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Edited Transcript of HDS earnings conference call or presentation 4-Dec-18 1:00pm GMT

Q3 2018 HD Supply Holdings Inc Earnings Call

Atlanta Jan 23, 2019 (Thomson StreetEvents) -- Edited Transcript of HD Supply Holdings Inc earnings conference call or presentation Tuesday, December 4, 2018 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Bradley Paulsen

HD Supply Holdings, Inc. - President of HD Supply Facilities Maintenance

* 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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* Bhupender Singh Bohra

Wolfe 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

* Evelyn Chow

Goldman Sachs Group Inc., Research Division - Research Analyst

* Hamzah Mazari

Macquarie Research - Senior Analyst

* Patrick Michael Baumann

JP Morgan Chase & Co, Research Division - 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

* Jason 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. Welcome to the HD Supply Third Quarter Earnings Conference Call. As a reminder, this conference call may be recorded.

I would now like to turn the conference over to Charlotte McLaughlin, Investor Relations. You may begin.

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

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Thank you, Candice. Good morning, ladies and gentlemen, and welcome to the HD Supply Holdings 2018 Third 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 2018 third quarter earnings release, both of which are available on our IR website at www.hdsupply.com.

Joe DeAngelo, our CEO, will lead today's call. He will be joined by Brad Paulsen, President of our Facilities Maintenance business unit; and Evan Levitt, our CFO, who will provide additional color on our financial performance. 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 2018 third quarter earnings call. As always, it is my privilege to share our 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 want to begin by turning to Page 3. The team has a lot to be proud of in the third quarter. We delivered exactly what we said we would when we communicated to the market back in September. Sales and earnings performance were at the high end of our expectations. We delivered 18% sales growth for the third quarter of fiscal 2018 and 9% sales growth on an organic basis, well in excess of our 300 basis point target for outgrowth.

I was pleased with our earnings performance of 16% adjusted EBITDA growth while continuing to generate strong free cash flow of $453 million on a trailing 12-month basis.

Early in the quarter, we promoted Brad Paulsen to run the Facilities Maintenance business unit. Brad joined the company in late 2015 to lead our Facilities Maintenance merchandising team. He quickly assumed responsibility in other areas, including pricing analytics and inventory management. We're excited about the experience and passion that Brad brings to Facilities Maintenance. He is a natural leader, and he is off to a great start. You'll hear from Brad shortly.

I want to take a moment to update you on our ongoing investments in Facilities Maintenance. We're seeing these investments positively impact our top line with third quarter sales growing approximately 500 basis points in excess of market. We believe we are in the early stages of realizing the full benefits of our investments. Our enhancements to our sales associate coverage model were employed in early 2018, and the feedback has been positive from both our associates and our customers.

As we highlighted during our Investor Day, we also implemented a sales console for our sales associates. This console provides our sales associates with dynamic customer and product data, improving our ability to be helpful and collaborative with our customers to provide the best solutions for their specific needs. Like all of our productivity tools, our sales console is continually evaluated and improved. I review and interact with our best sales performers, and their continued excellence speaks to the success of our ongoing investments.

We're also seeing fantastic results from our investment in web and mobile, with 70% of Facilities Maintenance sales being placed electronically, improving the efficiency of the customer-associate relationship. In November, we piloted our updated Facilities Maintenance web platform. We expect to see this fully rolled out by the end of the fiscal year. Early results are encouraging as we aim to make it even easier for our customers to identify the products they need and correspondingly make it easier to buy. This enables our sales associates to spend less time processing transactions, bringing them to focus on value-added solution selling.

Moving on to our Construction & Industrial business unit. We continue to see the team outperform and gain market share. This performance is a direct result of the great sales leadership under John Stegeman, our unique expertise within 14 different specialty construction trades under one roof and a robust end market.

We continue to see good, long-term projects across the country, including major airport renovations, construction of new sports and entertainment complexes, corporate headquarters, data centers and distribution centers.

Additionally, the A.H. Harris integration is progressing extremely well. We continue to be ahead of our originally planned schedule and expect the integration to be largely complete by the end of fiscal 2018. Realization of synergies are on track, and we are seeing the benefits of an integrated sales team supported by strong category management execution. I couldn't be more pleased with the enthusiasm and hard work of our associates as we complete this integration.

Across our business, we continue to deploy capital at the highest-return opportunities available. We believe that quality M&A is a core competency and a key value-creation lever, and we look forward to executing future opportunities in both businesses as we identify compelling value.

Our third quarter also saw the team execute on the successful refinancing of our debt obligations. And we will speak more about this later, but the interest savings will continue to benefit our free cash flow generation over the next several years.

We also continued to execute on our capital allocation strategy, opportunistically taking advantage of the recent financial market weakness in the third quarter and into the fourth quarter. During the third quarter, we purchased 2.4 million of our outstanding shares for $91 million. During the fourth quarter through November 30, we repurchased an additional 3.3 million shares for $125 million. As of November 30, we had $156 million remaining under our second share repurchase authorization. As part of our continuing capital allocation strategy, our Board of Directors has approved an additional $500 million share repurchase authorization, bringing our total unused authorization to $656 million.

We will exit 2018, our first fiscal year, with our portfolio optimized and our capital structure normalized as a stronger company. We look forward to continuing to focus on our 2 market-leading businesses where we have the ability to service our customers better than anyone in the industry.

I am 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 Brad to introduce himself and update you on the recent Facilities Maintenance activity.

