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

Q1 2018 HD Supply Holdings Inc Earnings Call

Atlanta Jul 29, 2018 (Thomson StreetEvents) -- Edited Transcript of HD Supply Holdings Inc earnings conference call or presentation Tuesday, June 5, 2018 at 12:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Charlotte McLaughlin

* Evan J. Levitt

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

* Joseph J. DeAngelo

HD Supply Holdings, Inc. - Chairman, President & CEO

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Conference Call Participants

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* Deane Michael Dray

RBC Capital Markets, LLC, Research Division - Analyst

* Evelyn Chow

Goldman Sachs Group Inc., Research Division - Equity Analyst

* Hamzah Mazari

Macquarie Research - Senior Analyst

* Keith Brian Hughes

SunTrust Robinson Humphrey, Inc., Research Division - MD

* Luke L. Junk

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

* Patrick Michael Baumann

JP Morgan Chase & Co, Research Division - Analyst

* Robert D. Barry

Susquehanna Financial Group, LLLP, Research Division - Former Senior Analyst

* Ronald Drew Weiss

Barclays Bank PLC, Research Division - Research Analyst

* Ryan Dale Cieslak

Northcoast Research Partners, LLC - VP & Senior Research Analyst

* Ryan James Merkel

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

* Wing Lau

Deutsche Bank AG, Research Division - Former Research Analyst

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the HD Supply First Quarter Earnings Conference Call. (Operator Instructions)

I would now like to turn the call over to Charlotte McLaughlin, Investor Relations. Please go ahead.

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Charlotte McLaughlin, [2]

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

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

Please note that some of the information you'll hear in today's discussion will include forward-looking statements within the meaning of the federal securities laws. Forward-looking statements are based on management's beliefs and assumptions and information currently available to management 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 ending January 28, 2018, and those described from time to time in our and HD Supply, Inc.'s other filings with the SEC. Any forward-looking information presented is made only as the date of this presentation, and we do not undertake any obligation to update or revise any forward-looking information.

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

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

And with that, I will now turn over the call to Joe DeAngelo.

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

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Well, thank you, Charlotte. Good morning, everyone. Thank you for joining us today for our 2018 first 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'm extremely proud of the team's first quarter performance. We started the year strong, delivering 14.2% sales growth for the first quarter of fiscal 2018, 9.9% sales growth on an organic basis. We also achieved 1.5x operating leverage for the company despite significant mix headwinds.

As we highlight on Page 3 of the presentation, we delivered 21% adjusted EBITDA growth and 79.5% adjusted net income per diluted share growth versus prior year. We continue to generate strong free cash flow and delivered $380 million on a trailing 12-month basis. We expect that to deliver about $500 million of free cash flow during 2018.

Overall, our first quarter sales and earnings came in above expectations despite significant disruption from severe winter weather in March and a cool start to spring in April. The company saw an overall modest drop in gross margin versus prior year, primarily due to a change in the mix of our business with the recent A.H. Harris acquisition.

Rebar continue to pressure gross margins in the Construction & Industrial business, and we expect that to persist through the first half of 2018. Our Facilities Maintenance team delivered a strong gross margin performance, which Evan will talk more about later in the call.

The A.H. Harris integration is progressing well. We were pleased with the results from A.H. Harris despite the winter weather in March, which impacted the Northeast part of the country particularly hard. We will continue to integrate the A.H. Harris acquisition into Construction & Industrial throughout 2018.

Planned synergies are on track, and we expect to see benefits from the integration of our sales and support team, enhanced sourcing capability and combined bridge networks. We have significant opportunity to grow faster than the market while, at the same time, realizing cost synergies of the combined companies. I couldn't be more pleased to welcome the A.H. Harris associates into our HD Supply family.

We've continued to execute on our second $500 million share repurchase program announced in August 2017. We've repurchased approximately 3.4 million shares at an average price of $37.16 per share through June 1 under this program. Evan will provide more detail around this shortly. We remain committed to deploying capital to the highest-return investments available. This includes opportunistically repurchasing shares under our remaining share repurchase authorization.

We will remain focused on growing our business organically while also identifying opportunities to consolidate the markets that remain highly fragmented. We will be disciplined in identifying potential accretive tuck-in acquisitions for both Facilities Maintenance and Construction & Industrial in an effort to maximize shareholder return and cultural fit.

Talent continues to be most our fundamental differentiator, and I am proud of the performance of our 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 and will now turn the call over to Evan who'll review topics of recent investor interest and an overview of our financial performance.

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

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Thank you, Joe, and good morning, everyone. On Page 4, we highlight areas of recent investor focus and continue to share with you our latest perspective on these topics.

