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Edited Transcript of HDS earnings conference call or presentation 5-Sep-18 12:00pm GMT

Q2 2018 HD Supply Holdings Inc Earnings Call

Atlanta Sep 12, 2018 (Thomson StreetEvents) -- Edited Transcript of HD Supply Holdings Inc earnings conference call or presentation Wednesday, September 5, 2018 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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* David John Manthey

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

* Deane Michael Dray

RBC Capital Markets, LLC, Research Division - Analyst

* Evelyn Chow

Goldman Sachs Group Inc., Research Division - Equity Analyst

* Hamzah Mazari

Macquarie Research - Senior Analyst

* Keith Brian Hughes

SunTrust Robinson Humphrey, Inc., Research Division - MD

* Patrick Michael Baumann

JP Morgan Chase & Co, Research Division - Analyst

* Ronald Drew Weiss

Barclays Bank PLC, Research Division - Research Analyst

* Ryan Dale Cieslak

Northcoast Research Partners, LLC - VP & Senior Research Analyst

* Ryan James Merkel

William Blair & Company L.L.C., 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 HD Supply's Second Quarter 2018 Earnings Conference Call. (Operator Instructions) And as a reminder, this conference is being recorded for replay purposes.

I'd now like to turn the conference over to Charlotte McLaughlin, Investor Relations. Please go ahead.

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

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Thank you, James. Good morning, ladies and gentlemen, and welcome to the HD Supply Holdings 2018 Second Quarter Earnings Call. A copy of the earnings press release and presentation can be found on the Investor Relations tab of the company's website at www.hdsupply.com.

Joe DeAngelo, our CEO, will lead today's call and provide an overview of our 2018 second quarter as well as comment on our recent execution and outlook. Following Joe's remarks, Evan Levitt, our CFO, will provide an overview of the main areas of interest from the investment community before going into detail on the 2018 second quarter performance, comment on monthly sales and provide guidance for the third quarter and full year of 2018. We will then conduct a Q&A and conclude with Joe's closing remarks.

Please note that some of the information you'll hear in today's discussion will include forward-looking statements within the meaning of the federal securities laws. Forward-looking statements are based on management's beliefs and assumptions and information currently available to management, which are subject to known and unknown risks and uncertainties, many of which may be beyond our control. We caution you that the forward-looking information presented is not a guarantee of future results, and that actual results may differ materially from those made in or suggested by the forward-looking information contained in this presentation.

For more information, please refer to our risk factors discussed in our annual report on Form 10-K for the fiscal year ended January 28, 2018, and those described from time to time in our and HD Supply, Inc.'s other filings with the SEC. Any forward-looking information presented is made only as of the date of this presentation, and we do not undertake any obligation to update or revise any forward-looking information.

This presentation contains certain non-GAAP financial metrics. For a reconciliation of such metrics to the nearest GAAP metric and other supplemental information, please see our earnings press release and refer to the appendix of the earnings call presentation.

(Operator Instructions) We want to provide an opportunity for as many people as possible to ask a question within our allocated 60 minutes. We appreciate your cooperation. Thank you for participating on the call and for your continued interest in HD Supply.

And with that, I will now turn over the call 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 2018 second quarter earnings call.

As always, it is my privilege to share the company's results with you on behalf of the over 11,000 HD Supply associates, who work hard every day as one team driving customer success and value creation. I am proud of the team's second quarter performance. We have continued to build on our momentum from earlier in the year, delivering 18.3% sales growth for the second quarter of fiscal 2018, 10.1% sales growth on an organic basis.

As we highlight on Page 3 of the presentation, we delivered 18.3% adjusted EBITDA growth and 54.7% adjusted net income per diluted share growth versus prior year. We continue to generate strong free cash flow and delivered $401 million on a trailing 12-month basis. We continue to expect to deliver about $500 million of free cash flow for the full year of fiscal 2018.

Overall, our second quarter sales and earnings came in above our expectations against an unpredictable macroeconomic backdrop. I am pleased that our Facilities Maintenance business has continued its mid-single-digit growth as we see ongoing benefits from our investments designed to make our business easy, accurate and helpful. Our Construction & Industrial business continues to grow at a double-digit rate, and we continue to see strong construction activity, including many large multiyear projects across our 15 priority districts. In both businesses, we will continue to focus on what we can control to deliver on our customer and shareholder promises.

The company saw an overall drop in gross margin of 100 basis points versus prior year, primarily due to a change in the mix of our business with the recent A.H. Harris acquisition and the double-digit organic growth of our Construction & Industrial business as well as mix changes within each business. Rebar continues to pressure our gross margin rate within Construction & Industrial. And as we previously discussed, a late spring shifted lower-margin sales from the first quarter into the second quarter within our Facilities Maintenance business. Evan will provide more detail on gross margins.