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Bradley Paulsen, HD Supply Holdings, Inc. - President of HD Supply Facilities Maintenance [4]

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Thank you, Joe, and good morning. I want to begin by extending my thanks to the entire Facilities Maintenance team who have made my transition period seamless. In my first 90 days, I've traveled across the country and saw firsthand the hard work and commitment of our over 5,000 associates who I'm now honored to lead and represent.

During my 3 years at HD Supply, I worked with every function of our Facilities Maintenance business and had a key role in setting the company's current strategy. I firmly believe that this strategy is appropriate to deliver an outstanding customer experience and to maximize returns for our shareholders. I am confident in the ability of my leadership team to execute and position Facilities Maintenance for continued sales outperformance in our highly fragmented market.

To that end, I am pleased to announce that Alyssa Steele has joined our team and will serve as our Chief Merchandising Officer. Alyssa brings the strongest credentials from both home improvement and e-tailing and is someone with whom I have had the privilege of working with for many years.

I'm incredibly proud of our team's execution in the most recent quarter. Their efforts, plus the continued realization of benefits from our recent investments, were the key drivers on our sales acceleration. Our team is fully committed to better leveraging our cost structure and improving our profitability as we grow. While our team planned for and expected weaker SG&A leverage in the second and third quarter of 2018 due to difficult comparisons from the prior year, plus recent pressure from product mix, freight and labor costs, our team is focused on enhanced cost leverage, and we expect to start seeing improvement in the fourth quarter and throughout 2019.

I would also like to take a moment to address the Section 301 Chinese tariffs. Our organization currently does not have any permanent investment, joint ventures or even [buying offices] in China which allows us to be nimble in making adjustments to help offset the current tariff impact. Our category management team has partnered throughout the year with our suppliers to develop plans that will allow us to continue to deliver value to our customers. We will continue to execute these plans, which include negotiating lower prices on Chinese products by taking advantage of the strength of the U.S. dollar and incentives provided by the Chinese government to their manufacturing base.

Additionally, as part of our continuous supply chain enhancement, we are always evaluating the best locations from which to source our products. While we are committed to offsetting as much of the tariff impact as possible, we do intend to pass on price increases where rising costs are unavoidable. We have recently begun making some modest price increases consistent with the current competitive environment, and the early indication is that the market is accepting these changes. We believe the current tariff environment is manageable where we can maintain our gross margin rates, but we do plan to monitor the environment closely and we'll take swift actions as they become necessary.

I am incredibly encouraged by what I've seen in my first 90 days, and I am excited about the opportunity to lead our team, help our customers and deliver value to our shareholders. I appreciate the opportunity to speak with you today and look forward to meeting more of you.

I will now turn the call over to Evan.

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

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Thank you, Brad, and good morning, everyone. On Page 4, we highlight areas of recent investor focus. First is tariffs. We've yet to see a substantial impact from the Section 301 tariffs as it does take some time for those costs to work their way through the supply chain. However, as Brad said, we believe the current environment is manageable.

Our initial focus is always to avoid or offset as much of the costs as possible, but we do intend to pass along unavoidable cost increases. We expect that price increases to offset unavoidable tariff-related costs could mean an additional 100 to 150 basis points of sales growth over time as these costs work their way through the supply chain.

For our Construction & Industrial business, rebar costs continue to be the largest tariff impact. Similar to last quarter, we are passing on 100% of the rebar cost increase year-over-year but are unable to pass along enough of a price increase to maintain prior year's rebar gross margin rate. The impact is that we earn the same or slightly more gross margin dollars than prior year for every unit of rebar sold, and our overall profitability is maintained.

The rebar price increase contributed almost 300 basis points of sales growth for our Construction & Industrial business in the third quarter and 30 basis points of gross margin compression. We are seeing signs of stabilization in the rebar market and expect the year-over-year impact to diminish over the next few quarters.

Next, the nonresidential construction end market. As Joe indicated, the nonresidential construction end market remains strong across our 15 priority districts. We continue to see strength in large, multiyear, multibillion-dollar projects, which gives us confidence in the future health of the market. We do not see any signs of a slowdown.

Hurricanes and wildfires. This quarter, we saw the impact of 2 hurricanes, one in the Carolinas and the other along the Florida Panhandle and Southern Georgia. We were fortunate that no HD Supply associates or immediately -- immediate family members were injured during these storms. The net impact of these storms on our business was not material.

Many Americans are now dealing with the aftermath of recent wildfires in populated areas of California. Our hearts go out to those affected as many lives have been lost, homes have been destroyed and families have been displaced. HD Supply has again been fortunate that no associates or immediate family members were injured in the devastation.

We have seen a modest negative sales impact in November as a result of road closures and inaccessible parts of the state preventing deliveries. HD Supply has assisted both our customers and first responders in these parts of the country during the disasters, and we will continue to help during the rebuilding phase. These events are generally neutral for HD Supply, with initial sales disruption followed by some additional demands during cleanup and recovery.

Now turning to Page 5. I will review our third quarter results. In terms of highlights, we delivered sales of $1.6 billion, an increase of $242 million or 17.7% over the third quarter of 2017.

Our organic sales in that period increased 9.4% over the third quarter of 2017. Our gross margin rate of 39% was down 60 basis points from the third quarter of 2017.

The A.H. Harris acquisition contributed 40 basis points of this decline, with business mix associated with the strong organic growth of our Construction & Industrial business comprising the remainder of the decline.