First is weather. We experienced significant winter weather in the Northeast in March. Four consecutive nor'easters led to branch closures and project delays, particularly in the newly acquired A.H. Harris branches. April, which is the start of our spring selling season, was unusually cold. This negatively impacted sales within our HVAC category.

As Joe indicated, we were pleased with our first quarter performance despite the headwinds of the winter weather and a cool start to spring. Our 2018 is off to a good start, and we are encouraged by our customers' response to our continued improvements in service and our ability to grow our business faster than the markets in which we operate.

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

Labor inflation. The labor market has been tightening for several months. We are seeing wage rates grow at an estimated 3% annual rate, with variability across geographic areas and job functions. We are committed to providing competitive wages in order to attract and retain the best-of-the-best talent. When wage rate adjustments are necessary, we take a targeted approach, adjusting rates by specific job function by location as necessary to remain competitive.

Tariff impacts. We have seen the impact of an increase in tariffs on imported rebar throughout 2017 and into 2018. The administration has recently announced additional tariffs on all steel and aluminum products from various countries. Steel rebar comprises approximately 10% of our Construction & Industrial business or about 5% of our total company business.

We have passed along some but not all of the cost increase through pricing adjustments. This has resulted in pressure on our rebar margins for the past 12 months. We expect this pressure to continue through at least the first half of 2018 before it gradually eases.

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

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

Tax reform. We currently expect to exhaust our net operating loss carryforwards and various income tax credits during fiscal 2019. Since we are primarily a domestic company, once we become a regular taxpayer, we will pay federal tax at about the statutory rate. Therefore, the reduction in the corporate statutory rate from 35% to 21% has a significant benefit for HD Supply. The additional cash flow that we generate as a result of tax reform will be applied to the highest-return investments available, including continued organic investment in our business, M&A activity and the return of cash to shareholders.

Now turning to Page 5, I'll cover our first quarter results. We delivered sales of $1,389,000,000, an increase of $173 million or 14.2% over the first quarter of 2017. Our organic sales in that period increased 9.9% over the first quarter of 2017.

Gross profit increased $68 million or 14% to $552 million. Our gross margin rate of 39.7% was down 10 basis points from the first quarter of 2017. Excluding the change in mix from the acquisition of A.H. Harris, gross margin increased approximately 20 basis points from the first quarter of 2017.

Our selling, general and administrative costs were up $38 million or 11.4% over the first quarter of 2017. As a percentage of sales, selling, general and administrative costs were 26.8%, a decrease of 70 basis points over the first quarter of 2017.

Adjusted EBITDA for the first quarter of 2018 was $190 million, up $33 million or 21%. We benefited from mix and approximately $7 million of Facilities Maintenance supply chain costs in the first quarter of 2017 that did not occur in 2018, partially offset by approximately $3 million of costs incurred for a previously announced accelerated investment.

Adjusted net income for the first quarter was $130 million, up $50 million or 62.5% compared with the first quarter of 2017. This represents adjusted net income per diluted share of $0.70 compared to adjusted net income per diluted share of $0.39 in the first quarter of 2017. The increase in adjusted net income and adjusted net income per diluted share reflects improved operating performance, the reduction in our interest expense from improvements to our capital structure and the reduction in weighted average shares outstanding. There were 185 million diluted weighted average shares outstanding during the first quarter of 2018.

I will now discuss the specific performance of our individual business units on Page 6. Net sales for our Facilities Maintenance business were $723 million during the first quarter of 2018, up $41 million or 6% from the first quarter of 2017. We estimate that the MRO market grew approximately 1% to 2% in the first quarter of 2018.

Facilities Maintenance gross margin increased approximately 110 basis points this quarter. The team continues to do a terrific job in category management. We also benefited from mix as the lower-margin HVAC category was less significant to our first quarter than normal as spring got off to a cool start. Facilities Maintenance's adjusted EBITDA for the first quarter of 2018 was $123 million, an increase of $15 million or 13.9% from the first quarter of 2017.

Net sales for our Construction & Industrial business were $666 million during the first quarter of 2018, up $130 million or 24.3%. On an organic basis, excluding the sales of the recently acquired A.H. Harris, our Construction & Industrial business grew 14.4%. We estimate the market was up approximately 6% for the quarter.

Construction & Industrial's gross margin decreased approximately 90 basis points. Approximately 30 basis points of the decline was due to the mix associated with the acquisition of A.H. Harris. An additional 30 basis points of the decline is from the reduction in margins of rebar. The remaining decline is from the mix of projects that our Construction & Industrial team supported during the quarter with a heavy concentration of large jobs that tend to have lower margins. Although these larger multiyear projects can have slightly lower margins, they represent good profitable work that give us confidence in the current and future health of the construction markets. Construction & Industrial's adjusted EBITDA for the first quarter was $67 million, up $18 million or 36.7%.