The A.H. Harris integration is progressing extremely well. We continue to be pleased with the results from this acquisition, and we are slightly ahead of our originally planned integration schedule. We expect to complete the integration by the end of fiscal 2018. Expected synergies are on track, and we are beginning to see the benefits from the integration of our sales and support teams, enhanced sourcing capability and combined branch networks. I couldn't be more pleased with the enthusiasm and hard work of the associates working to complete this integration.

We continue to execute our second $500 million share repurchase program announced in August of 2017. We have repurchased approximately 3.5 million shares at an average price of $37.23 per share through August 31 under this program. Evan will provide more detail around this shortly.

We remain committed to opportunistically deploying capital to the highest-return investments available. This includes acquisitions, share repurchases and continued investment in our businesses. We will remain focused on growing our business organically while also identifying opportunities to consolidate markets that remain highly fragmented. We will be disciplined in identifying potential accretive tuck-in acquisitions for both Facilities Maintenance and Construction & Industrial in an effort to maximize shareholder return and cultural fit.

Talent continues to be our most fundamental differentiator. We recently held our first Investor Day in our Atlanta Leadership Development Center on June 21, and I was proud to showcase our talent to our investors and sell-side analysts. We hope that you enjoyed the event as much as the team did, and I would encourage anyone who was unable to attend the event in Atlanta to review the Investor Day documents that are published on the Investor Relations section of our website.

We continue to be proud of the performance of each of the 11,000 HD Supply associates who work hard every day to deliver on our promises to our customers, fellow associates and shareholders. I'll provide some closing comments following Q&A, but

will now turn the call over to Evan for a review of topics of recent investor interest and an overview of our financial performance.

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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. As we normally do on Page 4, we highlight areas of recent investor focus and share with you our latest perspective on these topics.

First, the tariff impact on rebar. We've seen the impact of various tariffs on imported rebar throughout 2017 and into 2018. The impact of these tariffs has dramatically increased the cost of rebar. During the second quarter and first half of 2018, we've successfully adjusted our pricing to recover the year-over-year increase in the cost of rebar. However, in order to ensure that we provide value to our customers, we have not raised prices sufficient to maintain our rebar gross margin rate. Therefore, we are earning the same or slightly higher gross margin dollars on our rebar sales, but we are continuing to see gross margin rate compression. During the second quarter of 2018, rebar compressed our overall Construction & Industrial gross margins by approximately 40 basis points.

Next, proprietary brands. We primarily source our proprietary brands from Asia with about 3/4 of it coming from China. Proprietary brands account for around 17% of Facilities Maintenance sales. The current tariffs being charged on Chinese products do not have a significant impact on our sourcing.

Freight costs. Similar to many of our peers, we've seen an increase in third-party freight costs. We've been able to mitigate some of the impact of increasing freight costs through productivity enhancements stemming from investments within our supply chain. Additionally, we operate our own fleet for customer delivery, which enables us to more effectively manage our outbound freight costs and leverage our freight cost per unit as we deliver more to existing customers.

Inflation. There's been concern regarding an increase in inflationary pressures, including tariffs, freight fuel and labor costs. Like others, we are seeing these inflationary pressures. As always, we do our best to offset inflation through our category management initiatives, productivity and leverage of fixed costs as we grow. This enables us to continue to provide compelling value to our customers. We do, however, expect to pass on unavoidable cost increases as market prices rise.

The nonresidential construction end market. We focus our Construction & Industrial business on supporting 15 priority districts, which comprise 15 of the largest MSAs across North America that we believe have the ability to generate strong construction activity for many years. We are currently seeing strong activity across all priority districts.

Last year, we spoke of a gap in large multiyear construction projects as a number of large projects reached completion. Since last year, we've seen that gap filled with the start of several large new construction projects that will continue for multiple years. We estimate the overall market continues to grow in the low to mid-single digits, which is a favorable environment for HD Supply.

Now turning to Page 5, I'll cover our second quarter results. We delivered sales of $1,600,000,000, an increase of $248 million or 18.3% over the second quarter of 2017. Our organic sales in that period increased 10.1% over the second quarter of 2017.

Gross profit increased $83 million or 15.4% to $622 million. Our gross margin rate of 38.9% was down 100 basis points from the second quarter of 2017. Of that, approximately 40 basis points is attributable to the acquisition of A.H. Harris. The double-digit organic growth rate of our Construction & Industrial business creates additional gross margin mix headwinds as does the mix of business within each of our segments, which I will detail shortly.

Our selling, general and administrative costs were up $46 million or 13.6% over the second quarter of 2017. As a percentage of sales, selling, general and administrative costs were 24%, a decrease of 100 basis points from the second quarter of 2017.

Adjusted EBITDA for the second quarter of 2018 was $246 million, up $38 million or 18.3%. Adjusted net income for the second quarter was $182 million, up $55 million or 43.3% compared with the second quarter of 2017. This represents adjusted net income per diluted share of $0.99 compared to adjusted net income per diluted share of $0.64 in the second quarter of 2017. The increase in adjusted net income and adjusted net income per diluted share reflects improved operating performance, the reduction in our interest expense from improvements in our capital structure and a reduction in weighted average shares outstanding. There were 184 million diluted weighted average shares outstanding during the second quarter of 2018.

