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Edited Transcript of HDS earnings conference call or presentation 14-Mar-17 12:00pm GMT

Thomson Reuters StreetEvents

Q4 2016 HD Supply Holdings Inc Earnings Call

Atlanta Mar 14, 2017 (Thomson StreetEvents) -- Edited Transcript of HD Supply Holdings Inc earnings conference call or presentation Tuesday, March 14, 2017 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

* Joe DeAngelo

HD Supply Holdings, Inc. - Chairman & CEO

* Evan Levitt

HD Supply Holdings, Inc. - SVP, CFO & CAO

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Conference Call Participants

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* David Manthey

Robert W. Baird & Company - Analyst

* John Inch

Deutsche Bank - Analyst

* Joe Ritchie

Goldman Sachs - Analyst

* Ryan Merkel

William Blair & Company - 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 full-year and fourth-quarter earnings conference call.

(Operator Instructions)

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 [2]

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Thank you, Nicole. Good morning, ladies and gentlemen, and welcome to the HD Supply Holdings 2016 fourth-quarter and fiscal year-end 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 2016 fourth-quarter and full-year results 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 2016 fourth-quarter and full-year performance. He will comment on monthly sales and provide guidance for our first-quarter 2017 and full fiscal year 2017 outlook. We will then conduct Q&A and conclude with Joe's closing remarks.

Please note that some of the information you will hear in today's discussion will include forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. Forward-looking statements are based on management's beliefs and assumptions and information currently available to management and 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 29, 2017 and those described from time to time in our and HD Supply, Inc.'s other filings with the US Securities and Exchange Commission. 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.

For Q&A, please limit your remarks to one question and one follow-up question if necessary. 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. With that I will now turn the call over to Joe DeAngelo.

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Joe 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 2016 fourth-quarter and fiscal year-end call.

As always, it is my privilege to share our Company's results with you on behalf of the nearly 15,000 HD Supply Associates who work hard every day as one team driving customer success and value creation. 2016 was a transformative year for HD Supply and I'm proud of the team's relentless hard work and disciplined strategic execution. Despite a challenging uncontrollable environment, we delivered profitable growth, invested for repeatable growth, optimized and infused talent at all levels and improved our business mix.

We enhanced our capital structure by reducing debt and lowering our cost of capital. We moved the Facilities Maintenance field support teams from San Diego to Atlanta, sold the legacy San Diego headquarter building and broke ground on our new HD Supply leadership development center. We are entering 2017 with new capabilities, momentum and intense focus as we recommit to our historical outgrowth and operating leverage targets for 2017 and beyond.

As we highlight on page 3 for the full-year 2016 we delivered 4% annual sales growth, 7% adjusted EBITDA growth and 51% adjusted net income per diluted share growth versus prior year. Our strategic execution delivered sales growth in excess of our market estimate of approximately 200 basis points for 2016.

We executed category management across the Company to deliver 50 basis points of improvement in gross margin despite challenging comparables. This translated into operating leverage of 1.2 times which was in line with our guidance from the third-quarter earnings call. We also delivered $432 million in free cash flow from operations in 2016 which is an increase of $96 million, or 29% versus prior year.

Our net debt to adjusted EBITDA ratio has now lowered to 4.1 times, approximately 1 turn away from our targeted leverage of 3 times and down approximately 0.6 turns versus prior year. We performed in line with our expectations in the fourth quarter. We delivered growth and solid cash flow conversion as we pivoted into the second phase of our operational recovery of Facilities Maintenance.

As we highlight on page 4 of the presentation, we delivered 3% sales growth, 1.2% adjusted EBITDA growth and 63% adjusted net income per diluted share growth in the fourth quarter versus prior year. The team expanded gross margin 60 basis points in the fourth quarter versus prior year, driven by continued category management execution. Our SG&A expense as a percent of sales increased 100 basis points versus prior year as a result of ongoing talent infusion across the business and costs associated with our Facilities Maintenance supply chain actions.

Our EBITDA growth rate and operating leverage were in line with the expectations we shared on our third-quarter conference call. We have strong free cash flow momentum. In addition to delivering profitable growth, we continue to execute our capital structure strategy focused on debt reduction.

In the fourth-quarter 2016 we repaid $200 million in aggregate of our Term B1 loans, utilizing free cash flow generated by the business. We have reaffirmed our long-term financial leverage target of approximately 3 times net debt to EBITDA and are excited about our forward momentum.

Turning to page 5, I'd like to highlight some of our business unit execution achievements in 2016 and comment on forward momentum. First, I want to give an update on our Facilities Maintenance commercial recovery which continues to make solid progress. As a reminder, our Facilities Maintenance supply chain interruption began with the under-ordering of inventory in advance of the 2016 spring and summer selling seasons.

Corrective action was taken to adjust ordering in 2016 which resulted in an atypical amount of inventory, primarily long lead import inventory, arriving at our distribution centers during the busy summer selling season. As a result, our distribution center resources were stretched beyond ordinary course capacity and it took until November 2016 to process the inventory into our network and rebalance it throughout the country to perfectly meet our local customer promise.

On our third-quarter call we confirmed that the rebalancing phase was behind us and that we had pivoted into a commercial recovery. The three phases of our commercial recovery are progressing as we expected: first, by having product fully available-for-sale when and where the customer needs it; second, as we deliver consistently on our customer promise we execute our growth plays to earn growth in excess of market within our Maintenance business; third, we expect to see our property improvement business return to expected growth given the typical leadtime associated with this execution.