Turning to Page 7. As of the end of the first quarter 2018, our remaining gross federal net operating loss carryforwards approximated $675 million. On a tax-affected basis, our federal and state net operating loss carryforwards were approximately $205 million, representing the majority of our net deferred tax assets. We expect these net operating loss carryforwards and alternative minimum tax and other credits to continue to reduce the amount of cash taxes we pay through mid-2019.

During the first quarter of 2018, we paid cash taxes of approximately $2 million, primarily U.S. state and Canadian taxes. We estimate we will pay cash taxes of approximately $10 million to $12 million during the full year of fiscal 2018. We expect our GAAP tax rate to be approximately 25% to 26% in the fiscal 2018.

In the last 12 months, we generated $380 million of free cash flow. During the first quarter, we intentionally brought in inventory earlier than in prior years to ensure that we were ready for the selling season. This strategy has supported our strong sales during the first quarter of 2018, and we are confident in our ability to meet our customers' needs throughout the 2018 selling season.

The early purchase of inventory shifts some of our cash flow generation in 2018 to later in the year. We also invested in additional inventory for A.H. Harris as their inventory position was lighter than expected upon acquisition in March. During fiscal 2018, we expect to generate approximately $500 million of free cash flow.

Our capital allocation strategy is simple: we will deploy capital to the most attractive return opportunities available. These include organic investment in the business, opportunistic tuck-in acquisitions and a return of cash to shareholders currently through our shareholder -- through our share repurchase authorization. Through June 1, 2018, we have purchased 3.4 million shares of HD Supply stock for an average price of approximately $37.16 for a total of approximately $127 million under our second $500 million share repurchase authorization announced in August of 2017. We have approximately $373 million remaining under this authorization. We expect to continue to opportunistically purchase shares of HD Supply stock in 2018 through open-market purchases under a 10b5-1 plan based on market conditions.

Including the completion of our initial $500 million share repurchase authorization, we have purchased a total of 19.4 million shares of HD Supply stock for an average price of approximately $32.39 for a total of approximately $627 million. Through these share repurchase programs, we have reduced our outstanding share count by approximately 9.5% since the first quarter of 2017.

As of the end of the first quarter, our net-debt-to-adjusted-EBITDA leverage is 2.6x, within our targeted range of 2 to 3x. We invested $19 million in capital expenditures in the first quarter of 2018.

On Page 8, we provide first quarter 2018 monthly sales trend performance as well as the 2017 comparable. In February 2018, we delivered sales of $391 million, an increase in average daily sales of approximately 11.7% versus February 2017.

In March 2018, we delivered sales of $423 million, an increase in average daily sales of approximately 12% versus March 2017. Organic sales growth in the same period was 7.5%. In April 2018, we delivered sales of $575 million, an increase in average daily sales of approximately 17.7% versus April 2017. Organic sales growth in the same period was 10.3%.

In both years, there were 20 selling days in February, 20 selling days in March and 25 selling days in April.

May 2018, the first month of our fiscal second quarter 2018 ended May 27, so we can provide our preliminary sales results. We will not comment on May results beyond sales. There were 20 selling days in both May 2018 and May 2017. May sales were approximately $488 million, which represents average daily sales growth of approximately 18.7% versus 2017. Organic sales growth for May was 10.6%.

Average daily sales growth versus prior year by business was approximately 34.5% for Construction & Industrial and approximately 6.3% for Facilities Maintenance. Construction & Industrial's organic sales growth for May was approximately 16%.

On Page 9, we share our perspective on our second quarter 2018 guidance. For our second quarter 2018, we anticipate net sales to be in the range of $1,535,000,000 and $1,595,000,000; adjusted EBITDA to be in the range of $235 million and $245 million and adjusted net income per diluted share to be in the range of $0.92 and $0.97.

Our adjusted net income per diluted share range assumes a fully diluted weighted average share count of approximately 185 million. At the midpoint of the ranges, our second quarter net sales and adjusted EBITDA translate into approximately 16% growth and approximately 15% growth, respectively. On an organic basis, the midpoint of our second quarter 2018 sales range represents growth of approximately 8%.

For the full year, we are raising our 2018 guidance. We now expect net sales to be in the range of $5,820,000,000 to $5,940,000,000, adjusted EBITDA to be in the range of $832 million and $862 million and adjusted net income per diluted share to be in the range of $3.11 and $3.27, which does not include any additional share repurchases for the remainder of 2018.

Our adjusted net income per diluted share range assumes a fully diluted weighted average share count of approximately 185 million. At the midpoint of the ranges, our full year net sales and adjusted EBITDA translates into approximately 15% growth and 16% growth, respectively. On an organic basis, the midpoint of our full year 2018 sales range represents growth of approximately 8%.