Adjusted EBITDA for the third quarter of 2018 was $248 million, up $34 million or 15.9%.

On Page 6, I will discuss the specific performance of our individual business units in more detail. Net sales for our Facilities Maintenance business were $810 million during the third quarter of 2018, up $56 million or 7.4% from the third quarter of 2017. We estimate that the MRO market grew approximately 2% in the third quarter of 2018.

Facilities Maintenance gross margins were flat from the third quarter of 2017. We continue to see net mixed headwinds in Facilities Maintenance, with the lower-margin hospitality vertical and HVAC category growing faster than the remainder of the business.

On a year-to-date basis, our Facilities Maintenance gross margin rate is up approximately 10 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. And as we've previously indicated, flat gross margins in the current environment represent strong performance and highlights our ability to maximize the growth of gross profit dollars.

Facilities Maintenance adjusted EBITDA for the third quarter of 2018 was $149 million, an increase of $5 million or 3.5% from the third quarter of 2017. As expected, leverage continued to be impacted by the additional investment spend of $3 million and freight and labor costs. We expect SG&A leverage in Facilities Maintenance to improve in the fourth quarter as comps become easier and we continue to focus on cost containment.

Net sales for our Construction & Industrial business were $803 million during the third quarter of 2018, up $186 million or 30.1%. On an organic basis, excluding the recently acquired A. H. Harris business, our Construction & Industrial business grew 11.8%. We estimate the overall market was up approximately 5% to 6% for the quarter, and rebar pricing contributed around 300 basis points of growth.

Construction & Industrial's gross margins decreased approximately 20 basis points. Rebar margins drove 30 basis points of this decline while the mix associated with the acquisition of A. H. Harris contributed an additional 20 basis points to the decline, partially offset by category management. We are seeing the rebar market begin to stabilize, and we expect the unfavorable gross margin impact to lessen over the next few quarters. Excluding A. H. Harris and rebar impacts, gross margin rate at Construction & Industrial increased slightly as the team continues to focus on category management initiatives.

Construction & Industrial's adjusted EBITDA for the third quarter was $99 million, up $29 million or 41.4%. The team was able to leverage SG&A well, with EBITDA as a percentage of sales up 100 basis points.

Turning to Page 7. In the last 12 months, we generated $453 million of free cash flow. During fiscal 2018, we expect to generate approximately $475 million to $500 million of free cash flow. This is adjusted from our previous estimate of $500 million of free cash flow as we are looking at opportunities to bring inventory in early to better navigate the current tariff environment.

Also, keep in mind that the original A.H. Harris acquisition cost of $380 million was reduced to $362 million as less inventory was delivered than expected upon closing of the transaction. This necessitated us to invest in additional inventory for the A. H. Harris branches. The impact on total cash generation is neutral, but it does result in a lower cash outflow for the acquisition of the business and higher operating cash investment for inventory. We continue to believe that about $500 million of free cash flow is the correct normalized level of 2018 free cash generation for HD Supply.

As Joe discussed previously, we executed a series of successful refinancing transactions in the third quarter. We fully redeemed our $1 billion 5.75% senior notes due 2024 using cash on hand, borrowings under our revolving credit facility and the issuance of new $750 million 5 3/8% senior notes due 2026. This refinancing locks in a historically attractive lower interest rate, avoids the step-up in interest to 7% that would otherwise have occurred in April of 2019 and extends the maturity date on the senior unsecured notes to 2026.

Shortly after the new senior unsecured notes offering, we refinanced our existing term loans into an aggregate term loan tranche at a reduced interest rate of LIBOR plus 175 basis points. We also took this opportunity to reinvest some of our interest savings into fixing a larger portion of the interest on our outstanding debt.

Prior to our refinancing activity, less than 50% of our debt had a fixed interest rate. We entered into an interest rate swap to effectively fix the interest rate on $750 million of our outstanding term loan for the entire 5-year term. As a result, today, over 75% of our debt is effectively fixed, reducing our exposure to future increases in interest rates. Our weighted average interest rate is now approximately 5%.

We continue to benefit from our federal net operating loss carryforwards, which fully offsets our current federal income tax liability. In midyear 2019, we expect our net operating loss carryforwards to be fully utilized, at which time we will become a regular federal income taxpayer. We expect cash taxes next year to be in the range of $40 million to $50 million. Fiscal year 2020 will be the first year in which we are a regular taxpayer for the full year. Our expectations through 2020 for annual free cash flow continue to be approximately $500 million despite the change to cash taxes. Our ongoing GAAP tax rate will be approximately 26%.

Through November 30, 2018, under our second $500 million share repurchase authorization announced in August of 2017, we have purchased 9.1 million shares of HD Supply stock for an average price of $37.81 or a total of approximately $344 million. We have approximately $156 million remaining under this authorization. Including the completion of our initial $500 million share repurchase authorization, we have reduced our outstanding share count by over 12% since the first quarter of 2017.

On November 30, 2018, our Board of Directors authorized an additional $500 million share repurchase program, bringing our total unused authorization to $656 million. We will continue to opportunistically repurchase shares in the open market pursuant to our 10b5-1 plans.

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, bolt-on or tuck-in acquisitions and the return of cash to shareholders currently through our existing share repurchase authorization.

On Page 8, we provide third quarter 2018 monthly sales trend performance as well as the 2017 comparable. In August of 2018, we delivered sales of $513 million, an increase in average daily sales of approximately 17.7% versus August of 2017. Organic sales growth in this period was 9.9%.