We are currently in the second phase of the commercial recovery and are confident in our execution and outlook. We estimate that there was approximately 200 basis points of sales growth headwind for Facilities Maintenance during the fourth quarter associated with the legacy supply chain interruption and an additional 200 basis points of headwinds associated with property improvement slowdown and the industry-wide government-mandated R-22 phase-out, which is consistent with the commentary and guidance we previously disclosed in December.

We expect this impact to continue in the first quarter of 2017 before we begin to see a return to market outgrowth for the balance of the year. Our February performance at Facilities Maintenance was also in line with our expectations.

Facilities Maintenance has significant momentum. I am very proud of the transformational execution the team delivered in 2016 as we executed strategic change to continue to extend and evolve our capabilities. Consistent with all of our execution at HD Supply, the change is focused on improving our customers' experience, ultimately delivering differentiated profitable growth.

We recently had the opportunity to review our progress, outlook and execution priorities with nearly 2,000 Facilities Maintenance sales, operations and field support leaders as well as our supplier partners as part of our Annual Selling Family Summit in Atlanta. The energy, excitement and focus was exceptional. I will share a few examples of the accomplishments that we covered with the teams.

We made significant investments in talent in 2016. We infused over 200 new Atlanta-based field support teammates to all areas of the business. A recruiting rigor resulted not only in talent with strong cultural alignment but also added net new capabilities typically developed at world-class Fortune 50 companies that are aligned with and relevant for our go-forward execution priorities.

We made significant investments in refreshing our understanding of the customer needs and our opportunities to improve and extend our service differentiation. Our clarity has informed our current execution priorities and also helped crystallize an exciting multiyear customer-centric digital vision.

We made significant investments in our digital foundation across all areas of the business as well as our customer's daily e-experience. In 2016 e-commerce delivered double-digit growth versus prior year, now representing approximately 60% of orders, up 5 percentage points versus prior year.

We made significant investments in process discipline. We initiated a series of multifaceted initiatives across our supply chains to improve processes that will enhance our ability to consistently deliver on our associate, customer and shareholder promises. We improved critical merchandising and marketing processes to reduce cycle time and simultaneously improved the impact of the outlook.

We made significant investments in extending our team culture. As I mentioned, we've relocated the field support team to Atlanta from San Diego. We also retrofitted our customer care facility in Santee, California where we transferred approximately 250 customer facing specialists to extend our customer service experience as one team.

We monetized the legacy headquarter facility in excess of our financial and timing expectations. We broke ground on and are ahead of schedule with our leadership development center that will serve as a dedicated team building listening and learning environment for associates, customers and vendors. In each instance our work environment strategies co-locate teams to increase collaboration, innovation and real-time best performance translation.

We made enhancements to our operating capabilities. We have ingrained an intense daily cadence across the Company, focused on daily progress relative to critical execution metrics. Teams are laser focused on execution priorities where we plan, execute, refine and repeat on a daily basis to accelerate performance.

2016 was a transformational year for Facilities Maintenance and I couldn't be prouder of the relentless hard work, commitment to disciplined strategic change and one team intensity. We made enhancements to almost all aspects of the business over a short period of time while simultaneously delivering profitable growth and very strong cash flow.

Coincident with our improvements, Facilities Maintenance converted over 90% of EBITDA dollars to cash flow. The teams are focused in building momentum for a great 2017.

The Waterworks team continued to perform in 2016 despite uneven end market growth. The team executed well on strategic initiatives. I will share a few execution examples.

We added 96 new sales associates in 2016, aligned sales coverage models and have now trained over 2,700 sales and operations associates focused on selling more to existing customers, product knowledge and operational excellence. We established a national accounts team servicing design, build, operate contractors and private water companies. We saw solid traction in several large-scale meter infusible plastic projects.

We improved category management processes and infused talent to leverage our strategic vendor relationships. We saw outsized growth, approximately 3.6 times the Waterworks average, in our fire protection business, driven by selling more to existing customers and strong penetration of value-added services such as fabrication. We made strategic investments and opened two new locations in existing priority markets that will increase our ability to serve our local customers.

We made significant investments in our digital capabilities, a proprietary digital solution that improved the customer experience by reducing administration time and increasing workflow transparency.

Our view of the water infrastructure end market remains unchanged. There has not been a material change to municipal spend activity in the second half of 2016 but there continued to be strong spending in smart meters, pipes, dowels and fittings. And 2016 finally saw an increase in the release of larger waterworks projects in certain key districts such as Georgia and California.

Deflation in PVC pipes did have a negative impact on sales and operating margins at Waterworks throughout 2016. But we are generally optimistic with the outlook for PVC going forward.

As we've previously disclosed, Waterworks is our most weather-sensitive business. This winter was relatively mild across the country in 2016, but weather did adversely impact key geographies in January, including the Pacific Northwest, California, the Northeast and Mid-Atlantic.

February, our first fiscal month of 2017, was milder. And we saw an ticket order fulfillment as sales accelerated, driven by orders being shipped that were previously delayed from the end of 2016. This activity should normalize throughout the first quarter, and we would expect to finish the first quarter of 2017 operating in a more normalized growth rate in Waterworks.

We are optimistic about the focus on US infrastructure investments. We expect the progress to be slow in 2017 as the new administration finalizes the approach but believe that inflows of funds could begin in 2018 and represent multiyear project opportunities across the country for which the team is well-positioned to benefit. The Waterworks team is focused and aligned for growth.