On Page 10, we reiterate our end market outlook for 2018. As previously detailed, we believe the MRO market will continue to grow approximately 1% to 2%, the nonresidential construction end market will continue to grow low to mid-single digits and the residential construction market will continue to grow approximately mid-single digits. These specific end market estimates imply an approximate 2% to 3% end market growth estimate for HD Supply's end markets in 2018.

On Page 11, we summarize and consolidate our second quarter and fiscal year 2018 outlook views. To summarize, the teams are intensely executing across the company and are focused on achieving our financial and operational goals.

I'd like to thank you for your continued interest in HD Supply. And I'll now turn the call back 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) Our first question is from Robert Barry with Susquehanna.

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Robert D. Barry, Susquehanna Financial Group, LLLP, Research Division - Former Senior Analyst [2]

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A very nice start to the year. Was just curious on the top line. Anything in particular that you're cautious on? Just looking out, I mean, the guide for 2Q is at 8 -- out of the gate, you're at 10.5%. I think the comp in June is actually a nice bit easier, a little harder in July.

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

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Yes. Nothing in particular that we are concerned about. The team is operating well. We've got a lot of momentum. But we are just getting into the start of selling season, so we look forward to continuing the momentum. And selling season will tell the story.

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Robert D. Barry, Susquehanna Financial Group, LLLP, Research Division - Former Senior Analyst [4]

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Got it. And then just wanted to follow up on the rebar comments about seeing that pressure start to abate in the second half. Just curious, what are the underlying assumptions behind that view? And how much of seeing that abatement, do you think, is in your control?

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

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Yes. I think, Robert, we're a little ahead of the curve in terms of impact of tariffs on the steel markets because we've been seeing them since the first quarter of 2017. So as we get into the back half of 2018, we're anniversary-ing quite a bit of the drop in margins we've already seen and the increase in tariffs. So it's nothing that we haven't already seen, nothing that we don't know how to operate in this type of environment. And in terms of how much is under our control, we will control everything that we can. We'll stay disciplined. We'll buy intelligently. We'll manage our inventory properly. But we will stay competitive with the market. So we do expect to see some additional pressure through the first half. I don't think that pressure goes away entirely in the second half, but it begins to ease.

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Robert D. Barry, Susquehanna Financial Group, LLLP, Research Division - Former Senior Analyst [6]

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Got it. I know, last quarter, you'd speculated that the mills might respond to these tariff regimes by actually shifting some production to other products, maybe even helping rebar pricing. And I mean, any signs of that behavior starting to materialize?

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

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No, too early to tell, Robert.

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Operator [8]

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Our next question is from Julian Mitchell with Barclays.

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Ronald Drew Weiss, Barclays Bank PLC, Research Division - Research Analyst [9]

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This is Ronnie Weiss on for Julian. The Q1 operating leverage, pretty solid, 1.5x. I guess the updated guidance still implies somewhere in that 1.1 range though, and it doesn't seem like rebar investments are drastically stepping up as we move through the year. So is there anything kind of one-off to call out of why the operating leverage would be a bit lower the remainder of the year than it was in Q1?

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

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Yes, Ronnie. We did have the benefit of the $7 million of onetime costs that were incurred in the first quarter of 2017, so we had an easier comp from a cost perspective in the first quarter. Also point to the Facilities Maintenance strong gross margin performance in the first quarter, 110 basis points of improvement in gross margin. We think we can continue to defend our gross margin and perform well in gross margins, but we are not forecasting additional 110 basis points of improvement throughout the year. And that improvement was also partially aided by mix as HVAC got off to a slow start because of the cool weather in April.

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Ronald Drew Weiss, Barclays Bank PLC, Research Division - Research Analyst [11]

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Got it. And then just a quick follow-up on the A.H. Harris dilution to gross margins, 30 basis points for the quarter. Should we be thinking about that kind of steady throughout the year? Or should it step down a bit?

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

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No, that will be pretty steady throughout the year. That's simply a mix issue of the acquired business versus the consolidated business.

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Operator [13]

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Our next question is from Evelyn Chow with Goldman Sachs.

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Evelyn Chow, Goldman Sachs Group Inc., Research Division - Equity Analyst [14]

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I was hoping to start maybe with a question on SG&A leverage, just specifically in C&I. Noting you guys achieved a really good EBITDA margin expansion despite gross margins being down so significantly, what kind of actions are you taking there? And what is the expectation moving through the rest of the year?