In September 2018, we delivered sales of $481 million, an increase in average daily sales of approximately 19.4% versus September 2017. Organic sales growth in the same period was 10.9%.

In October 2018, we delivered sales of $618 million, an increase in average daily sales of approximately 16.3% versus October 2017. Organic sales growth in this period was 7.7%. In both years, there were 20 selling days in August, 19 selling days in September and 25 selling days in October.

November 2018, the first month of our fiscal fourth quarter 2018, ended November 25, so we can provide our preliminary sales results. We will not provide information on November results beyond sales. November sales were approximately $426 million, which represents average daily sales growth of approximately 14.6% versus 2017. Organic sales growth for November was 6.8%. Average daily sales growth versus prior year by business was approximately 23.1% for Construction & Industrial and approximately 7% for Facilities Maintenance. Construction & Industrial's organic sales for November was approximately 6.6%.

On Page 9, we share our perspective on our fourth quarter 2018 guidance. We now expect sales to be in the range of $1,375,000,000 and $1,425,000,000, adjusted EBITDA to be in the range of $173 million and $183 million, and adjusted net income per diluted share to be in the range of $0.63 to $0.68. Our adjusted net income per diluted share range assumes a weighted average diluted share count of 180 million as of November 30, 2018, and does not contemplate additional share repurchases.

As we have shared previously, the fourth quarter of fiscal 2018 includes a 53rd week, which occurs every 5 or 6 years. Our guidance includes the impact of the 53rd week and the holiday shift, whereby this year's Christmas Eve and New Year's Eve fall on a Monday. Last year's Christmas Eve and New Year's Eve fell on a Sunday. Our Construction & Industrial business will be closed on Christmas Eve and New Year's Eve, resulting in 2 fewer selling days during the period. Adjusting for this, the midpoint of our fourth quarter 2018 sales growth and adjusted EBITDA growth are expected to be 12% and 13%, respectively.

On Page 10, we update our guidance walk for the full year. We are increasing our 2018 guidance of net sales to now be in the range of $5,976,000,000 to $6,026,000,000. Adjusted EBITDA is now expected to be in the range of $857 million to $867 million. And we expect full year 2018 adjusted net income per diluted share to be in the range of $3.33 to $3.38. This assumes a fully diluted weighted average share count of $183 million (sic) [183 million].

On Page 11, we provide our initial end market outlook for 2019. We believe the MRO market will continue to grow approximately 1% to 2%. Our nonresidential construction end market estimate is up low to mid-single digits. And our residential construction market estimate is up low to mid-single digits. These specific estimates imply an approximate 3% growth estimate for HD Supply's end market in 2019.

On Page 12, we give our initial thoughts around 2019. We expect to generate 300 basis points of sales outgrowth on top of the 3% end market growth estimate. Additionally, we expect to deliver 9% to 10% adjusted EBITDA growth on a 52-week basis.

Free cash flow is expected to be approximately $500 million based on this adjusted EBITDA level, with working capital investment equal to approximately 18% of sales growth, capital expenditures of about 2% of sales, cash interest to be approximately $100 million to $110 million, and cash taxes to be approximately $40 million to $50 million.

On Page 13, we summarize and consolidate our fourth quarter and fiscal year 2018 outlook views.

In summary, we are pleased with our performance through the first 3 quarters of the year. We are focused on a strong finish to fiscal 2018, and we are preparing for a successful fiscal 2019.

Thank you for your continued interest in HD Supply. And Candice, 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) And our first 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 [2]

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Hey, nice quarter, everyone. So first of all, on the fourth quarter EBITDA guidance, the margins are coming in a little bit weaker than I was expecting. Can you just talk about what the main drivers are there? I'm guessing it's still mix, but maybe just walk through that for us.

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

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Yes. So we actually do expect improvement in the Facilities Maintenance operating leverage for the fourth quarter. The fourth quarter does have some noise in it relative to the 53rd week and in particular, the holiday shift that I mentioned. With Christmas Eve and New Year's Eve falling on a Monday this year versus a Sunday last year, our Construction & Industrial business will be closed those 2 days. So we've got 2 fewer selling days in the quarter, where we still have our normal operating expenses for those days related to rent and payroll. Even our Facilities Maintenance business, those businesses will be open and making deliveries for Facilities Maintenance on those days, but they'll be lighter volume days.

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

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Okay, got it. And then just to avoid any confusion, can you just confirm what the 2019 EBITDA guidance is? I'm coming up with kind of $930 million to $940 million, but just want to confirm that.

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

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Yes. Well, Ryan, as I shared, it's 9% to 10%. And right now, it's more of a framework than official guidance. We'll give specific guidance on the next call. But right now, we're thinking 9% to 10% EBITDA growth off of our 2018 52-week EBITDA. And you can see what the projected 52-week EBITDA is on our guidance walk in the presentation, where we break out the impact of the 53rd week.

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

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Got it, okay. And then lastly, on the price impact of 100 to 150 basis points, when do you think you'll be realizing that? And then is that a broad-based price increase? Or is it more isolated?

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

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It's not broad-based. It will be targeted in the products where -- in categories where we see cost increases and where the market allows and the market moves. So we do expect that 100 to 150 basis -- it's over the next several quarters as it flows through the supply chain.

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Operator [8]

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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 [9]

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First off, assuming the share repurchase during fiscal '19, as you look to the end of the year, what type of total debt-to-EBITDA do you feel you'll be at? And I guess, maybe a more generalized question. You've clearly run with much higher levels of leverage in the past, but what is the range that you're comfortable with today in terms of total debt-to-EBITDA?