Construction & Industrial had another record year in 2016. The team continued to deliver on elevated expectations by intense focus on selling more to existing customers in priority districts and improving margins through disciplined category management execution.

We also took action to extend and evolve the Construction & Industrial business model and consolidated Home Improvement Solutions, a leading repair and remodeled branch-based business, into Construction & Industrial. Today Construction & Industrial is comprised of three leading diversified models that share synergies across talent, process and execution initiatives with product, customer and end market diversification. I will share a few 2016 execution highlights.

C&I delivered approximately 11% EBITDA margin in 2016, over 200 basis points better than the previous peak despite lower non-residential construction levels versus peak periods. 76% of Construction & Industrial branches are now performing at a double-digit EBITDA rate, up 3 points versus prior year. 49 branches now have in-store purchases of over 40% of sales.

C&I delivered 15% sales growth in the best performing region and opened two new locations in priority districts. There continues to be positive momentum in non-residential construction across several priority districts including New York, New Jersey, Washington DC, and the Southeast while certain districts did see a slowdown, particularly in the Gulf states and California. Despite this we expect current solid activity trends to continue throughout 2017 in the majority of our markets. Evan will provide more details, including the impacts to market growth and guidance.

At the enterprise level we continue to execute on our capital structure and business mix objectives. We made continued progress with our capital structure beginning in April 2016 with the refinancing of $1 billion of 11.5% senior notes in October 2016 with the redemption of $1.275 billion of 7.5% senior notes. These actions will save us approximately $120 million annually in future cash flows and further expand our flexibility for prepayment without penalty to assist in future debt repayment. Evan will give more details on the capital structure later on. We also simplified our business mix with the sale of HD Supply Interiors in May 2016.

On page 6 as we look forward to 2017 our strategy is clear. We remain committed to our five growth plays and shareholder promise of 300 basis points of growth in excess of market, 1.5 to 2 times operating leverage and 75% cash conversion. The customer is always at the core of our strategy and execution priorities are built upon extending our service differentiation.

What they need, where they need it and when they need it is the basis for our execution. Disciplined sales execution, supply chain and digital are core elements of our execution capabilities. We have clear strategic near-term actions that the teams are executing linked to exciting multiyear roadmaps to extend and evolve our capabilities.

We will remain disciplined and focused on controllable execution. We will continue to differentiate ourselves through sustainable advantages and selling more to existing customers continues to be a primary focus as we extend our approximate 8% share in an estimated $85 billion addressable market. Flat year-over-year gross margin represents a strong performance in a challenging environment, and as we have shared in the past we expect to see fluctuations in gross margin from quarter to quarter.

The first quarter of 2017 in particular has a difficult comparison from a strong 2016 gross margin performance. Also as we have in the past we will continuously invest in growth, primarily talent, and always take action to deliver on our core principles. We are committed to 1.5 to 2 times operating leverage and consistent with the past our Facilities Maintenance business targets the lower end of the range while Construction & Industrial should operate at a higher end of that range.

We will continue to generate strong free cash flow to accelerate debt reduction, building on the momentum achieved in 2016. We expect to achieve our 3 times targeted net debt to adjusted EBITDA leverage ratio by the end of 2017 or early 2018.

As a reminder, we believe the appropriate long-term financial leverage for HD Supply is 2 to 3 times. As we have previously stated we will continue to reinvest into the business and will share more specific information on our capital allocation strategy by the end of 2017.

In summary, I believe we have established the best team in the industry and are well-positioned to achieve our goals. As I have mentioned previously, 2016 was a year of transition. We have taken the lessons learned and I'm confident that we are entering the 2017 selling season from a position of strength to earn above market growth.

We remain committed to delivering our through-the-cycle target of sales growth of approximately 300 basis points in excess of market and 1.5 to 2 times operating leverage. We are staying focused on executing our growth plays, investing for disciplined long-term growth and working hard every day to get better and faster at delivering an exceptional HD Supply customer experience.

I will provide some closing comments following Q&A. I will now turn the call over to Evan to review recent investor interest and our financial performance.

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Evan Levitt, HD Supply Holdings, Inc. - SVP, CFO & CAO [4]

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Thank you, Joe, and good morning everyone. I will start with areas of recent investor focus on page 7 and share with you our latest perspective on these topics.

First, corporate tax reform. We continue to hear about the new administration's focus on corporate tax reform and are encouraged by the potential outcome. As a reminder, once our net operating loss carryforwards are exhausted we will be a taxpayer at approximately 39% to 40% of pretax income which includes the federal statutory rate of 35% plus a 4% to 5% net state rate. As a predominantly domestic Company, any reduction in the federal statutory rate will directly improve our future after-tax cash flows.

A border tax. We are a North American Company and have little direct exposure to international economies. The limited exposure we have is a result of our proprietary brands which we manufacture predominantly in Asia with our strategic vendor partners. To provide context, our proprietary brands account for approximately 15% of Facilities Maintenance annual revenue.

In terms of our total Company, this is approximately 5% of HD Supply's annual purchases. However, like our industry peers, we believe that a significant amount of our domestic suppliers source product from overseas and, therefore, we may be exposed to second order inflation via those suppliers. Our competitors would be similarly impacted and we believe inflation would likely be a positive for our business.

Infrastructure. We are encouraged around the active infrastructure discussion and are well-positioned to benefit from incremental infrastructure investment in both our Construction & Industrial and Waterworks businesses. It is difficult to quantify the impact this may have on our business until more policy details are released and specific projects are approved. We have not factored this investment into our outlook.

