Deal Denial; Acquisition Affirmation
A week ago, Bloomberg reported that home improvement retailer Lowe’s was in talks to acquire MRO distributor HD Supply. The next day, Lowe’s issued a press release saying it was not in any such discussions and had no plans to acquire the company. Instead, the prodigal distributor returned home this week when The Home Depot announced it was re-acquiring HD Supply.
Lots of analysts are covering the long history between these two companies, but the synopsis is that when Bob Nardelli was running Home Depot, he decided to get into distribution. He formed the “HD Supply” division, bought a bunch of companies and integrated them. When Frank Blake became CEO, he spun off the division to private equity, and HD Supply has been shedding business units ever since. The company went public a few years ago, and it’s down to one business unit now – Facilities Maintenance – after selling its construction supplies unit, White Cap, to private equity a couple of months ago.
I served as Vice President of Marketing for HD Supply White Cap from 2010 to 2017, and, over that timeframe, the company was one of the best growth and profitability stories in distribution (honestly, I played a small role in that success). But HD Supply has always been more interested in the MRO business than other segments; the margins are very attractive, and the growth was impressive for several years before leveling off more recently and then declining thanks to COVID-19.
Valuation Stock Talk
Home Depot must have wanted this deal pretty badly because the company paid $56 a share. That’s a 25% premium to HD Supply’s stock price pre-announcement and represents an enterprise value of over $8 billion. Analyst Gary Gambino, writing for Seeking Alpha, puts the price tag at 17.9X EBITDA. That’s a pretty heady multiple for an MRO distributor that’s seen quite a bit of sales erosion during the pandemic.
However, the price isn’t so hard to justify if you look at some underlying forces at play:
- HD Supply was heavily exposed to the hospitality industry, which has been particularly devastated by COVID. That is obviously not a management or execution problem – it’s an Act of God. The stock is certainly below where it would have been in a COVID-free, world and the hospitality industry will come back, at least to a large degree.
- Home Depot is likely trying to cover its flanks by keeping Lowe’s out of B2B distribution. This would have been a logical argument in any case, but the odd press release from Lowe’s only a week before the deal was announced makes it appear that HD Supply had two suitors, and there was some sort of bidding war. I had a finance professor in business school who used to say, “When a company can’t justify an acquisition price, they call it, ‘strategic.’” I’d say this was strategic but probably justified.
- Multifamily may be turn into a gold mine next year – and HD Supply gets three times more revenue from multifamily than hospitality. Various industry sources are telling me that many hospitality properties may get converted to multifamily use. Also, multifamily thrives when there is unit turnover, which is when people leave a unit and someone else moves in. That’s been artificially (and mercifully) constrained during COVID as various governmental entities have forbidden evictions. That won’t last much longer.
- Home Depot is in a good position to leverage HD Supply’s capabilities to accelerate sales growth. The company bought Interline Brands (a direct competitor to HD Supply Facilities Maintenance) in 2015, and it’s been expanding its pro initiatives ever since.
Add it all up and it doesn’t appear to me that Home Depot would have a hard time putting together a discounted cash flow model that makes an $8 billion price tag for HD Supply look reasonable. It’s already expected to be accretive to earnings, although it’s too small to make more than a blip in the financial results of a behemoth company like The Home Depot.
Home Depot Pro and HD Supply – What’s the Strategy?
We know there is significant opportunity to better serve our Pro customers, who we believe represent about 45 percent of our sales today. The value proposition that we are creating for our Pros is a comprehensive ecosystem that encompasses product, exclusive brands, delivery, credit, service, digital capabilities, tool rental and more. We believe what we are building is unique to the marketplace. The store experience is being enhanced, delivery is a key component that we are building out through our supply chain investments,and the B2B site experience is being designed to make it easier for our Pros to engage with The Home Depot from the job site.”
Menear also noted that the company is now the “fifth largest ecommerce operation in the United States. And approximately 50% of the time customers choose to pick up their online order in our U.S. stores.”
In his remarks, Menear used this slide, which sums up the Pro strategy.
Obviously, when Home Depot uses the word, “Pro,” it is referring not just to residential building contractors and remodelers. In its 2019 annual report, the company says, “The Home Depot Pro serves a number of business customers, including hotels, hospitals, apartment/condominium property managers, educational institutions, government agencies, commercial property managers and housing authorities.” For a comprehensive view of Home Depot’s Pro offering, visit https://www.homedepotpro.com.
To support both its retail and B2B efforts, Home Depot operates 200 distribution centers and is building 150 new “fulfillment facilities” with the “goal of reaching 90% of the U.S. population with same or next-day delivery for extended home improvement and MRO product offerings, including big and bulky goods.” Plus, it operates nearly 2,000 stores.
HD Supply fits neatly into all of this – it’s easy to imagine a couple of new boxes on the HomeDepotPro.com page – one for hospitality and one for healthcare. HD Supply’s products that are not already listed on Home Depot Pro’s Multifamily and Institutional sites would be added and the acquired distribution centers rationalized into the ongoing logistics development plan.
I doubt that HD Supply’s customers will object to its acquisition by Home Depot – execution issues notwithstanding, of course. Assuming a competent integration, customers will get access to more products and better delivery capabilities. Provided Home Depot keeps the sales and service employees, it’s reasonable to expect customer revenues to grow instead of decline.
Between the Devil and the Deep Orange Apron: The Plight of MRO Distributors
Amazon Business continues to build an unprecedented online offering of MRO products and services – including a massive marketplace with assortment and fulfillment provided by tens of thousands of suppliers. There is no ecommerce-driven distributor that can compete in the long run. Home Depot, meanwhile, is leveraging physical assets and the ability to offer a massive assortment available same day by delivery or pick-up. The company also offers an array of services; the full value proposition neutralizes the advantages held by branch-based distributors – at least those that focus on “on-the-carpet” MRO.
These two disruptors – one coming from the tech industry, wielding cutting-edge ecommerce capabilities and the other coming from retail, brandishing overwhelming assets and working capital – are squeezing MRO distributors in the middle. And it’s an asymmetric battle – there aren’t any distributors threatening large retailers or developing an online presence to rival major players like Amazon.
If you’re in the MRO distribution business, I suggest you get more industrial ASAP, since neither Amazon nor Home Depot plays in that space right now. And you’d better expand your value-added services immediately into a much more complex and sophisticated offering than most distributors offer today.
There’s only one MRO distributor that doesn’t have to worry about any of that: HD Supply. If you’re an investor in that company, then you should thank your lucky stars that CEO Joe DeAngelo negotiated such a good price for the company. Add him to your Christmas gift list and buy him something proportional to the value he’s created by returning HD Supply back to its original parent. Like a Ferrari.