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

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So today, David, we're at about 2.5x debt-to-EBITDA leverage, which is in -- right at the midpoint of the range that we'd like to remain in, which is 2 to 3. We have no issue going to the lower end of that range or the higher end of that range as our capital allocation strategy is an opportunistic strategy. We buy back stock opportunistically. We're interested in M&A opportunistically. And obviously, we're growing our business and investing in our business organically. Could we go above 3x if the opportunity -- the right opportunity presents itself? Yes, we could with the intent that we would quickly pay down debt to get within that 2 to 3x range again. And so we like where we are right now. We do generate a fair amount of cash at the end of the year. And as you've seen, we've been aggressive with our share repurchase program over the last couple of months.

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David John Manthey, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [11]

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Right. And given the high percentage of sales that are coming in via the web and the app today, how are you changing your approach to sales? And how are salespeople remaining relevant to their customers as their roles have morphed over time?

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [12]

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So the role of our salesperson is actually continuing to increase. With, I don't know, highly trained, a highly technical sales team that we have, we view them as being truly a value-add partner through the process. As an example, we discussed tariffs. This is a team that can go out and partner with our customers on property to explain what's happening in the market and help them with their budgets through the course of the year. So while we do see the transactions moving online in some cases, that partnership and identifying the right products to make sure that the property is run properly is stronger than ever.

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Operator [13]

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And our next question comes from Julian Mitchell, Barclays.

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Jason Makishi, Barclays Bank PLC, Research Division - Research Analyst [14]

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This is Jason Makishi on for Julian. Just talking about -- referring to the monthly sales sort of deceleration that occurred later in the quarter, in November. You highlighted that there's -- and particularly in November, there's some of that wildfire impact. But given the continued strength that you've specifically called out in the nonresidential end markets, could you talk a little bit more about any other pockets of slowdown that you might have seen and give a little bit more detail around those?

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

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Yes. So the month of November, we did see some impact from the wildfires in California as well as wet weather in the Northeast and Midwest. And we think that, that impacted our November sales by -- for the Construction & Industrial business by about 100 basis points. But also keep in mind the comps for November were particularly difficult. The comps for November for Construction & Industrial were 16.4%. So if you look at the 2-year stack comps that we delivered, we've been delivering pretty consistent in the Construction & Industrial business, 23% to 25% 2-year stack comps.

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Jason Makishi, Barclays Bank PLC, Research Division - Research Analyst [16]

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Understood. And just kind of following up on the previous line of questioning. You mentioned how Facilities Maintenance, you were expecting an improvement in the operating leverage. Could you just kind of quantify what you expect that step-up to be, either in the core operating leverage or just sort of net of all the noise, whichever one is easier to quantify?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [17]

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Yes. So we don't provide specific guidance by business. But for the last 2 quarters, as we expected and as we originally planned, the operating leverage for Facilities Maintenance was below 1 for a variety of reasons, including some difficult comps as well as some pressure on freight and labor costs and the continuing $3 million a quarter investment. In the fourth quarter, we do expect to lever the Facilities Maintenance results at 1 or above, and then we expect to continue to improve that into 2019.

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Jason Makishi, Barclays Bank PLC, Research Division - Research Analyst [18]

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Understood. And is there any sort of similar trajectory of improvement in C&I or the performance there has been strong enough that you expect it to just sort of keep up, level set into 2019?

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

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We've been pleased with the operating leverage of the Construction & Industrial business throughout the year. Now again, I will point out that, that holiday shift will put some pressure on Construction & Industrial's leverage in the fourth quarter since they will be closed for 2 days that they were open last year.

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Operator [20]

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And our next question comes from Evelyn Chow of Goldman Sachs.

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Evelyn Chow, Goldman Sachs Group Inc., Research Division - Research Analyst [21]

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Maybe just starting on the tariff impact from 301. Helpful to understand the actions you're taking on price. Could you just help us bridge your comments from previously thinking about 3/4 of that private-label business in FM being produced in China versus what you've shared with us today about the relatively minimal impact from 301?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [22]

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Yes. So first, Evelyn, we haven't seen a lot of that cost roll through yet because the 301 tariff just went into place at the end of September. So it does take some time for that to roll through the supply chain. And as you pointed out, about 75% of our private-label product does come from China today. Not all of that is impacted by the Section 301 tariffs. Not even 1/2 of that is impacted by the Section 301 tariffs. So we will see some impact there. But as Brad indicated, our first priority is to offset that increase in tariff through negotiation of better pricing with our partners and our factories in China so that when we talked about a 10% tariff, the actual cost increase that we will take will be substantially less than 10%. But we do intend to pass along the cost increase that we can't avoid. And so we tried to quantify that with 100 to 150 basis points. We think that level of price is sufficient to cover the cost increase that will roll through in the current tariff environment.

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Evelyn Chow, Goldman Sachs Group Inc., Research Division - Research Analyst [23]

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Understood, Evan. And then I actually wanted to clarify some remarks you made on FM's EBITDA rate for the quarter. So if I heard correctly, gross margins in FM were flat. I think EBITDA margins were down about 70 bps. I know the accelerated investments are continuing but not really increasing year-over-year. So what else drove the deleverage this quarter?