I will now discuss the specific performance of our individual business units on Page 6. Net sales for our Facilities Maintenance business were $820 million during the second quarter of 2018, up $51 million or 6.6% from the second quarter of 2017. We estimate that the MRO market grew approximately 1% to 2% in the second quarter of 2018.

Facilities Maintenance gross margins declined approximately 50 basis points from a difficult comparison in 2017. As we expected, we saw a shift in lower-margin business from the first quarter of 2018 to the second quarter of 2018 as a result of the late start to the warmer spring weather. Specifically, our property improvement business grew double digits in the second quarter. And within the property improvement business, we did more installation work than normal, further compressing gross margins. Also pressuring margins, HVAC had a strong second quarter after a slow start to the year.

On a year-to-date basis, our Facilities Maintenance gross margin rate is up approximately 30 basis points from fiscal 2017. We continue to expect Facilities Maintenance gross margin rate to be flat to slightly up for the full year of 2018. Facilities Maintenance's adjusted EBITDA for the second quarter of 2018 was $150 million, an increase of $5 million or 3.4% from the second quarter of 2017.

Net sales for our Construction & Industrial business were $781 million during the second quarter of 2018, up $197 million or 33.7%. On an organic basis, excluding the sales of the recently acquired A.H. Harris, our Construction & Industrial business grew 14.7%. We estimate the overall market was up approximately 6% for the quarter.

Construction & Industrial gross margins decreased approximately 60 basis points. Approximately 30 basis points of the decline was due to the mix associated with the acquisition of A.H. Harris. An additional 40 basis points of decline is from the reduction in gross margin rate of rebar.

As I indicated previously, we have recovered all of the year-over-year tariff-related cost increase through price, but we have not charged an additional markup on this cost increase. Therefore, we earn the same or slightly higher gross margin dollars on each unit we sell, but we do see some compression in rebar gross margin rate. We also continue to see a shift towards larger jobs, which tend to have lower gross margin rates associated with them. Our Construction & Industrial team performed well, executing on category management initiatives to offset some of these margin pressures. Construction & Industrial's adjusted EBITDA for the second quarter was $96 million, up $33 million or 52.4%.

Turning to Page 7. As of the end of the second quarter of 2018, our remaining gross federal net operating loss carryforwards approximated $495 million. On a tax-effective basis, our federal and state net operating loss carryforwards were approximately $161 million, representing the majority of our net deferred tax assets. We expect these net operating loss carryforwards and various tax credits to continue to reduce the amount of cash taxes we pay going forward through the middle of 2019.

During the second quarter of 2018, we paid cash taxes of approximately $3 million, primarily U.S. state and Canadian taxes. We expect we will pay cash taxes of approximately $10 million to $12 million during the full year of fiscal 2018. We expect our GAAP tax rate to be approximately 25% to 26% in fiscal 2018.

Over the last 12 months, we generated $401 million of free cash flow. During fiscal 2018, we expect to generate approximately $500 million of free cash flow.

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, tuck-in acquisitions and a return of cash to shareholders currently through our existing share repurchase authorization.

Through August 31, 2018, we have purchased 3.5 million shares of HD Supply stock for an average price of $37.23 or a total of approximately $129 million under our second $500 million share repurchase authorization, announced in August of 2017. We have approximately $371 million remaining under this authorization. We expect to continue to opportunistically purchase shares of HD Supply stock through open-market purchases under our 10b5-1 plan based on market conditions.

Including the completion of our initial $500 million share repurchase authorization, we have purchased a total of 19.4 million shares of HD Supply stock for an average price of $32.41 or a total of approximately $629 million. Through these share repurchase programs, we have reduced our outstanding share count by nearly 10% since the first quarter of 2017.

As of the end of the second quarter, our net debt-to-adjusted EBITDA leverage is 2.4x, within our targeted range of 2.3x. We invested $28 million in capital expenditures in the second quarter of 2018.

On Page 8, we provide second quarter 2018 monthly sales trend performance as well as the 2017 comparable. In May of 2018, we delivered sales of $488 million, an increase in average daily sales of approximately 18.7% versus May of 2017. Organic sales growth in this same period was 10.6%.

In June 2018, we delivered sales of $486 million, an increase in average daily sales of approximately 18.7% versus June 2017. Organic sales growth in the same period was 10.4%.

In July of 2018, we delivered sales of $626 million, an increase in average daily sales of approximately 17.8% versus July 2017. Organic sales growth in the same period was 9.7%. In both years, there were 20 selling days in May, 19 selling days in June and 24 selling days in July.

