily. As I laid out, I mean, it all depends what tariffs actually go into place and for how long. The current schedule of tariff increases is pretty substantial in the back half. Most of that will be felt in 2020. So it could be something similar to the 2020 increase. It could be something similar to 2019.

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Operator [52]

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And our next question comes from John Inch of Gordon Haskett.

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John George Inch, Gordon Haskett Research Advisors - MD & Senior Analyst of Multi-Industrials [53]

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So in the last downturn, an environment that's highly unlikely we're going to replicate, HD Supply really did a great job of preserving FM EBITDA. I believe it expanded. And I'm just wondering, in this period, whatever this is going to turn into, what are the contrasts, Evan and Joe, between this time and then that may make that comparably sort of similar or maybe different? So I'm thinking kind of technology or competition. I mean, is there an ability, do you feel, as the environment deteriorates, to replicate your performance to whatever degree as you did in the past?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [54]

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Yes. So certainly, we've got -- certainly, we'll start by saying that the Facilities Maintenance business is a, I'll call it, a recession-resistant business. By nature, MRO being maintenance, repair and operation has that demand profile to it, and then MRO of the living space environment is even better. So you're correct, Facilities Maintenance business held up very well during the last downturn.

Looking forward, we have got better tools today to manage a downturn than we did in the past, as we talked about, the pricing and analytic tools, the sales console and dashboard that we've got for our sales associates. And we continue to work on improving our service offering to the customer in terms of on-time delivery in full every time.

On the negative side or on the headwind side of performance during a downturn, our hospitality business is a little larger than it was. Back then, the hospitality business tends to grow a little faster than the company average, hospitality being a little more cyclical than multifamily, and the property improvement business. Again, the property improvement business has been growing slightly faster than the core. The property improvement business, while it crosses all of the verticals, it is a discretionary purchase, so it could be impacted in the downturn. But we feel very confident that Facilities Maintenance business holds up very well in a downturn.

And then flipping over to our Construction & Industrial business, I'd say our Construction & Industrial business has dramatically improved from the last downturn. During the last downturn, we were about 70% residential construction. Today, we're about 75% nonresidential construction. Though our construction is still a cyclical business, nonresidential construction is significantly less cyclical than residential.

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John George Inch, Gordon Haskett Research Advisors - MD & Senior Analyst of Multi-Industrials [55]

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And the fact, Evan, that so much of FM today is online or it's what, 70% or something, does that -- how do you see that impacting sort of trends in a downturn? Because in theory, right, competitors can respond much more rapidly if they want to cut price or whatnot. But again, I just -- I'm wondering how you guys see it.

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [56]

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Yes, I think if you look at the -- the pricing environment has become much more dynamic because of the online, John, so I think you're correct there. But the way that we approach, since we solely focus on these professional managed living spaces, is we have one-on-one negotiations with virtually every customer of significance, and we're very agile in terms of the adjustment that we're able to put in there. And we're relatively opaque relative to people to be able to see what our pricing is. Whereas if you're standing up and you're selling to a consumer also, your pricing is pretty much posted out there, and people can scrape and grab and adjust to that.

So although we believe that there will be a continuation of a very aggressive pricing environment because people are always trying to get the best deal, and I think certainly online does enable that, I think the way we structured our business model and the technologies we apply to our business model allow us to win in that environment similarly. I mean the advantage we have is we were a catalog business. And so essentially what you did is you digitized the catalog. And we were also a business that evolved as we did that to be much stronger in terms of the precision of our pricing.

And so I'd say absent the investments we made in 2017, 2018, we might be a little flat-footed, but today, we're not. So we're very comfortable competing in a very transparent competitive environment because our competitors, quite frankly, the large ones, are much more transparent than we are. And so we have their information, they don't have ours, and we can be great for our customers on an individual basis, on an individual SKU basis. So I think we're prepared for the fight.

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John George Inch, Gordon Haskett Research Advisors - MD & Senior Analyst of Multi-Industrials [57]

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And on that pricing point, just as a follow-up, Joe, on C&I specifically. I mean, are there opportunities perhaps for some share gain based on better pricing tools? You're already a low-cost provider right in the space. Are there -- I just think somehow these downturns sometimes are opportunities for better-capitalized companies or tougher competitors like you to go and take some market share. So how are you thinking about that?

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [58]

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You're right on with that, John. I mean being the powerhouse through a recession is a key fundamental of strengthening the Construction & Industrial business. And certainly, you have a number of very positive dynamics that allow you to do that. Being better capitalized, you're certainly able to maintain your investment profile through a downturn. You're also very aggressive and you can buy very well, particularly as the consolidator of space within -- consolidator of choice within the space.