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

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The accelerated investment, that $3 million, is about 1/2 of that 70 basis points. And the other 1/2 is primarily freight and labor costs, more so labor than freight. We did have a difficult comparison from last year, and we are working on cost containment in both of those areas. But our comparables get easier going forward as well. So we are confident that we will better leverage those results going forward in the fourth quarter and 2019. And I just do want to point out this is -- we did expect this. This is what we initially planned. This is what we initially guided to all the way back in March as well as our most recent comments that we made in September.

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Evelyn Chow, Goldman Sachs Group Inc., Research Division - Research Analyst [25]

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Understood. And maybe just to follow up on that point. It sounds like SG&A leverage will benefit from some easing comps. What other visibility do you have into improving that, whether it's on wage inflation, freight inflation or other aspects of the bridge that you're seeing?

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

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Yes. So inflation -- we do expect to see some wage inflation and freight inflation continue. But certainly, we're taking actions to offset some of those pressures, particularly in freight, the most important thing that we can do is optimize our usage of freight by using the lower-cost modes of freight versus the higher-cost modes. The lowest-cost mode is to use our own delivery, our own -- move products on our own trucks and of using full truckloads versus partial truckloads versus small parcel. And so we're working hard on doing that.

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Operator [27]

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

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Deane Michael Dray, RBC Capital Markets, LLC, Research Division - Analyst [28]

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Just to get some more color on the A. H. Harris coming in with lower inventory. I guess it shouldn't be surprising, since they were being acquired, they didn't replenish inventory. But what does this mean for the normalized free cash flow generation of the business? How are you thinking about that in terms of what kind of working capital you had to put in? Just what would be normalized?

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

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Yes. So Deane, you're -- I think you're referring to my comment that originally the purchase price for A.H. Harris was $380 million. We actually wound up paying $362 million since less working capital is delivered with the company when we acquired it. That was actually good news for us because it's a cash-neutral event, but then we're able to buy the inventory that we want, and it's fresh inventory as we roll into the integration of A. H. Harris. The normalized cash flow for 2018, we think is still around $500 million. And we think we'll still be close to there, between $475 million and $500 million. Now we are carrying a little more inventory than we ordinarily would today, and we may carry a little more at the end of the year as we navigate through the tariff environment. We are trying to be as opportunistic as possible with buying inventory and how much we carry. And that will continue as we move through the end of the year and even into 2019 as the tariff environment's fluid.

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Deane Michael Dray, RBC Capital Markets, LLC, Research Division - Analyst [30]

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Got it. And then on the outgrowth expectations for 2019, I'm trying to bridge the excellent outgrowth this quarter because of the accelerated investments. You said it was a 500 basis points outgrowth. How much of that is sustainable in terms of the better sales effort and so forth? And might there be upside when we think about the opportunities in 2019 on that outgrowth?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [31]

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Yes, okay. Our commitment is always 300 basis points of outgrowth. Now as you pointed out, the most recent quarter, we've successfully grown faster than that. We will always continue to try to grow faster than that 300 basis points. We do believe there's more upside in the investments that we've made and that we are making in the business, but our commitment will remain at 300 basis points of outgrowth and we'll always try to do better than that.

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Deane Michael Dray, RBC Capital Markets, LLC, Research Division - Analyst [32]

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Got it. And just one quick clarification. Have you actually changed any suppliers at this point with regard to Chinese exposure? Or are you just positioning so if you need to, you can change them?

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [33]

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Yes, up to this point, we have made 0 changes to our supplier base.

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Operator [34]

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And our next question comes from Hamzah Mazari of Macquarie.

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Hamzah Mazari, Macquarie Research - Senior Analyst [35]

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My first question is just on C&I. I know you're not seeing a slowdown right now, but how should we think about decremental margins in C&I? And specifically, how is that business today different than past cycles? It seems like it's pretty different than the last cycle.

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [36]

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Yes. I think, Hamzah, this was a business that was primarily a residential business, at least majority residential business. Now it's, majority, a nonres business. So that's the first big change. It's also one that John and team have made basically now a national business. That wasn't a complete national business. Certainly, A. H. Harris has planted seeds to be able to make that happen. And when you talk about the strength of those 14 trades, our job is to make those 14 trades ubiquitous across the country and under every group. So now you have a repeatable business model that enters into basically a great market backdrop, nonres versus dependent on res, and very much focused on how do I get all the value-added portion of really big project work. So it is a very different, much better business than when we went through the downturn last cycle with much less commodity content. It had a lot of rebar content in there now. Now it's a specialty rebar business versus a primary rebar business in many cases.

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

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And Hamzah, we're still very bullish on the nonresidential construction environment. We see the nonresidential construction environment buoyed by robust corporate earnings growth, real strong corporate cash flow, in part because of tax reform, high employment. We still have historically low interest rates, and there are tax incentives for corporations to invest. So we like that backdrop for nonresidential construction.

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Hamzah Mazari, Macquarie Research - Senior Analyst [38]

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Great. Very helpful. And then just my follow-up question is just on longer-term free cash flow conversion. It seems like you've been running in the low 50% range, even if you look out to the '19 guidance and make some assumptions. Is that the right run rate for this business long term? Or does that step up if -- given any levers on working capital or investments in FM begin to show greater benefits? We're just trying think about how this business should be looked at on a free cash flow conversion of adjusted EBITDA if we look at that metric longer term. Or sort of is this low 55% range kind of normal?