August 2018, the first month of our fiscal third quarter of 2018, ended on August 26, so we can provide our preliminary sales results. We will not comment on August results beyond sales. There were 20 selling days in both August 2018 and August 2017. August sales were approximately $513 million, which represents average daily sales growth of approximately 17.7% versus 2017. Organic sales growth for August was 10.2%. Average daily sales growth versus prior year by business was approximately 33.1% for Construction & Industrial and approximately 6% for Facilities Maintenance. Construction & Industrial's organic sales growth for August was approximately 15.7%.

On Page 9, we share our perspective on our third quarter 2018 guidance. For our third quarter 2018, we anticipate net sales to be in the range of $1,560,000,000 and $1,610,000,000, adjusted EBITDA in the range of $239 million and $249 million and adjusted net income per diluted share in the range of $0.95 and $1.

Our adjusted net income per diluted share range assumes a fully diluted weighted average share count of approximately 184 million. At the midpoint of the ranges, our third quarter net sales and adjusted EBITDA translate into approximately 16% growth and approximately 14% growth, respectively. On an organic basis, the midpoint of our third quarter 2018 sales range represents growth of approximately 8%.

On Page 10, we update our guidance walk for the full year. We are raising our 2018 guidance of net sales to now be in the range of $5,900,000,000 to $6 billion. Adjusted EBITDA is now expected to be in the range of $845 million to $870 million; adjusted net income per diluted share in the range of $3.22 to $3.35, which does not include any additional incremental share repurchases for the remainder of 2018. Our adjusted net income per diluted share range assumes a fully diluted weighted average share count of approximately 184 million.

At the midpoint of the ranges, our full year net sales and adjusted EBITDA translate into approximately 16% growth and 17% growth, respectively. Guidance for both the third quarter 2018 and full year 2018 includes our best thinking around the timing and scope of tariffs and other inflationary pressures.

On Page 11, we reiterate our end market outlook for 2018. As previously shared, we believe the MRO market will continue to grow approximately 1% to 2%. We expect the nonresidential construction end market to grow low to mid-single digits, and the residential construction market will continue to grow approximately mid-single digits. These specific end market estimates imply an approximate 3% end market growth estimate for HD Supply's end markets in 2018.

On Page 12, we summarize and consolidate our third quarter and fiscal year 2018 outlook views. To summarize, the teams are intensely executing across the company and are focused on achieving our financial and operational goals.

I'd like to thank you for your continued interest in HD Supply. And James, we are now ready to take some 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 Ryan Merkel with William Blair.

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Ryan James Merkel, William Blair & Company L.L.C., Research Division - Research Analyst [2]

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So I want to start with some clarification questions on the FM business. So if I heard you right, Evan, it sounds like there was a gross margin mix and some timing shift from 1Q, which was kind of driving why the EBITDA margin in FM was down year-over-year. Is that right?

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

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That's right. As we expected, the slow start to the spring weather shifted some of our HVAC sales from the first quarter to the second quarter. We also had a very strong property improvement business. As you know, property improvement is an area of growth for the company, but it is slightly lower gross margins. And then we had our normal mix headwinds with the hospitality business growing slightly faster than the core business as well.

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Ryan James Merkel, William Blair & Company L.L.C., Research Division - Research Analyst [4]

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And then as we get into the fiscal third quarter, should we be getting back to sort of normalized operating leverage in FM at that kind of 1.2, 1.3 range? Or does gross -- or the margins still kind of stay weak into the third quarter?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [5]

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The mix pressures we see -- that we saw in the second quarter, we are seeing continue in the third quarter. We still have a strong HVAC business here in the third quarter. Property improvement is growing well as is the hospitality business. So we will continue to see some of these margin pressures in the third quarter, and that is reflected in our guidance.

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Ryan James Merkel, William Blair & Company L.L.C., Research Division - Research Analyst [6]

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All right. Got it. So temper operating leverage in the FM business and then the C&I business sort of continues strong and sort of mix up.

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [7]

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That's right, and we're confident over the cycle we deliver about that 1.5x operating leverage on the core growth of 300 basis points in excess of market. We do want to make sure that we don't let that operating leverage metric prevent us from growing faster than 300 basis points in excess of market, which because, in many cases, that additional growth is in lower-margin business but still profitable business. And in any given quarter, obviously, we have variation as we see the mix of the business evolve and some of the inflationary pressures that we talked about.

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Ryan James Merkel, William Blair & Company L.L.C., Research Division - Research Analyst [8]

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Got it. And just lastly, August organic growth up 10%, it's very strong. Guidance sort of implies a moderation in September and October. Can you just clarify for us, is that just tough comparisons versus any kind of slowdown in demand? And maybe is the moderation going to happen both in FM and C&I sort of at the same time?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [9]

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Yes. That is primarily because of difficult comparisons. Beginning in the month of September, we lap the double-digit organic growth rates of Construction & Industrial, so those comparisons get more difficult. And so that slowdown that's implied in the guidance is primarily in the Construction & Industrial business.