And the ability to gain a lot of shares as you come out of the downturn is exactly what we did this last time. And we intend to do it again and even better because we have the capital and the cash flow profile to be able to continuously invest and maintain our working capital. Whereas many of the smaller competitors, their lines compress as they take their working capital down. And when they come out of a downturn, they can't meet the increased demand of their customers.

So it's a great question. It's a great point. I think we're well positioned from the markets we will service and from our ability to maintain an investment profile and really maintain coming out of the next downturn. So we feel very good about it.

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Operator [59]

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And our next question comes from Stephen Volkmann of Jefferies.

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Stephen Edward Volkmann, Jefferies LLC, Research Division - Equity Analyst [60]

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Just a couple of follow-ups, if I could. First, on the tariffs, I understand the dynamic of sort of covering the dollars but not the margin. But ultimately, say, I don't know, 2020, do you expect to cover the margin as well?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [61]

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It all depends on the market dynamics and what the market allows.

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Stephen Edward Volkmann, Jefferies LLC, Research Division - Equity Analyst [62]

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Okay. So TBD. And then sort of shifting to kind of the outgrowth question. I noticed property improvement is actually down a bit year-to-date. The rest of the business in FM seems to be growing a little bit more. What's happening in that business? Is that just a fundamentally slower business? Is there something you can do to sort of jump-start that? Is it still a focus? Just any thoughts there would be great.

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [63]

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Our prime business is always going to be our MRO business, and we're in the property improvement business because we want to be able to be feeding that MRO business as we go forward. It allows us to really do a large capital improvement and understand the inventory within the unit. So we think it's a feeder ultimately for the MRO business.

I will say that property improvement is a more discretionary purchase, and it's one that we want to make sure that we're doing that with a high degree of excellence with the best customers. So we are more discretionary in terms of the business that we're taking there. And so I think it's an evolving business model for us. That is a nice, natural extension of MRO, but we probably wouldn't be in the property improvement business if we weren't in the MRO business.

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [64]

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Yes. It will also be a little choppier over time since it is project-based. So you get a couple of big projects in one period in the prior year and then you anniversary it, so it's going to bounce around a little more.

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Stephen Edward Volkmann, Jefferies LLC, Research Division - Equity Analyst [65]

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Okay. Are there labor constraints there as you just sort of discussed in some of the other customer areas?

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [66]

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Yes, but to a much lesser extent. The requirements from a skill perspective and an experience perspective is much less than when you're doing large concrete projects, you're doing interiors of buildings. I mean that's very complex stuff, so you need somebody that's been on job, well-trained for a number of years.

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Operator [67]

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And our next question comes from Michael McGinn of Wells Fargo.

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Michael Lawrence McGinn, Wells Fargo Securities, LLC, Research Division - Associate Analyst [68]

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I just had a quick question on the private-label exposure, you mentioned it's 18% of sales right now. Given the current tariff environment, is there any change to your long-term target of 20% of brands coming from private?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [69]

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No. In fact, we see no reason we can't be in the 20s. The margin profile is quite a bit more attractive on the proprietary brands than it is on the branded product. Most of our peers that have been at this longer than we have are well into the 20s. And despite the Chinese tariffs, many of our proprietary brands still have a cost advantage over the branded products as both are often made in China often side by side. And so they both have that same cost input, and the proprietary brand continues to have the cost advantage. Again, what you might -- what you'll likely to see is some of that product migrating away from China, but it will maintain its cost advantage.

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Michael Lawrence McGinn, Wells Fargo Securities, LLC, Research Division - Associate Analyst [70]

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Great. And then just on the free cash flow, it looks like it came down a little bit. Receivables are coming a little weaker than expected. Evan, do you have any color on that? We heard from other distributors that customers are kind of throwing their weight around. What are you guys seeing in the current environment?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [71]

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Receivables are always a challenge to collect receivables as quick as you can. Certainly, in a more difficult environment, it gets more difficult. Certain parts of the country are more difficult, particularly on the construction side. Yes, we're watching that very closely. And we do see receivables extending slightly, but we will not let that get out of hand. We will walk away from business where we are not comfortable that we're going to get paid or paid timely. And so we will be very aggressive in that area. We do not want to get caught short. I think you may see some competitors overextend themselves, and that's a recipe for disaster.

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Michael Lawrence McGinn, Wells Fargo Securities, LLC, Research Division - Associate Analyst [72]

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Okay. And if I could sneak in one more. Sorry to harp on this, but Facilities Maintenance gross margin, HVAC coming in a little weaker. I had always presumed that was a lower margin or a mixed category for you guys. Can you point to any other product categories that are driving that margin framework down for the fiscal '19?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [73]

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It's really the tariff environment that is reducing our margin framework going forward. Now we always have -- we always do have some headwinds. The hospitality business is always lower margin. We pointed out that our MRO business, relative to the total this quarter, had an outsized performance. And so that benefited our margin this quarter. But hospitality generally grows faster, and hospitality is lower margin than multifamily.