Although we remain optimistic about the potential impact, it is possible that we see a slowdown in infrastructure spend while the federal infrastructure investment is debated and local municipalities consider access to federal funds prior to initiating net new projects.

The energy market recovery. Despite last week's decline, the energy market recovery continues to be positive for the broader economy. HD Supply's upside to this trend is limited given our minimal direct exposure to the oil and gas market.

As a reminder, we supply HDPE pipe through our Waterworks business used to bring water to and remove water from certain fracking regions. Our HDPE business, including core Waterworks and other applications, is less than 5% of total Waterworks sales.

The competitive environment. There is no change to the competitive environment. We have clarity of understanding of our customers' needs, defined execution strategies to improve and evolve the customer experience and we will focus on what we can control to extend our differentiation.

The construction markets. Construction markets remain mixed through geographically but we remain optimistic on the forward outlook. We like others share the growing enthusiasm regarding the prospect of infrastructure investment.

However, we expect to see certain large multiyear projects in which we have participated come to completion and create comparability considerations as new projects are breaking ground. For example in Atlanta, we have had multiyear projects underway at the new Braves stadium and the new Falcons stadium, both of which will be complete this spring. That said, we continue to see solid pockets of strength in most geographies including our northern priority districts Denver and the Southeast.

We have noticed pockets of unevenness in certain Gulf states, Houston and California. Despite this, we expect solid activity trends to continue throughout 2017 in the majority of our markets and we are comfortable with the growth rates we shared on our December call of low to mid-single-digit non-residential construction growth in 2017.

Our portfolio. We now have three large leadership business units. Each operate independently in large, highly fragmented markets with capabilities to differentiate.

We participate in profit pools where we are experts in the customer segment and build unique capabilities around extending our service differentiation. In addition, each business unit enjoys attractive cash flow characteristics in varying economic environments which generates funds to continuously invest in growth.

Even at our peak leverage we have never been constrained in financing and acquisition. Our strategy has been to grow organically and streamline our business. As we approach our 3 times leverage ratio target, questions around acquisitions are becoming more frequent.

Our strategy in this area has not changed. We look at many acquisition targets each year, primarily bolt-ons that could provide us new capabilities or products. We are highly selective and will only do an acquisition that meets our financial hurdles and is a good cultural fit.

Weather. As we have stated in the past weather can have a significant impact on our results as unusually cold or wet weather can impact underground and outdoor construction activities. Prior to this week's storm, much of the country has experienced a relatively mild winter.

However, we did experience some unusually wet weather on the West Coast and several of our facilities experienced closers in the Northeast and Pacific Northwest due to inclement weather. Our February Waterworks sales benefited from warmer weather during the month of February, our first fiscal month of fiscal 2017, as orders were shipped that were previously delayed due to inclement weather at the end of 2016.

One point that I will highlight before I go through our fourth-quarter and full-year performance. This quarter we revised Construction & Industrial's reported financial results to include our Home Improvement Solutions business. Home Improvement Solutions is a leading California specialty retailer with more than 30 years of experience providing home improvement products and building materials to remodeling contractors, tradesmen and do-it-yourself customers.

Home Improvement Solutions has been operated by the Construction & Industrial team over the past year but historically reported separately as part of our corporate and other reportable segment. Reflecting our continued integration, Construction & Industrial performance will now include Home Improvement Solutions. We have provided revised historical figures on pages 22 to 26 of the presentation materials.

Now turning to page 8 I will cover our fourth-quarter results. We delivered sales of $1.634 billion, an increase of $50 million or 3.2% over the fourth quarter of fiscal 2015. We believe this level of growth exceeds our estimate of market growth by approximately 100 basis points, below our target of 300 basis points in excess of market but consistent with our revised expectations for 2016.

Gross profit increased $26 million, or 4.9% to $560 million. Gross margin was 34.3%, a 60 basis point improvement over the fourth quarter of 2015. The improvement is primarily a result of our category management execution and favorable product and services mix.

Our selling, general and administrative costs were up $27 million or 7.3% over the fourth quarter of 2015. As a percentage of sales selling, general and administrative costs were 24.4%, an increase of 100 basis points over the fourth quarter of 2015. During the fourth quarter of 2016 we incurred $9 million of costs associated with corrective action for the Facilities Maintenance supply chain in line with our guidance from the third quarter of 2016 and a $3 million incremental charge for our self-insured medical program as medical claims continue to run higher than our original expectations.

Adjusted EBITDA for the fourth quarter of 2016 was $169 million, up $2 million or 1.2%. Adjusted net income for the fourth quarter was $90 million, up $35 million, or 63.6% compared with the fourth quarter of 2015. This represents adjusted net income per diluted share of $0.44 compared to adjusted net income per diluted share of $0.27 in the fourth quarter of 2015.

The increase in adjusted net income and adjusted net income per diluted share reflects the reduction in our interest expense from the recent improvements in our capital structure. There were 203 million diluted weighted average shares outstanding during the fourth quarter of 2016.

I will now discuss the performance of our individual business units in more detail starting on page 9. Revenue for our Facilities Maintenance business was $620 million during the fourth quarter of 2016, up $14 million, or 2.3% from the fourth quarter of 2015. For fiscal year 2016, revenue from Facilities Maintenance was $2.762 billion, up $72 million or 2.7%.

We estimate that the MRO market grew approximately 200 basis points in the fourth-quarter and full-year 2016. We estimate Facilities Maintenance grew in line with the market for 2016. Facilities Maintenance's adjusted EBITDA for the fourth quarter of 2016 was $98 million, down $4 million, consistent with our expectations.