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

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So Hamzah, the way to look at free cash flow is 75% EBITDA is our target for pretax, preinterest cash flow. So 75% of EBITDA, subtract cash interest, which currently is in that $100 million to $110 million range going forward and then -- that's cash interest, $100 million to $110 million range going forward, and then cash taxes. Cash taxes this year only about $12 million, that's 2018; 2019, $40 million to $50 million. And then 2020 and beyond, we'll become a full cash taxpayer. We're looking at probably a 24%, 25% cash tax rate on book earnings.

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Operator [40]

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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 [41]

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Just a couple questions here. Maybe following up on Deane's question. That FM sales growth has been really strong versus the market, but you've also said a couple times here that you're in early stages of realizing full benefits of all those investments. So is there any way you can give us any color on what full realization would mean? Any pilots you have in specific markets or technologies where you're seeing even more top line pickup?

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

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As we said previously, we're always looking to keep our commitment to 300 basis points of outgrowth, always trying to do as much as we can. The investments that we're making, we highlighted a number of those during our Investor Day, and Joe referred to a number of them on the call. First, the dynamic information that we're providing our sales associates through the sales console. So they've got better and better information about their customers and about the products their customers need at their fingertips. The new website or the new web platform that's being rolled out makes it easier for customers to interact with us and frees up our sales folks' time to do more solution selling, more value-added selling rather than processing transactions for our customers. And these -- so these investments, we're going to continue to enhance these investments.

Now there's also what we call our sales enablers, which are analytics, so pricing analytics, supply chain improvements so that we continue to get our products to our customers faster, more accurately at lower cost. So these are all the investments that we're working on that we do expect to improve our ability to gain share going forward. But as I said, right now, we're going to keep our commitment to 300 basis points of outgrowth.

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Patrick Michael Baumann, JP Morgan Chase & Co, Research Division - Analyst [43]

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Got it, okay. Makes sense. On the tariffs, you guys talked about additional 100 to 150 basis points of top line, I guess, over time from price as these work their way through. Is this mostly at FM? And then also, just a follow-up to that. Just given the inventory strategy you alluded to as impacting free cash this year, will there be any short-term benefit to operating leverage? Or how should we think about kind of timing lag related to this stuff?

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

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So the 100 to 150 basis point comment on price was relative to Facilities Maintenance. The Construction & Industrial business actually is seeing quite a bit of price right now, 300 basis points from tariffs -- tariff-impacted rebar costs increase year-over-year, which is where their biggest impact is today. But look, certainly, both businesses are managing through the tariff environment, and we think it is manageable. And I'm sorry, I didn't get the second half of your question.

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Patrick Michael Baumann, JP Morgan Chase & Co, Research Division - Analyst [45]

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Just the inventory strategies you guys talked about as impacting free cash flow for 2018, is there going to be any short-term benefit to operating leverage as you take in more of this inventory early? Or how should we think about time -- like is there any timing lag on kind of price versus cost?

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

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Yes, so -- yes, we certainly are being as opportunistic as we can with purchasing inventory and navigating the tariff environment. Our first goal is always to avoid cost increases, whether that means changing our buying or our negotiations. And we do think we can pass along price -- or we do think we can pass along those unavoidable cost increases. As to whether that's additional opportunity for operating leverage, we're certainly going to always do our category management initiatives, try to improve our operating leverage. But at this point, we're still committing to a flat gross margin. We do think flat gross margin, particularly in this environment now, is very good performance.

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Patrick Michael Baumann, JP Morgan Chase & Co, Research Division - Analyst [47]

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Are your own customers trying to buy ahead of price increases at all?

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

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We have not seen that. Most of our customers have very limited storage space, and that's part of the value that we add, that we guarantee delivery next day in local market for the products that they need that they don't have room to store themselves on-premise.

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Patrick Michael Baumann, JP Morgan Chase & Co, Research Division - Analyst [49]

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Okay. And then last one from me, just on C&I. You mentioned the 300 basis points of tariff impact from rebar. How do you -- how does that play out -- that was in the third quarter, I guess. How does that play out in fourth quarter? And when do you lap those kind of numbers from a rebar price impact to C&I top line perspective?

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

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Yes. So we have seen rebar pricing begin to stabilize certainly over the last several months. Right now, assuming the prices remain stable, we will lap that in the summer of 2019 with 300 basis points of outgrowth in sales and 30 basis points of margin compression diminishing between now and the second half of next year.

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Patrick Michael Baumann, JP Morgan Chase & Co, Research Division - Analyst [51]

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Got it, great. Thanks a lot, guys. Congrats on the quarter and results and good luck.

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Operator [52]

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And our next question comes from Ryan Cieslak of Northcoast Research.

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Ryan Dale Cieslak, Northcoast Research Partners, LLC - VP & Senior Research Analyst [53]

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The first question I had, I wanted to go back to the tariff comments, and I know you said that you're seeing limited impacts so far to date with some of the costs maybe still having to roll through. But of the costs that actually have rolled through and some of the pricing that you have actually implemented to date, related to that, can you just give some color on how that's flowed through? Has it actually been able to maintain the margin rate on those type of price increases and cost inflation?

And then secondly, what is your FY '19 guidance? I know it's not really guidance, more of a framework, but the 9% to 10% EBITDA growth, what are you assuming as it relates to the overall impact from the tariffs?