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Operator [10]

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Our next question comes from Evelyn Chow with Goldman Sachs.

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Evelyn Chow, Goldman Sachs Group Inc., Research Division - Equity Analyst [11]

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Maybe just a quick question first on nonres. So you have been sounding increasingly positive on the end market. You noted there were several multiyear projects that you could potentially benefit from. Help us kind of think about the potential addition to your growth rate over the next few years? And also, the mix of projects, what that entails for your profitability.

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

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Yes. So Evelyn, we always commit to 300 basis points of growth in excess of market. Then we operate as hard as we can to deliver growth in excess of that. The Construction & Industrial teams did a -- has done a fabulous job over the last 12 months in executing on that. We've now essentially had 4 quarters of double-digit organic growth. So real strong performance by the Construction & Industrial business. We'll continue to work hard to execute and deliver at that level, but our commitment is 300 basis points faster than the market.

In terms of the mix of projects, large projects are great because they give us confidence in going -- in projecting out more than a couple of quarters. We do see good activity in large projects, but we are lapping some pretty difficult numbers starting here in the third quarter.

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Evelyn Chow, Goldman Sachs Group Inc., Research Division - Equity Analyst [13]

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Got it. That makes sense, Evan. And then maybe just turning to your Slide 4, where you noted some of your topics of recent interest. I know on the rebar side of things, you're saying that what you're getting right now from price doesn't quite make up the same gm rate as you used to get. Is that sort of a similar picture for the rest of sort of how price and inflation works across the other pieces of your portfolio?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [14]

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Yes. That's the way we are looking at it, and we are expecting. So when we look at potential tariffs that are being discussed by the administration, these are pretty significant increases in costs that -- on certain products that these tariffs would imply. So if you think about a 25% tariff, if you pass along that 25% cost increase to your customer, that's one thing. In order to maintain your gross margin rate, you'd need to pass on an increase, more likely 35% to 40%, to maintain your gross margin rate, essentially passing on a markup on the tariff. I don't think that is realistic.

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Evelyn Chow, Goldman Sachs Group Inc., Research Division - Equity Analyst [15]

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Makes sense. And then maybe last question for me. I know at the Analyst Day, you mentioned the possibility you might take a look at some actions related to your debt. Could you kind of refresh us on your thinking on that?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [16]

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Yes. So we've got $1 billion of senior notes that become callable in April of 2019. The current interest rate on that debt is 5.75%. The rate does rise to 7% in April of 2019. So we are incentivized to do something with that debt between now and April of 2019, but we look at it as an opportunistic refinancing opportunity. So we continue to monitor the markets, and you may see us yet enter the credit markets in the balance of the year to refinance that debt prior to April of 2019 with the intent of lowering the rate from 5.75% to something less than that and avoid the step-up to 7%.

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Operator [17]

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Our next question comes from Ronnie Weiss with Barclays.

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Ronald Drew Weiss, Barclays Bank PLC, Research Division - Research Analyst [18]

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Just going back to the mix for a second. I was wondering if you could quantify how big the impact was to both the businesses for FM and the large projects on C&I?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [19]

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So for FM, the -- both the property improvement -- well, the property improvement business and the HVAC business were growing about double digit relative to the core business, obviously growing in total about 6%, so absent property improvement and HVAC, a little less than that. So it was a significant mix issue for property improvement and HVAC. Similar for hospitality. Hospitality is -- we normally see hospitality grow faster than the core business. So that's not new, but it is a gross margin mix headwind that we regularly face.

Then I'll point out within property improvement, we had an increase in the amount of installations that we did this year versus last year. So the installation work, that labor is particularly lower-margin activity that we do, and the installation business was up significantly even within property improvement.

On the Construction & Industrial side, we don't specifically disclose our mix of large projects versus small projects. But this is a trend that we've seen over the last year. Hasn't meaningfully changed, that trend.

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Ronald Drew Weiss, Barclays Bank PLC, Research Division - Research Analyst [20]

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Got it. And then in FM, I'm just trying to boil down to kind of what else may have weighed on the margin in Q2. I guess, was the full decline year-on-year due to the mix? Or was there some -- I guess, the second part of that question is, on the $12 million of investments, kind of how much have you spent year-to-date? And kind of what that was in Q2 as well?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [21]

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So we are still spending about $3 million a quarter on those investments, and so that continued in the second quarter. The gross margin rate really was entirely -- that gross margin decline in Facilities Maintenance was entirely from mix, the property improvement business, the HVAC business primarily.

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Operator [22]

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Our next question comes from Ryan Cieslak with Northcoast Research.

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Ryan Dale Cieslak, Northcoast Research Partners, LLC - VP & Senior Research Analyst [23]

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I guess the first question, you guys called out freight as being more -- certainly a cost headwind. It seems like that's happening for most distributors and most companies right now. Can you just dissect that a little bit as it relates to maybe how that impacted the second quarter here for you versus the first? And is it a combination -- is it mostly related to your third-party costs, or are you seeing some inflation as well with some of your drivers for your internal fleet as well?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [24]

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Yes, that's a good question, Ryan. So certainly, we do see some increasing costs in what I'll call freight in. So that's the freight to deliver the product to its first HD Supply facility. And that freight-in cost is included in our gross margin. So that is -- that's a pressure within the gross margin rate in both businesses.