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

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Yes. So Evelyn, leveraging fixed costs is a big part of our business model. As you know, in distribution, as you get denser and deliver more to existing customers, your cost per unit goes down, that's your cost per -- cost to serve per unit goes down. And when you generate strong double-digit, 14%, organic growth, you get that type of leverage. Now at a more modest growth rate of 300 basis points in excess of market, we can still get leverage but not quite at that rate.

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Evelyn Chow, Goldman Sachs Group Inc., Research Division - Equity Analyst [16]

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Got it. That makes sense. And then maybe just a higher-level strategic question. You've been operating the HDS portfolio now with FM and C&I, integrating Harris. As you've been operating the entity as it stands today, how should we think about the synergies between the 2 businesses? And are you finding areas where maybe the go-to-market has been changing or evolving?

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

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So your question is synergies between A.H. Harris and HD Supply?

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Evelyn Chow, Goldman Sachs Group Inc., Research Division - Equity Analyst [18]

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Or rather between C&I and FM.

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

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Okay. So certainly, the 2 businesses -- we share talent across the 2 businesses, and we also share market knowledge across the businesses. So we see in the Construction & Industrial business a lot of the early reads on the environment, on the marketplace on construction of multifamily housing units. And then we support those housing units through maintenance within our Facilities Maintenance business. And then, obviously, all of the back-office support functions that you would expect that we share leverage, from IT to tax benefits, those types of support functions.

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Operator [20]

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Our next question is from Ryan Merkel with William Blair.

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Ryan James Merkel, William Blair & Company L.L.C., Research Division - Research Analyst [21]

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So 2 questions on FM, if I can. First, have you seen suppliers raising prices? Or have you been successful holding back the price increases?

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

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Yes. So Ryan, we do see some modest price increases. It's not across the board. It's really kind of, category by category, there's variability. I wouldn't say that it is an across-the-board inflationary environment that we're seeing right now. And where we do see that pressure for increasing costs, we do push back to make sure that it is justified and the cost increase from the vendor is real -- or the cost increase that a vendor is incurring is real. And we make sure that we are not taking that cost increase before others, and in many cases, we're able to take it after. So we look at that very closely. We do think that if we do see a pickup in inflation and the market moves, we will move with the market. But our focus right now is on providing our customers with compelling value and offsetting some of the price increases we're seeing because, right now, most of the price increases we're seeing are on -- in freight and labor that we've been able to offset through productivity to ensure that we continue to provide our customers with great value.

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Ryan James Merkel, William Blair & Company L.L.C., Research Division - Research Analyst [23]

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All right. So bottom line, it sounds like you're not worried about price/cost as it relates to product inflation.

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

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The team's doing a great job making sure that we have that aligned and balanced.

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Ryan James Merkel, William Blair & Company L.L.C., Research Division - Research Analyst [25]

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Perfect. Okay. And then secondly, maybe for Joe, it's great to see the FM sales and margin expansion. Can you just give us a summary of what is now going right and why you're confident that we can sustain this performance?

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

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Yes. Well, I think all the investments we put in are paying off. And so I think it's been an absolute focus and discipline around ensuring we're investing in our selling channels and all the enabling functions. And we'll give you a good look at that on Investor Day when we showcase that. But I think all the investments we've been putting in are paying off exactly the way we thought they would.

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Operator [27]

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Our next question is from Karen Lau with Deutsche Bank.

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Wing Lau, Deutsche Bank AG, Research Division - Former Research Analyst [28]

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Joe and Evan, you guys talked about how labor cost is impacting your businesses on the cost side. But I was wondering if you can talk a little bit on the top line impact as well. Because there are a lot of labor shortages going on in the construction market, and then, obviously, material costs are going up for that market as well, so I'm just curious on your view. And have you heard anything from your customers about kind of whether those costs would have some impact on future activity? I realize you remain very upbeat on the market, and you had very strong results in C&I. Just curious what you're hearing and if those would have any impact on your pricing for that business as well.

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman, President & CEO [29]

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Yes. I think you've had a period of time now where the construction markets have been tight on labor, and so this isn't kind of a new issue that's just emerged. I think the thing to note is when you are an expert in this space, we can work with our customers to make sure that their job stays on time. And if there is a shortage there, we can certainly recommend products that require less labor to be able to execute. So that's why a complete solution and somebody on site every day with you can make a big difference. And our ability to keep those job sites running as an integral part of that construction cycle is really, really important. So look, we're [at fight]. We'll do whatever it takes to make sure that we work hand in hand with our customers to make sure that their jobs are not delayed because of any particular tightness. But right now, we haven't experienced anything that's been [dampening] demand out there. And I don't anticipate anything that, working well with our customers, would dampen the demand out there.

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Operator [30]

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Our next question is from Luke Junk with Baird.