For the full year, adjusted EBITDA was $523 million, down $6 million from the full-year 2015. The fourth-quarter performance includes approximately $3 million of incremental facility costs, approximately $3 million in incremental freight cost to expedite product delivery and approximately $3 million of incremental surge labor to accelerate distribution center execution.

The teams are actively managing and working to normalize costs associated with the 2016 supply chain issue while balancing investments and operational requirements in advance of the 2017 selling season. The financial impact of the Facilities Maintenance corrective action and investments for full-year 2016 is approximately $30 million.

Revenue for our Waterworks business was $551 million during the fourth quarter of 2016, up $18 million or 3.4%. For fiscal year 2016, revenue for Waterworks was $2.622 billion, up $112 million or 4.5%. We estimate the market grew approximately 100 to 200 basis points for the quarter and for the year.

We estimate Waterworks grew approximately 200 basis points in excess of the market for the fourth-quarter and full-year 2016. Waterworks adjusted EBITDA for the fourth quarter was $42 million, up $1 million or 2.4%. For the full year, adjusted EBITDA was $234 million, up $12 million or 5.4%.

Full-year operating leverage was 1.2 times. Waterworks operating leverage was impacted by the timing of growth investments related to the sales talent additions and two new locations.

Revenue for our Construction & Industrial business was $466 million during the fourth quarter of 2016, up $19 million or 4.3%. For fiscal year 2016, revenue for Construction & Industrial was $2.063 billion, up $131 million or 6.8%. We estimate the market was up approximately 300 basis points for the quarter and approximately 400 basis points for the year. We estimate Construction & Industrial grew approximately 100 basis points in excess of the market for the fourth quarter and 300 basis points for the full-year 2016.

Construction & Industrial's adjusted EBITDA for the fourth quarter was $40 million, up $6 million or 17.6%. This represents operating leverage of 4.1 times. For the full year adjusted EBITDA was $224 million, up $40 million or 21.7%. Full-year operating leverage was 3.2 times.

Turning to page 10, as of the end of the fourth-quarter 2016 our remaining gross federal net operating loss carryforwards approximate $1.8 billion. On a tax-affected basis our federal and state net operating loss carryforwards are approximately $700 million, representing the majority of our net deferred tax assets. We continue to expect these net operating loss carryforwards to substantially reduce the amount of cash taxes we pay going forward.

During fiscal year 2016 we paid cash taxes of approximately $13 million primarily associated with Canadian taxes, US state taxes and federal alternative minimum tax. We estimate that we will pay cash taxes of approximately $4 million to $5 million in the first quarter of 2017 and $15 million to $25 million during the full-year fiscal 2017. We expect our GAAP tax rate to continue to remain approximately 39% to 40% in fiscal 2017.

During the fourth quarter of 2016, we continue to execute on our capital structure strategy to reduce debt by repaying $200 million of our Term B1 loans ahead of schedule using cash flow from operations. As a result, the Company incurred a $5 million loss on extinguishment of debt which was primarily non-cash write-offs of $2 million of unamortized original issue discount and $3 million of unamortized deferred financing costs.

During fiscal 2016 we generated $432 million of free cash flow. We expect to continue to use free cash flow to reduce our indebtedness to less than 3 times net debt to adjusted EBITDA. As of the end of the fourth quarter, our leverage is 4.1 times.

As Joe mentioned, we expect to reach our target indebtedness by the end of 2017 or the beginning of 2018. We invested $22 million in capital expenditures in the fourth quarter of 2016 and $81 million or approximately 1.1% of sales for the full year of 2016. We estimate our ongoing annual capital expenditure requirements to be approximately 1.3% to 1.4% of annual sales in fiscal year 2017 and beyond.

In fiscal 2016 we accelerated and expanded our 2015 restructuring plan, incurring $20 million of restructuring charges comprised primarily of severance, relocation and related costs, offset by a net gain of $11 million related to real estate transactions under the plan. In total, the Company incurred net restructuring charges of $18 million and expects the plan to deliver a payback in approximately two years via a reduction in costs. The Company completed the activities as expected in 2016.

On page 11 we provide fourth-quarter 2016 monthly sales trend performance as well as the 2015 comparable. In November 2016, we delivered sales of $526 million, an increase in average daily sales of approximately 2.3% versus November 2015. In December 2016 we delivered sales of $527 million, an increase in average daily sales of approximately 3.6% versus December 2015.

In January 2017 we delivered sales of $581 million, an increase in average daily sales of approximately 3.4% versus January 2016. There were 18 selling days in November, 20 selling days in December and 23 selling days in January.

February 2017, the first month of our fiscal first-quarter 2017, ended February 26, so we can provide our preliminary sales results. We will not comment on February results beyond sales.

There were 20 selling days in both February 2017 and February 2016. February sales were approximately $535 million, which represents average daily sales of approximately 6.4% versus prior year. Average daily sales growth versus prior year by business was Waterworks approximately 15%, Construction & Industrial approximately 5.3% and Facilities Maintenance approximately 0.2% versus prior year.

As a reminder, February and the remainder of the first quarter represents a difficult comparison for HD Supply as sales growth in the first quarter of 2016 was 7.3%, the highest growth quarter of fiscal 2016. In February 2016 specifically we grew 9.2% over 2015, which represented our largest monthly sales growth of the year. Facilities Maintenance sales growth in February 2017 is consistent with our expectations as Facilities Maintenance generated sales growth of 9.5% in February 2016, representing the most difficult comparison of the year.