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [54]

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So I'll take the first half of that question. And as I mentioned earlier in the call, a real credit to our sales team in partnering with our customers to explain the tariffs, the product-level impact that they would experience at the property and then, again, assisting them with their budgets as they plan for 2019. The pass-through has come through in the form of price and up to this point, been able to hold our margin rates, and that's the plan, as we mentioned, moving forward. We'll see what happens with the most recent announcement from this weekend on the 90-day kind of trade truce, if you will. But our teams have been working for a month to develop scenario planning around how we would attack that and, again, continue to deliver value back to our customers.

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Ryan Dale Cieslak, Northcoast Research Partners, LLC - VP & Senior Research Analyst [55]

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Okay, yes. But then on the FY '19 guidance or framework?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [56]

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Yes. So Ryan, the 2019 framework assumes the current tariff environment, so the current 10% tariff environment. Obviously, this [might change] when we speak next, and when we speak next, we may have an update on what to expect with regard to tariffs.

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Ryan Dale Cieslak, Northcoast Research Partners, LLC - VP & Senior Research Analyst [57]

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Okay, sounds good. And then for my follow-up, just going back to the comments with regard to operating leverage within FM and potentially starting to see that improve in the next couple quarters. I just wanted to specifically think about FY '19, it seems like you go back and you look at the type of growth you're having right now, and historically you've typically been able to put up operating leverage within FM above 1.5x. You obviously have some mixed headwinds this year. I think the 53rd week in '18 actually it was dragging down on the operating leverage. Is there a path -- and again, I'm not looking for specific guidance, but is there a path, based on those moving pieces, that you can get something, again, at least up to 1.5x, if not more, here into fiscal '19?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [58]

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Yes. Ryan, certainly possible, although I'll tell you we are looking at it from the perspective of that 9% to 10% EBITDA growth. So we're looking at it as growth -- profitable growth of EBITDA and conversion to cash flow versus a specific operating leverage target.

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Ryan Dale Cieslak, Northcoast Research Partners, LLC - VP & Senior Research Analyst [59]

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Okay, fair enough. How about if I ask it this way, what would be -- what would drive upside to that 9% to 10% growth for you guys?

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

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What would drive upside to the 9% to 10% growth would be additional top line growth, so additional share gain.

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Ryan Dale Cieslak, Northcoast Research Partners, LLC - VP & Senior Research Analyst [61]

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Is there anything incremental as it relates to your gross margin initiatives or cost opportunities you see into next year, as I guess, as it relates to the EBITDA growth?

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

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Yes. Look, I think this better operating leverage and cost initiatives get us to the 9% to 10% earnings growth. That's what we're working hard at and we work hard at every day. Gross margins, again, we think flat gross margins are really good -- is really good performance in this environment. And so when you're talking about Facilities Maintenance and you're talking about a 1.5x operating leverage, keep in mind the Facilities Maintenance business is an 18% EBITDA business. So if you're talking about a 1.5x operating leverage, that's a 20 -- about a 27% contribution margin. That's a pretty hefty contribution margin for each incremental sales dollar.

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Operator [63]

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And our final question comes from the line of Nigel Coe of Wolfe Research.

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Bhupender Singh Bohra, Wolfe Research, LLC - Research Analyst [64]

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This is Bhupender here for Nigel. So I just wanted to touch on 2019 guidance here. When you look at the market growth of about like 3%, we have seen resi growth like this year to be mid-single. I think you were projecting that to be low to mid-single in '19 for both the businesses. Could you give some color on the markets? Like if you go through the [whole here] like the nonresi market, what are you thinking should be on the high side of the low to mid or on the resi, like on the -- either at the midpoint or the low end?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [65]

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Sure. So the MRO business is a stable business. So we continue to believe that grows at about the 1% to 2% rate. On the construction side, as Joe indicated, we're primarily a nonresidential construction shop. We've been growing in that 5% to 6% rate -- market rate over the last couple of quarters. We've got it called at low- to mid-single-digit growth rate. So, so far this year, the market has been on the high end of that range. Going forward, we're still going to call it as low to mid-single-digit growth. That's what we see based on the triangulation of third-party data that we look at, so these are third-party economic forecasts. We look at what our customers and our competitors and our vendors are reporting as well as what they're telling us, and then we survey our own field associates. And so we do feel good about the market. We think it's a good, invested market. We don't currently see a slowdown in nonresidential construction, so we're going to continue to call it at low to mid-single digit.

On the residential side, I think you've probably seen some folks reporting a slight slowdown in residential construction. That is less impactful to HD Supply than nonresidential construction and certainly less impactful than it's been in the past. But we still see growth in residential construction even if it's at a bit of a slower pace.

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Bhupender Singh Bohra, Wolfe Research, LLC - Research Analyst [66]

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Okay, got it. Just want to follow on here on the investments you guys are making in FM. We have Brad here, just wanted to run through him, what kind of cadence are we looking for as we look for the payback of these investments? Like going through 2019, are they like first half loaded, second half loaded, something?

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Bradley Paulsen, HD Supply Holdings, Inc. - President of HD Supply Facilities Maintenance [67]

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To kind of echo what Evan shared earlier, this is a continuous process for us. Our investments are really focused on 2 buckets: our sales channels and our enabling functions. The conversation that we have with ourselves, we've got to make sure every investment we make obviously delivers a great return, but also improves either our customer or associate experience. There is not a single answer to your question. Every investment is a little bit different. But we do have a very high sense of urgency to realize that return as quickly as possible.

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Operator [68]

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And that concludes our question-and-answer session for today. I'd like to turn the conference back over to Joe DeAngelo for closing remarks.

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [69]

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Great. Well, thank you for your questions. In summary, on Page 15, 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 [70]

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