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Luke L. Junk, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Associate [31]

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First question, Evan, just wondering if you can bridge the C&I EBITDA versus prior year. In other words, what was the underlying operating leverage in the business plus the dollar contribution from A.H. Harris? And specific to the acquisition, just wondering if things are tracking to your expectations thus far. And any qualitative observations you can share a few months in here?

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

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Yes. So the business is tracking to our expectations. We believe it performed similar to the guidance that we gave coming into the year, particularly on sales. It is difficult for us, Luke, to give you an EBITDA number for A.H. Harris or the impact on operating leverage of A.H. Harris because we're already integrating the 2 businesses. So we're already sharing resources. And in fact, some sales that are made by an A.H. Harris salesperson will be fulfilled by a legacy HD Supply branch and vice versa, so very difficult for us to break that out. And because of that, we're not going to do that. We will provide you with an estimated impact on the sales line so that you can see what the organic sales growth is versus the total sales growth. But it's just -- it'd be too speculative to do it on the EBITDA line.

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

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But I would tell you the integration with the C&I team and the Harris team has been spectacular. I mean, the teams are really working well together. Tremendous excitement about how we can bring the best of the best of both models and make our existing model better. And the Harris team has been really excited about joining the team and being able to have the opportunity to earn more.

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Luke L. Junk, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Associate [34]

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Great. And then second question, staying on C&I. Just curious what you're seeing in terms of the bidding environment today, especially as it relates to what continues to be, obviously, a more aggressive approach in the market from your standpoint. Any particular areas of the country or specific trades where you feel like you're getting better-than-average gains here?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [35]

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We see strong performance across the country, across all of our 15 priority districts. We grew up as a West Coast business, so we do have a bigger market share on the West Coast, but we're excited about the East Coast as well. The A.H Harris acquisition really helps us grow our business in the East Coast and serve our customers better. In terms of being more aggressive on bidding, I wouldn't necessarily characterize it as more aggressive on bidding. I'd characterize it more as a change in the mix of the jobs that we're working on. The larger jobs tend to be more competitive because they're well known and everybody wants to be on them, they are high-profile jobs. And we're certainly taking our share of those jobs.

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

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Yes. And I'd say, look at -- if you look at the size of the jobs in every priority district, these are big jobs. I mean, they span multiyear execution. And so we're really pleased, across the country, there is major jobs happening and we don't see any gaps.

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Operator [37]

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

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

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Evan, would like to have you go back to your comment related to price/cost where you said you try not to take cost increases before others. And I think you've suggested that you have this power in the market or at least influence where you can get from suppliers an early read on price increases coming through so you can turn around and get those price increases from your customers and kind of manage that lag effect. Is this a strategy? How successful have you been? And what's baked into your assumption for the second half?

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

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Yes. Certainly, that's an advantage that we have, Deane, with our market presence. And more -- actually, more so than the market presence, I'd talk about it as the relationships we have with our supplier base. So we've got good partners in our supplier base that we stay close to that help us understand what's happening in the marketplace from a cost perspective as well as a perspective of what new types of products are coming to market and are going to be introduced. And so being the larger player in the space gives us the advantage to partner with those vendors and make sure that we're getting the best programs, the best product, the best pricing and the best sales support from the vendor communities.

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman, President & CEO [40]

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Being the best with the vendors' innovation is most important, I mean, because that brings us productivity to our customers. And our customers constantly need to get better, and we're an integral part of that by unleashing that innovation with the supplier first.

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Deane Michael Dray, RBC Capital Markets, LLC, Research Division - Analyst [41]

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Great. And then, also on pricing, it was interesting that the FM catalog this year does not include prices. I think that's for the first time. But you do have this new app where customers can use their smartphone to scan products. Just maybe give us a sense of how that rollout has been, the reception for customers. And am I correct in it's around 80% of customers do not pay a list price?

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

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Yes. That's about right -- about 80% of our sales in the Facilities Maintenance business is pursuant to some type of national contract, and so the list price in the catalog isn't necessarily relevant to them. But yes, the tools that we're introducing, we're introducing them very thoughtfully so that they work together. As you point out, this is the first year that we removed all pricing out of the catalog. We've been moving in that direction over the last several years, as you can imagine and as our customers expect. It's difficult to hold price for a full year. And in many times -- in many cases, when we're changing that price, we're taking it down versus up to be competitive in the market and to provide good value to our customers. But the tools do work together. So you can scan any item within the catalog through the HD Supply app and get your price, your contracted price. But the teams have worked incredibly hard -- the pricing teams have worked incredibly hard to make sure that we are protecting our margin and providing compelling value to the customer.