But as far as product category, HVAC puts pressure on product margins. Appliances, because they're big ticket, could put pressure on gross margin performance, but most of the decline that we're expecting now is because of tariffs. We always have those other headwinds that we're facing, and we're normally successful in offsetting them.

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Operator [74]

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And our next question comes from Patrick Baumann of JPMorgan.

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Patrick Michael Baumann, JP Morgan Chase & Co, Research Division - Analyst [75]

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Just wanted to go back to HVAC really quick, down high single digits in the quarter, just seemed like a big decline versus what the industry probably did during your fiscal quarter. So just wondering if there's anything that would explain that. Were there any big HVAC projects, new installations last year, like maybe within property improvement, that are driving a tough comp there? Just wanted a better understanding. Or is it just the cooling degree days and you're seeing less replacement activity?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [76]

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Cooling degree days and replacement activity is a big part of it. You mentioned property improvement. That does have an impact as well. HVAC is a big category within property improvement. Property improvement is a little weaker than last year, so yes, that has an impact as well.

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Patrick Michael Baumann, JP Morgan Chase & Co, Research Division - Analyst [77]

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Okay. And then a question on your end market in the quarter. You didn't mention what you thought the growth -- or I don't think you did, what you thought the growth rates were in C&I for the end market and in service maintenance. Just curious what you think those were.

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [78]

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Yes. So Facilities Maintenance, we continue to believe that it's a pretty steady market. It's a 1% or 2% grower. On the construction business, residential construction was down a bit. We see it in the single-family starts, and we see it in our business in the markets in which we operate and compete in residential. Nonresidential is -- was up low single digits, about, I'd call it, 2% to 3%.

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Patrick Michael Baumann, JP Morgan Chase & Co, Research Division - Analyst [79]

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Okay. So overall, kind of up low single digits for the end markets in the quarter? Is that one way to think about it?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [80]

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Yes. On a combined basis, probably about 2%.

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Patrick Michael Baumann, JP Morgan Chase & Co, Research Division - Analyst [81]

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Yes. Yes, makes sense. And then any update or any kind of change in the competitive environment? I mean, obviously, tariffs is one of the fluidity with regard to pricing or what have you. Just curious if there's any, outside of that, any kind of increased intensity from the competitive environment, whether traditional or nontraditional?

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [82]

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It's been pretty stable quarter-over-quarter.

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Operator [83]

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And our next question comes from Chris Dankert of Longbow Research.

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Christopher M. Dankert, Longbow Research LLC - Research Analyst [84]

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I guess I just really want to make I'm understanding your comments around C&I as well as possible here. So I mean the majority of the deceleration that you were saying is due to labor constraint. I mean if I look at kind of what you're guiding back half of this year versus last, we're talking about 700, 800 basis points of deceleration on labor. I mean that's a structural demographic issue. I mean, are we saying that growth in the C&I business is impaired in the low single-digit range kind of going forward here?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [85]

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Yes. We're not saying that our growth opportunities are impaired. We are reducing the market outlook. At this time last year, I think we're calling the market low to mid-single digits, and now we're saying flat to low single digits. So we're reducing the market, call it, 3% or so. And then the guidance for the back half of the year is based on our current trend, as I said earlier. We're always going to try and do better than that and outgrow the market, but our current trend is what it is, and so we want to be cautious for the back half of the year.

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Christopher M. Dankert, Longbow Research LLC - Research Analyst [86]

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Yes. I'm just trying to think big picture here when you're not going to be able to kind of train up a whole new labor force quickly, so the idea that C&I is going to bounce back into double-digit growth even in the next year or so seems like a bit of stretch now.

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO & Chief Administrative Officer [87]

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Well, the labor force that we're talking about is primarily the customers' labor force, the skilled labor and for the contractors. And I think you're right, it is somewhat constrained, and it will continue to be a constraining factor in ongoing construction growth, but there's a lot of activity out there. So our share in the current marketplace is single digit. So while it gets tougher that you don't just get that share or that growth falling into your lap, you got to go earn it and you got to eat off of somebody else's plate. But that opportunity is there, and that's what we intend to do.

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Operator [88]

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And ladies and gentlemen, this does conclude our question-and-answer session. I would now like to turn the call back over to Joe DeAngelo for closing remarks.

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [89]

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Well, thank you for your questions. Although we delivered results within our guidance range, we are not pleased with our first half 2019 performance. We're intent on delivering a successful back half. And thank you for your continued support and interest in HD Supply.

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Operator [90]

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Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone, have a great day.