As Joe mentioned, we held our Annual Selling Family Summit for Facilities Maintenance in February 2017. During the week of the Summit, the majority of our sales professionals and operations leaders are participating in the conference versus actively calling on customers. We estimate a negative impact on February sales of $3 million to $4 million from the event.

In fiscal 2016 we held the Summit during the month of March and, therefore, expect to recoup this year-over-year negative impact by the end of the first quarter.

Waterworks, on the other hand, had a favorable February 2017 performance impacted in part by an uptick in order fulfillment as shipments surged in February due to weather delays at the end of fiscal 2016. We estimate the impact of this shift negatively impacted sales during the fourth quarter of 2016 and positively impacted sales during February 2017 by approximately $8 million. We expect the sales growth in Waterworks to normalize as we continue through the first quarter.

On page 12 we share a perspective on our first-quarter 2017 guidance. For our first-quarter 2017 we anticipate revenue to be in the range of $1.840 billion and $1.890 billion, adjusted EBITDA in the range of $205 million and $220 million and adjusted net income per diluted share in the range of $0.60 and $0.68. Our adjusted net income per diluted share range assumes a fully diluted weighted average share count of approximately 203 million.

At the midpoint of the ranges our first-quarter sales and adjusted EBITDA translate into approximately 5% and negative 1% growth respectively versus prior year. Our first-quarter EBITDA guidance includes approximately $10 million of costs associated with the 2016 Facilities Maintenance supply chain recovery including $2 million associated with labor we opted to retain through a lower sales volume quarter to be prepared for the upcoming selling season, $5 million associated with freight expense and $3 million associated with rent expense attributed to real estate secured to expand distribution center capacity.

We expect labor and freight cost to moderate over 2017 and as mentioned we remain committed to delivering historical growth and operating leverage at Facilities Maintenance. We will anniversary the beginning of the supply chain issues in May of 2017.

The first quarter of 2016 was one of the mildest winters we've seen in recent years and it could prove to be a difficult comparison in 2017. The first quarter is also historically a low volume quarter and, therefore, variation from year to year is amplified when looking at growth rates in percentage terms. We remain confident in our ability to achieve our full-year 2017 financial goals and expect to return to more normalized operating leverage performance in the second quarter. We expect operating leverage to be at the high end our slightly above our normal targets in the third and fourth quarters.

On page 13 we continue to use our framework that includes end market growth expectations in addition to our estimate of growth in excess of market to illustrate our current perspective on full-year sales outlook. To inform our end market perspectives we triangulate various data points including customer, supplier, competitor and other publicly available data and most importantly proprietary field level perspectives across the Company. Despite the uncertainty in the market, we remain optimistic that our markets will continue to perform in 2017 at similar levels to 2016.

We will continue to refine our view as the year progresses. Our views for 2017 are for residential construction to increase mid single digits, non-residential construction to increase low single digits to mid single digits, water infrastructure to be down low single digits to up low single digits and the MRO market to remain stable, increasing 1% to 2%. The specific end markets imply an approximate 2% to 3% end market growth for HD Supply's end market in 2017.

On page 14 we reaffirm our controllable execution long-term targets for HD Supply at 300 basis points in excess of our estimates of market growth for 2017. We continue to believe our long-term operating leverage target range of 1.5 to 2 times is appropriate. As always seasonal, cyclicality, one-time headwinds or tailwinds and investment timing may result in variation in the operating leverage calculation on a quarterly basis.

On page 15 we illustrate a cash flow framework for 2017. Our end market outlook, 300 basis points of growth in excess of market growth and operating leverage target of 1.5 to 2 times, sets the backdrop. Our incremental net working capital needs should be approximately 15% of incremental sales.

Our capital expenditures are estimated at approximately 1.3% to 1.4% of annual sales. We expect to pay approximately $180 million in cash interest. We expect our 2017 cash taxes to be between $15 million and $25 million.

As a result, depending on the performance of end markets and controllable execution one could construct a scenario that would result in approximately $600 million to $650 million in free cash flow for fiscal year 2017. We expect to continue to use free cash flow for debt reduction.

On page 16 we consolidate our outlook views. The left-hand side of the page summarizes our first-quarter 2017 outlook and the right-hand side of the page summarizes our current full-year 2017 observations.

To summarize, we delivered solid results in 2016 and have laid the groundwork to return to our commitment of 300 basis points of market outgrowth and 1.5 to 2 times operating leverage in 2017 despite a challenging uncontrollable environment. We will continue to stay focused on what we can control and work to get better at everything we do.

I'd like to thank you for your continued interest in HD Supply. I will now turn the call over to the operator for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) David Manthey, Baird.

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David Manthey, Robert W. Baird & Company - Analyst [2]

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Hi guys. Good morning. First off, regarding the rumors of a Waterworks sale, I'm wondering if you have any comments regarding that possibility or just more generally how you view any other potential portfolio changes over the course of the next several years?

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

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We have always had the same spec, David, so all of our businesses need to be leadership businesses with a clear path to distant number one. So we meet the criteria of leadership, we think we've got the right stack of path to be a very distant number one in all three of our businesses.

And we will operate only in North American markets highly fragmented. So I think we are hitting the spec of where we are. Constantly as people approach us we will always evaluate and approach and we will see if that creates value for our associates and value for our shareholders. And that's consistent with what we have done over the last 10 years.