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Deane Michael Dray, RBC Capital Markets, LLC, Research Division - Analyst [43]

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Got it. Just last quick question as a follow-up to Rob's question on the rebar. It sounds like you don't want to go toe to toe with the steel mills here. And is the strategy to go towards more a specialty rebar, special sizes? And what kind of opportunity is that for you?

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

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Yes. We've been doing that over the last several years. So we've gotten away from delivering just truckloads of rebar. What we generally sell are odd-lot quantities or even more so, a fabricated rebar, so it's bent or shaped to customer specifications. So we're adding value to the rebar itself, distinguishes us a bit from a steel mill selling a full truckload of steel, enables us to claim a little more value because we're adding value to the product.

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Operator [45]

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Our next question is from Patrick Baumann with JPMorgan.

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Patrick Michael Baumann, JP Morgan Chase & Co, Research Division - Analyst [46]

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A quick question just going back to, I think, Ryan's question on FM. Just curious what you're seeing from a sales perspective there. I mean, it looks like the outperformance versus the market is as good as it's been for a long time here. Right now, I calculate 400 to 500 basis points in the quarter versus market that you said was up 1% to 2%, I think, and it looks like may sustain this and it even picked up into what looks like a much tougher comp. So just curious, is there anything to call out here from a category or market perspective? Did the market really tick up in May? Or is it just kind of just what you said, traction on those investments you've been making?

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman, President & CEO [47]

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I think it's -- we're earning those investments, and we're seeing the payback from those investments we've made. So across the board, I think, with every size of customer, any type of customer, every category, we're experiencing the winning that we've invested in.

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Patrick Michael Baumann, JP Morgan Chase & Co, Research Division - Analyst [48]

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Okay. And then maybe along those lines, just any update on the competitive environment from The Home Depots, Lowe's, Fergusons of the world or any others that are making noise these days?

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

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It's been pretty consistent. I mean -- so they're out there relatively transparent. The playbook really hasn't changed.

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Patrick Michael Baumann, JP Morgan Chase & Co, Research Division - Analyst [50]

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Got it. And then last one for me just on gross margins. How do you see them trending for the year now given the 1Q strength in FM? Just curious, do you see them as kind of stable this year or down or up a little bit? How do you see that playing out?

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

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Yes. So for Facilities Maintenance, we certainly see that stable to potentially up 10 or 20 basis points here. I certainly wouldn't bake in the 110 basis points of improvement the rest of the way. The team does a terrific job through category management, taking cost out wherever we can, being as efficient wherever we can. But it is hard work out there. We've said in the past that a flat gross margin in this environment is good execution, but we truly believe that. A flat gross margin is really good execution. The execution we had in the first quarter was terrific by the team. Again, it was aided a little bit by mix. And so the team's going to continue to work hard. We'll defend our margins, maybe squeak out some modest growth in gross margin. But that's what I have planned for the rest of the year.

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Operator [52]

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Our next question is from Hamzah Mazari with Macquarie.

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Hamzah Mazari, Macquarie Research - Senior Analyst [53]

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The first question is just on the FM business. Your FM business is pretty concentrated on multifamily, hospitality, health care. Just curious if, one, you can get bigger in other areas and whether that's attractive. And then along those lines, is the service component an opportunity for you guys? I know it's sort of 10% of the FM business, but any thoughts there?

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

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Yes. I would say the verticals that we're in are the ones that we have the opportunity in, we've scoped out and we're expert in, so we're going to continue to grow within that. And there's plenty of room with a market that's over $50 billion. And certainly, when you look at the service opportunity of installations and the property improvement overall, that's clearly a nice growth area for us that we self-perform today by the customer. So our ability to package that in and be the expert there is something that we'll continue to focus on and grow. And all those areas are growing well, so very pleased with what we're executing across the board in all our verticals and across the board in the property improvement within those verticals.

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Hamzah Mazari, Macquarie Research - Senior Analyst [55]

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Great. And just a follow-up question for Evan. It looks like free cash flow conversion just as a percent of EBITDA is around 59% for this year. I know you touched on inventory a little bit in your earlier remarks. Is that a normal run rate for you guys going forward? Or does that step up?

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

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Yes. The way we look at cash flow is we look at a 75% conversion pretax, pre-interest because the tax and interest bounce around a bit for us as we've improved our capital structure and tax will change as we become a taxpayer. So we look at cash conversion pretax, pre-interest as 75% of EBITDA and then subtract cash paid for taxes and interest. This year, cash paid for taxes will be 10% to 12%; cash paid for interest, about $120 million.

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Operator [57]

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Our next question is from Ryan Cieslak with Northcoast Research.