The freight out is primarily on our own trucks. So these are the deliveries to our customers. We do see some inflation in freight out related to fuel and related to driver wage rates as well as third-party carriers that we use, to a lesser extent. That cost, the freight-out cost is included in our SG&A. So we do not include freight out in gross margin. That's included in selling, general and administrative expenses and is creating some pressure there.

So we do see pressure in both areas. We work hard to mitigate as much of that as we can through the supply chain initiatives that we've undertaken, driving tighter routes on deliveries and some of the logistics investments we've made and by delivering more to existing customers. Because the more we deliver to an existing customer, the more we could put on a truck that's running the same number of miles, the lower the cost per unit of that delivery.

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Ryan Dale Cieslak, Northcoast Research Partners, LLC - VP & Senior Research Analyst [25]

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Okay, appreciate the color there. And then for my follow-up, this FM segment organic growth, really good to see that staying again, once again, 400, 500 basis points above market into August. Certainly, with the more difficult comp, it looks like the underlying trend within that business is continuing to move higher. What -- is there anything -- I know you called out HVAC sales being seasonally strong or maybe some of that coming into the second from the first and maybe even less and some into August. But is there anything that's onetime in nature that maybe suggests that, that underlying trend starts to plateau into the back half of this year? Or do you still think that there's still a lot of momentum in this business to take it and maybe take it even higher?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [26]

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I don't know if I would characterize it even as onetime. Certainly, those mix issues hit us particularly hard this quarter. As I indicated, some of that mix issue, we're going to see again in the third quarter. That's not necessarily bad. It means we're growing share in those categories, and we do want to grow share in those categories and in those businesses. It's up to us as a team to sell the full basket to maintain margins and to again pass on cost increases to the extent they're unavoidable. So I wouldn't characterize it as onetime. But it is -- it was a particularly difficult quarter from a mix standpoint.

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [27]

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Yes. But I would say that our service model is out there and it's winning, and all our investments are targeted in how do we make that service model win more.

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Operator [28]

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Our next question comes from Patrick Baumann with JPMorgan.

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Patrick Michael Baumann, JP Morgan Chase & Co, Research Division - Analyst [29]

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Just following up on Ryan's question earlier. Just on the FM gross margins, they're up, I guess, you said 30 basis points year-to-date, and you noted an expectation to have it flat to slightly higher for the year. Just curious how we think about overall operating leverage for the business this year in the context of that gross margin guidance.

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [30]

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So within the earnings deck, I believe it's on Page 10, we've walked forward our earnings guidance for the year starting with the 1.5x operating leverage on the core business. And then we layer in the sort of the onetime items or events that impact us here in fiscal 2018, including the raising of guidance at -- that we did at both at the end of the first quarter and at the end of the second quarter here.

So for total company, we still do expect the 1.5x operating leverage on the core growth with those onetime items. The Facilities Maintenance business again right now is being impacted a bit by mix. But we're confident in that business, that it's a 1.5x operating leverage business on core growth through the cycle.

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Patrick Michael Baumann, JP Morgan Chase & Co, Research Division - Analyst [31]

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Okay, makes sense. And then you noted no impact on proprietary brands from the current tariffs. Just wanted to clarify whether this includes the proposed list as well. And if not, have you analyzed the potential impacts from any of that stuff?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [32]

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Yes, a good question, a good clarification opportunity on that one. We've seen very minimal impact on the current tariffs on the $50 billion of products that are currently in place. The additional $200 billion that's being proposed and is open to public comment, it's open to public comment through tomorrow, and then the President will make his decision. Those tariffs will have an impact on our sourcing. It's a little early to say how much. Again, even with -- even when we see those tariffs, it's our job to offset as much of it as we can. But our expectation is that the unavoidable cost increase, we pass on. And I'm sorry Patrick, I'll just add one more point on that. Our best thinking on that is currently reflected in both our third quarter and full year guidance.

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Patrick Michael Baumann, JP Morgan Chase & Co, Research Division - Analyst [33]

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What is your best thinking on that? So you've quantified it? Is there kind of a number you've dialed in for inflationary pressures related to that $200 billion?

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

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Yes. Without seeing what it is yet, I'm not comfortable sharing that. It's a pretty wide range.

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Operator [35]

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Our next question comes from Deane Dray with RBC Capital Markets.

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Deane Michael Dray, RBC Capital Markets, LLC, Research Division - Analyst [36]

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Just to circle back on SG&A came in lower versus expectations. You addressed it in your earlier comments. But what was driving that? And just like, when you gave the explanation about the freight out, that would be adding to SG&A. So just was surprised to see it coming in lower this quarter.