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David Manthey, Robert W. Baird & Company - Analyst [4]

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Okay, fair enough. Then finally could you describe the purchasing system that you now have within the FM business and can you confirm that all FM inventory is within HD Supply warehouses today?

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

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Yes, so it's pretty simple. So we have integrated our inventory teams and our merchandising teams which gives us a complete closed loop around the team that finds the product, the team that's specifying how much we are going to have and then deploying it where it should be so we can sell through.

So we have no third-party relationships that we are operating today. We either have our dedicated distribution center facilities or dedicated HD Supply operated overflow facilities. And so it's a nice, clean, tight network that's centrally controlled through our merchandising team all through a systematic execution of SAP.

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David Manthey, Robert W. Baird & Company - Analyst [6]

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Got it. Okay, thanks, Joe.

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Operator [7]

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John Inch, Deutsche Bank.

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John Inch, Deutsche Bank - Analyst [8]

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Thank you, good morning everyone. Hey, Evan, you commented publicly recently, you said your supply chain's in as good as condition as it has ever been. And Joe your commentary right now sort of suggested that, reflected that in terms of the integration.

I guess I'm wondering why are you still reporting Facilities Maintenance margins despite the very easy comparisons, why were they down a point year over year? Were there mix issues in the quarter that affected that? Because the costs were right in line with what we thought in terms of the inventory items, so I'm just wondering what else might have occurred.

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Evan Levitt, HD Supply Holdings, Inc. - SVP, CFO & CAO [9]

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Well, the margins were in line with what we expected. As you pointed out we had some ongoing costs associated with the supply chain recovery. Non on the commercial side we are still in the midst of our commercial recovery which we've shared occurs in three phases.

The first is being in stock with product when and where the customer needs it so we can fulfill those orders as they come. As we demonstrate that reliability we can expect to continue to expand our share of wallet with our customers to sell them new products in new categories. Then finally we will see the return to growth of our property improvement business which has a longer sales lead time and is generally in season beginning in the April-May time frame.

So our margins are where we expected them to be. Keep in mind when we are only growing about 2% it's more difficult to leverage the fixed costs that we can leverage when we return to that 300 basis points of outgrowth.

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John Inch, Deutsche Bank - Analyst [10]

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So it sounds like you expect margins to be down year over year in this first quarter for FM. That's what you are expecting?

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Evan Levitt, HD Supply Holdings, Inc. - SVP, CFO & CAO [11]

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That's correct.

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

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Yes, we need to get in season, John.

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John Inch, Deutsche Bank - Analyst [13]

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And then were you guys trying to strike a slightly more positive tone on non-resi construction? I couldn't quite, I wasn't -- you didn't change your guide, but I'm just wondering if you did? And if so, why would, I don't want to put words in your mouth, but if you have struck a more optimistic tone, what would've changed just in the last three months?

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Joe DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [14]

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I think the tone is about the same. We wanted to give you a little more detail on the priority districts where we are seeing it continue to be good and we wanted to be very clear in terms of the districts where we have seen it fade. I think for us it's very hard to tell when you are out of season, whether or not a little bit of move is something that's going to be a trend or not.

But generally, John, and I think we've said this in the last call is we feel really good about the customers we are talking to. There is no customers that I have talked to in the non-res construction environment that didn't say, hey, we feel really good about the year and we are proceeding as we thought.

So I think it's in line with being a solid market out there. I think that's the right description of it.

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John Inch, Deutsche Bank - Analyst [15]

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Okay, maybe then a little bit better but sort of generally the same trend. Let me just finally ask you, the economy does seem to certainly be getting better on a number of fronts. We will see if that can continue.

Are you guys adequately, if you go back a year ago we suffered inadequate inventory and now the slope of the curve seems to be turning upwards slightly. I realize MRO stuff is demand inelastic, but maybe it gets a little bit better. Are you adequately supplied in terms of the pre-buying required for the spring season in case the economy actually gets better or is there still, have you sort of erred a little bit more cautiously?

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Joe DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [16]

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No, absolutely. We made sure we went in thick on inventory and thick on labor so that we could meet the season. We're running to make sure that this season is our best season.

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Evan Levitt, HD Supply Holdings, Inc. - SVP, CFO & CAO [17]

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That's right. John, we are carrying about $30 million of additional inventory beyond what we would normally carry at a year-end.

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John Inch, Deutsche Bank - Analyst [18]

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Got it. Okay, thank you. I appreciate it.

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Operator [19]

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Joe Ritchie, Goldman Sachs.

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Joe Ritchie, Goldman Sachs - Analyst [20]

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Thanks, good morning guys. Evan, just a quick clarification. So February sales would have been up about 2% then if not for the $3 million to $4 million timing impact in FM?

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Evan Levitt, HD Supply Holdings, Inc. - SVP, CFO & CAO [21]

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The $8 million was worth about 5 percentage points for Waterworks. I'm sorry, you are talking about the --

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

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FM.

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Evan Levitt, HD Supply Holdings, Inc. - SVP, CFO & CAO [23]

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For FM.

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Joe Ritchie, Goldman Sachs - Analyst [24]

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For FM, correct, for FM.

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Evan Levitt, HD Supply Holdings, Inc. - SVP, CFO & CAO [25]

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Yes, that's right, John.

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

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Your math is right.

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Evan Levitt, HD Supply Holdings, Inc. - SVP, CFO & CAO [27]

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I'm sorry. I thought you were asking about the Waterworks shift from the fourth quarter to February.

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Joe Ritchie, Goldman Sachs - Analyst [28]

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Got it. So FM would have been around 2%.