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Ryan Dale Cieslak, Northcoast Research Partners, LLC - VP & Senior Research Analyst [58]

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My first question, just really quick, going back to the FM sales in the months of April and May. I think you guys had highlighted some slower sales in April as it relates to HVAC. And just wondering maybe what that impact was. And did that actually then pick up in May and maybe is part of the acceleration in the sales growth during the month of May?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [59]

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Yes. Certainly, in May, we saw a more return to normal of the HVAC business. In the month of April, I'd say the impact to the Facilities Maintenance business of a slow start to the HVAC season is somewhere around 100 basis points.

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Ryan Dale Cieslak, Northcoast Research Partners, LLC - VP & Senior Research Analyst [60]

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Okay, that's helpful. Appreciate it. And then thinking about your updated full year guidance. Certainly, the top line trends continue to move in the right direction. It seems like exceeding your expectations. How do you guys think about maybe -- or maybe give some color if you can on what you're assuming from a cost perspective as it relates to rebar, wages and freight. Is there some incremental assumptions in terms of headwinds there that you guys are currently assuming within your guidance?

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

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In terms of rebar, we are assuming additional pressure on gross margin rate. And so we've been seeing that all along. We've got the expectation that, that pressure continues at about the current rate through the second quarter and then gradually eases. We do have expectations for increasing labor costs. We talked about that. We're seeing about 3% year-over-year increase, so it's not unmanageable. And we manage that by ensuring we continue to get more efficient with our labor, both in the distribution centers and our drivers. And we continue to see increases in freight costs. But we're better able to manage that than most since we operate our own delivery fleet. And so as you deliver more to your existing customers, as you grow and you're able to dense in your deliveries on a truck, your cost -- your delivery cost per unit drops. So that's how we offset the increase in freight costs and fuel costs.

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Ryan Dale Cieslak, Northcoast Research Partners, LLC - VP & Senior Research Analyst [62]

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Okay. Just to be clear, Evan, so you are assuming some incremental headwinds as it relates to wages and freight into the back half of the year or the next couple of quarters relative to your initial guidance you gave last quarter?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [63]

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No, I wouldn't say different than the guidance we gave last quarter. This was included in our full year guidance from last quarter and included in our plan of what we expected in 2018.

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Ryan Dale Cieslak, Northcoast Research Partners, LLC - VP & Senior Research Analyst [64]

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Got you, okay. And the last one for me is just -- I think you mentioned the nonres market in the first quarter, if I heard you right, was up 6%. Was that right?

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

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We're estimating the nonres construction market in the first quarter was up about 6%, yes.

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Ryan Dale Cieslak, Northcoast Research Partners, LLC - VP & Senior Research Analyst [66]

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Okay. And then just how do you -- so thinking about the outlook that you guys still have in that low single-digit to mid-single-digit range, is that just maybe just some conservatism? Or is there something that you guys see out there that you're keeping an eye on versus maybe -- thinking maybe more at the higher end of that range versus the lower end?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [67]

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Yes. So you're right, we've said low to mid-single digits. 6% is on the higher end of that range. I still consider that a mid-single digit. But also keep in mind it's the first quarter. So the construction season really starts here in April and May. And so before we reevaluated our estimated growth rate of that market on a go-forward basis, we want to see it through the construction season.

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Operator [68]

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Our next question comes from Keith Hughes with SunTrust.

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Keith Brian Hughes, SunTrust Robinson Humphrey, Inc., Research Division - MD [69]

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A question on A.H. Harris. They have a -- at least part of their business is fabrication, forming, things of that nature. Are you going to be looking to do more acquisitions of that variety to complement the existing White Cap?

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Evan J. Levitt, HD Supply Holdings, Inc. - Senior VP, CFO, Chief Administrative Officer [70]

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Yes. Keith, we -- our legacy White Cap business, we do, do fabrication within that business as well. And you're right, we acquired additional fabrication capacity through the A.H. Harris acquisition, and that is certainly a benefit to us. As we look at additional M&A, absolutely, we're looking for opportunities to either dense in, in a given market or to identify opportunities and specialties that we can leverage across our business. So whether that's fabrication or an expertise in a particular product category, we'd be very interested in that.

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Operator [71]

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And I'm showing no further questions. I would now like to turn the call back to Joe DeAngelo for any further remarks.

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Joseph J. DeAngelo, HD Supply Holdings, Inc. - Chairman, President & CEO [72]

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Well, thank you for your questions. I would like to encourage those of you who have not signed up for Investor Day on June 21 to contact Charlotte McLaughlin and our Investor Relations team. We believe this is a great opportunity to meet our extended leadership team, learn more about our strategic and financial outlook and have the opportunity to experience the HD Supply Facilities Maintenance growth investment showcase as well as the HD Supply Construction & Industrial branch experience.

In summary, on Page 13, 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 [73]

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