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [37]

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Yes -- no, you're right. The freight out is certainly pressure within SG&A that we offset. We did a real nice job of leveraging fixed costs. The business grew 10% organically, gives us some opportunity to leverage those fixed costs and particularly at Construction & Industrial, growing organically in the low to mid-teens, gives you an opportunity to really leverage. And that's the key to the business model. That's the key to our ability to generate operating leverage.

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Deane Michael Dray, RBC Capital Markets, LLC, Research Division - Analyst [38]

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Okay, that's helpful. And then on A.H. Harris, you said the integration's going well. You're ahead of plan. Can you share with us a bit about more clarity on this 40 basis points hit to margins. Is -- how much of that is the mix? And what specifically is it about their mix? And might there still be some inefficiencies in the business in how it's being integrated and it's -- just hasn't yet reflected in the profit improvement there. So how do we look at that 40 basis points at this stage?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [39]

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Yes. So certainly, the A.H. Harris business has a mix issue for all of HD Supply, given that its margin rates are more similar to our construction business than the Facilities Maintenance business. But then, even within Construction & Industrial, it creates mix issues at the gross margin level.

Now we do get some benefit in SG&A. So when you asked about the SG&A rate, leveraging those fixed costs in SG&A. We also do get a little bit of benefit from the A.H. Harris mix. They tend to have lower gross margin and lower SG&A rate, and some of that is just the nature of the business, the Kenseal business that we acquired as part of A.H. Harris. That's the waterproofing and sealant business. That product generally has lower gross margins, but then also has lower SG&A associated with it.

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Deane Michael Dray, RBC Capital Markets, LLC, Research Division - Analyst [40]

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And just to clarify, how much of that 40 basis points would be addressed through the integration efforts, reducing redundant expenses and so forth?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [41]

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Yes. So certainly, there is some benefit in densing out the Northeast where in the past, we were inefficient in the Northeast from the perspective that we didn't have a lot of density. When you do have density in a region in distribution, your SG&A rate goes down significantly because you can run your deliveries with full trucks and shorter routes. So we're not prepared to share the specifics in terms of how much we save in the SG&A rate. But we are starting to see some of that. And there is more to come.

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Operator [42]

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Our next question comes from David Manthey with Baird.

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David John Manthey, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [43]

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First of all, assuming when you talk about mix within segments related to PI and HVAC timing, I assume that should normalize. Are you implying that FM and overall gross margin should uptick slightly from the second quarter to the third quarter then?

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

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Yes. So David, what I shared is that we are continuing to see a strong HVAC and PI business into the third quarter. So I do expect those gross margins -- that gross margin pressure that we saw in the second quarter to ease. But we still do have significant mix issues in the third quarter.

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David John Manthey, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [45]

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Okay. And I assume -- well, obviously, A.H. Harris will remain constant. And C&I, if that continues to be strong, will have a downward effect as well.

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

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Yes, that's right. The A.H. Harris business is, again, is dilutive to gross margin versus C&I but not necessarily dilutive to EBITDA margin at C&I.

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David John Manthey, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [47]

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Okay. And then thinking a little bit longer term, as you look out over the next, say, 2 or 3 years or more, is there a point at which you'll have to adjust your 1.5x operating leverage expectation? And what I mean by that is, should we assume that as the reported margins of the company rise, contribution margins will have a diminishing leverage effect at some point? I'm just wondering in terms of messaging how you plan on approaching that topic as we get out there.

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [48]

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Yes. So I think your point is a relevant point, that the further you go on and the longer and higher we raise our EBITDA margins, the more difficult it is to maintain the 1.5x operating leverage. But we do believe we can maintain that level of profitability on core growth, again, the core growth being market growth plus 300 basis points of outgrowth. Additional outgrowth beyond that likely will be in businesses that could have lower gross margins and lower EBITDA margins. Now still profitable, still adding to earnings, still adding to cash flow, but could put pressure on an overall 1.5x operating leverage rate.

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [49]

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The key here is that we're going to focus 100% on how do we have consistent-through-the-cycle double-digit earnings per share growth. And that's what you solve for from an operating perspective. You don't constrain yourself in terms of how you operate the business. Every business decision grows earnings per share.

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [50]

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Yes, that's a big point. We talk a lot about operating leverage on these calls, but I'll tell you, we certainly look at operating leverage when we set our targets. But once those targets are set, the teams are focused on beating their earnings number: beating sales, beating earnings, beating cash flow. That's what they're driving towards. Not -- they're not really driving towards an operating leverage number after the target is set.

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Operator [51]

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Our next question comes from Keith Hughes with SunTrust.

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Keith Brian Hughes, SunTrust Robinson Humphrey, Inc., Research Division - MD [52]

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Just a question on rebar. There's a few indices in the last 30 days (inaudible)

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [53]

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Keith?