And then I guess the expectation then as we get out of 1Q, maybe just give us a little bit more color on your expectation for property improvement services. Also the issue that you highlighted last year with the change in refrigerants on the HVAC side, just provide a little bit more color on how that's helped boost your growth trajectory in FM as the year progresses.

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Joe DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [29]

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So the key is, Joe, we need to get in season. So you need to really get in season to be able to see if the conversion to 410, which we've been pushing very hard at the end of the year and talking to all the customers, is successful going forward. So there's a little bit of learning to that.

You need to get the heat. We are well-positioned from an inventory standpoint across the board. And so we feel strong about that once we are in season second quarter that we've got good programs, great line logic and we've had great discussions with our customers.

We need to see the buy follow with that. Property improvement as Evan said has a longer lead time. Our quoting activity is excellent at the moment, so we think that will be converting second quarter, mid-second quarter into third quarter.

And the balance of the MRO we are just out there running our growth plays now, so we have proven for a period of time that our customer promise is there the way it should be perfectly for our customers. And now we are just out there account by account, door to door, every day, every 24 hours making sure we are trying to sell in categories that they are not buying today. And we see that that's all on track, nine days left to sell in March, 20 days to sell in April and then we will be in season.

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Joe Ritchie, Goldman Sachs - Analyst [30]

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Got it. But you feel confident in the progress that you are making, Joe?

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

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Yes, 100%.

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Joe Ritchie, Goldman Sachs - Analyst [32]

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Got it. Okay, one follow-up question. You had about $30 million in extra cost.

Some of that goes away in 2017. Some of it stays. Maybe talk a little bit about what kind of tailwind you can see on the margin line for FM just from the lower cost that you can maybe start to parse away in 2017 that were kind of one-time in nature in 2016.

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Evan Levitt, HD Supply Holdings, Inc. - SVP, CFO & CAO [33]

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Yes, so Joe, we will continue to see some elevated cost roll through margin in the first quarter as a result of what we spent on freight, expediting freight to get inventory in stock. That will flow itself through. It's primarily in the first quarter, a little bit in the second quarter.

Once we get into the third quarter that should all be behind us and that's worth about $3 million to $5 million a quarter in gross margin. And then we've got the additional benefit of labor costs being more in line with volume where last year we had the surge labor which was also about $3 million to $5 million a quarter.

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Joe Ritchie, Goldman Sachs - Analyst [34]

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Okay, got it. So it could be up to $6 million to $10 million per quarter once we get into the back half of the year, is that fair?

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Evan Levitt, HD Supply Holdings, Inc. - SVP, CFO & CAO [35]

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That's fair.

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Joe Ritchie, Goldman Sachs - Analyst [36]

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Great, thanks guys.

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Operator [37]

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Ryan Merkel, William Blair.

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Ryan Merkel, William Blair & Company - Analyst [38]

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Thanks. I wanted to start with operating leverage target for the year.

To hit the midpoint you are going to need operating leverage above 2 times for the rest of the year. Evan, you spoke to this a little bit. But I just wanted to clarify, is this what you are expecting for the second quarter to the fourth quarter, op leverage above 2 times?

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Evan Levitt, HD Supply Holdings, Inc. - SVP, CFO & CAO [39]

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For the second quarter we are expecting a normalized operating leverage. So in the 1.5 to 2 times range what we seen historically.

And then in the third quarters and fourth quarters we expect we will be at or above 2 times. And that will get us to the lower end of the 1.5 to 2 times range for the year.

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Ryan Merkel, William Blair & Company - Analyst [40]

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Okay, so you are pointing us to the lower end of that 1.5 to 2 times for this year, the upper end there is really not in the cards?

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Evan Levitt, HD Supply Holdings, Inc. - SVP, CFO & CAO [41]

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I wouldn't say it's not in the cards. Right now we are guiding towards the lower end.

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Ryan Merkel, William Blair & Company - Analyst [42]

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Okay. And then the pickup in the operating leverage, is that mainly a function of the Facilities Maintenance growth starting to pick back up once you get into the selling season and then the cost falling off in FM? Is there anything else to consider?

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Evan Levitt, HD Supply Holdings, Inc. - SVP, CFO & CAO [43]

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No, you are exactly right, the pickup in the sales, the fall-off of the costs, our comparables year over year get easier. As Joe asked on the last question it's about $6 million to $10 million improvement in SG&A cost on the back half of the year per quarter.

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Ryan Merkel, William Blair & Company - Analyst [44]

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Okay and then just lastly, is it still your expectation that Facilities Maintenance growth can get to mid single digits by May as we start to hit the easier comparisons and the rental cycle picks up?

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Evan Levitt, HD Supply Holdings, Inc. - SVP, CFO & CAO [45]

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Yes, that's correct.

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Ryan Merkel, William Blair & Company - Analyst [46]

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That's correct. Okay, thank you.

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Operator [47]

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That is all the time we have for questions today. I would like to hand the call back over to Mr. Joe DeAngelo, CEO, for closing remarks.

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Joe DeAngelo, HD Supply Holdings, Inc. - Chairman & CEO [48]

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Great. We'll think of for your questions.

In summary on page 18 I was very pleased with the team in 2016. We continue to see growth across the businesses and have laid the foundations for a powerful 2017.

The team knows what needs to be done and is energized to deliver best-in-class results. Thank you for your continued support and interest in HD Supply.

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Operator [49]

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Ladies and gentlemen, thank you for participating in today's conference. That does conclude today's program.

You may all disconnect. Everyone have a great day.