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Keith Brian Hughes, SunTrust Robinson Humphrey, Inc., Research Division - MD [54]

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Can you hear me? Sorry, is that better?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [55]

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We hear you.

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Keith Brian Hughes, SunTrust Robinson Humphrey, Inc., Research Division - MD [56]

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My question is on rebar prices. In the last 30 days or so, there's some rebar indices that have kind of come off here in price. I just wanted to see if you've seen that in your business. And when prices, as they will eventually, fall, how quickly will that flow through the income statement at C&I?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [57]

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Yes. So changes in rebar price flow through pretty quickly. We turn rebar particularly quickly. We normally keep about 30 days of supply of rebar on hand. In some cases, we expand that to about 60 days to ensure that we can meet some of these larger projects that our customers are working on. And so it does flow through quickly.

And I will say in terms of the rebar markets themselves, they are volatile. We've seen periods over the last year where rebar prices have pulled back a bit. And actually, we were hopeful each time that occurred that we'd see a more normalization or at least a stabilization of rebar prices. But each time we've been disappointed, and rebar has increased again. So we'll see if we do get some stabilization.

If we get stabilization in the rebar markets, that would certainly be a good thing. But we're comfortable operating in any environment. Like I shared, the team's done a nice job now in being able to pass on the year-over-year cost increase. And so while it does contribute more to the top line growth, we don't necessarily earn a significant amount more in gross margin dollars. But we're not earning any less. So we get a little bit of top line growth, similar profitability. And that was driving some of the outgrowth at C&I. The outgrowth or the organic growth at C&I was close to 15%. Absent rebar, it was closer to 12%.

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Operator [58]

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Our next question comes from Hamzah Mazari with Macquarie Capital.

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Hamzah Mazari, Macquarie Research - Senior Analyst [59]

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My first question is just on tariffs. I know you gave a lot of color on current tariffs and rebar and sort of how you've baked it into guidance on the incremental $200 billion. But my question is specifically sort of, how fungible is your supply chain on the proprietary product side? And then if the incremental $2 billion of tariffs does hit, how much of a lag is there from tariffs increasing your cost base to when you can pass it through? I know you don't give detail on national account contracts, but just given how your contracts are structured, what's the lag on the pass-through? And then just the supply chain, any comments around that, too.

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [60]

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Yes, Hamzah, those are great questions. So first on the supply chain, as I said, we produce about 75% of our proprietary branded products in China. We don't have any permanent investments in China. So we could look to source that product in other countries. To do so does take some time. And obviously, there is a little bit of disruption in doing so. So you don't do so without significant thought, and it takes a period, it would take a period of months. So it's not weeks, it's months. But it could be done in many cases.

In terms of the timing of when the $200 billion -- or the tariffs on the $200 billion of imports hits and then when we would see it, there is certainly a lag in terms of when those tariffs are placed on the product and when it hits our DCs. Now when the tariffs go into place, we would pay the duty when it hits our shore on the West Coast. So you're talking a few weeks before, at most before it's hitting our distribution centers. And then, obviously, we've got our existing inventory, which we turn generally 4 to 5 times a year. So that cost would start flowing through potentially the latter half of the third quarter, more so the fourth quarter or 2019.

Now on the domestic side, it's harder for us to say as to when domestic manufacturers -- or I should say, domestic suppliers that we buy from, who may be importing from China, how that flows through. We could potentially see that sooner.

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Hamzah Mazari, Macquarie Research - Senior Analyst [61]

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Great. That's very helpful color. And then just my follow-up question is just around pricing. I know you mentioned sort of pricing is in line with the market. But any more color as to sort of, do you view the market as -- market pricing as rational? Or do you view market pricing as more than covering inflationary costs at this stage in the cycle? Or do you view sort of market pricing as still sort of -- has room to go versus sort of prior cycles when demand's been solid, inflation's in the system and your suppliers are raising price. So just any color around pricing. I know you don't specifically quantify price.

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [62]

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Yes. We are seeing some rational activity within the markets on pricing. So it is our expectation that we will be able to pass on unavoidable inflationary costs, be it from tariffs or otherwise.

That being said, as I shared with Evelyn on her question, when you've got a very significant increase in price or in cost, passing on that cost gives you some additional top line growth, protects your gross margin and your profitability, but does compress your gross margin and EBITDA margin rates. And depending on the level of tariffs we see and the level of cost increase we see in the marketplace, that may be the case. But it is our expectation to pass on cost.

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Operator [63]

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That concludes our question-and-answer session. So I'd like to turn it back over to Mr. DeAngelo for concluding remarks.

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [64]

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Great. Well, thank you for your questions. In summary, on Page 14, the team is focused and energized to continue to deliver on our customer, associate and shareholder promises. Thank you for your continued support and interest in HD Supply.

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Operator [65]

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Thank you. Ladies and gentlemen, that does conclude today's conference. Thank you very much for your participation. You may all disconnect. Have a wonderful day.