HD SUPPLY HOLDINGS, INC. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
Overview This Management's Discussion and Analysis of Financial Condition and Results of Operations is combined for two registrants:HD Supply Holdings, Inc. andHD Supply, Inc. Unless the context indicates otherwise, any reference in this discussion and analysis to "Holdings" refers toHD Supply Holdings, Inc. , any reference to "HDS" refers toHD Supply, Inc. , the indirect wholly-owned subsidiary of Holdings, and any references to "HD Supply ," the "Company," "we," "us" and "our" refer to Holdings together with its direct and indirect subsidiaries, including HDS.HD Supply is one of the largest industrial distributors inNorth America . We operate through one reportable segment with a leading position in the Maintenance, Repair & Operations ("MRO") market sector. Through approximately 44 distribution centers, in theU.S. andCanada , we serve this market sector with an integrated go-to-market strategy. We have more than 5,500 associates delivering localized, customer-tailored products, services and expertise. We serve approximately 300,000 customers, which include contractors, maintenance professionals, industrial businesses, and government entities primarily in multifamily, hospitality, healthcare, and institutional facilities markets. Our broad range of end-to-end product lines and services include approximately 200,000 stock-keeping units of quality, name-brand and proprietary-brand products as well as value-add services. OnAugust 10, 2020 , HDS entered into a Transaction Agreement (the "Transaction Agreement") with an affiliate of Clayton, Dubilier & Rice (the "Purchaser") to sell the Company's Construction & Industrial business to Purchaser for a purchase price of$2.9 billion in cash, subject to customary adjustments. OnOctober 19, 2020 , the Company completed the sale of it Construction & Industrial business. For additional information, see "Note 2 - Discontinued Operations" in the Notes to Consolidated Financial Statements within Item 1 of this quarterly report on Form 10-Q.
OnNovember 15, 2020 , Holdings entered into an Agreement and Plan of Merger (the "Merger Agreement") with The Home Depot, Inc., aDelaware corporation ("Parent"), andCoronado Acquisition Sub Inc. , aDelaware corporation and a wholly owned subsidiary of Parent ("Merger Sub"). Pursuant to the terms of the Merger Agreement, Parent has agreed to cause Merger Sub to commence a tender offer (as it may be extended, amended or supplemented from time to time, the "Offer") to purchase any and all of the outstanding shares of common stock, par value$0.01 per share, of the Company (the "Shares"), at a price of$56.00 per Share (the "Offer Price"), net to the holder thereof, in cash, without interest thereon. For additional information, see "Note 14 - Subsequent Event," in the Notes to Consolidated Financial Statements within Item 1 of this quarterly report on Form 10-Q.
Impact of COVID-19 on Our Business
The COVID-19 pandemic has resulted, and is likely to continue to result, in significant economic disruption and has and will likely continue to adversely affect our business. As of the date of this filing, significant uncertainty exists concerning the magnitude of the impact and duration of the COVID-19 pandemic and the magnitude of the impact of the pandemic on our sales, operations, and supply chain and our customers, suppliers, vendors, and business partners.HD Supply was deemed an essential business in all areas in which we operate. As a result, we have continued to service our customers. However, our customers have been impacted by various factors related to the pandemic, including the response of governmental and other regulatory authorities to the pandemic, such as "shelter-in-place," "stay-at-home" orders, mandatory quarantine orders, travel restrictions, and restrictions on landlord remedies. These factors resulted in a slowing of our sales to the affected customers. Many of our hospitality customer locations were closed or operating at a meaningfully diminished capacity, which negatively impacted sales beginning in the last half of the first quarter and may negatively impact sales until the response to the COVID-19 pandemic moderates. Many of the markets in which we operate have eased restrictions that were in place earlier in the year, subject to change depending on the scope and nature of the continuing pandemic. 29 Table of Contents
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND HD SUPPLY RESULTS OF OPERATIONS
With respect to liquidity, we are continuously evaluating our cash positions and
have taken actions to reduce costs and spending across our organization. This
includes reducing hiring activities, adjusting pay programs, and limiting
discretionary spending. We have also reduced anticipated spending on certain
capital investment projects. In addition, we may choose and currently have the
ability to access available credit facilities and have capacity to do so. See
"Liquidity and capital resources - External Financing" of this Item 2 of this
quarterly report on Form 10-Q for further information.
We will continue to actively monitor the situation and may take further actions
that alter our business operations as may be required by federal, state or local
authorities or that we determine are in the best interests of our employees,
customers, suppliers, and shareholders. Alternatively, we may reverse some of
the actions previously taken as we deem appropriate.
Description of business
We operate our Company through one reportable segment, distributing Maintenance,
Repair and Operations ("MRO") products, providing value-add services and
fabricating custom products. We serve the multifamily, hospitality, healthcare
and institutional facilities markets. Products include electrical and lighting
items, plumbing supplies, HVAC products, appliances, janitorial supplies,
hardware, kitchen and bath cabinets, window coverings, textiles and guest
amenities, healthcare maintenance and water and wastewater treatment products.
Discontinued Operations
On October 19, 2020 , the Company completed the sale of its Construction &
Industrial business. In accordance with Accounting Standards Codification
("ASC") 205-20, "Discontinued Operations," as amended, the results of the
Construction & Industrial business are classified as discontinued operations.
All periods presented have been revised to reflect this presentation. For
additional information, see "Note 2 - Discontinued Operations ," in the Notes to
Consolidated Financial Statements within Item 1 of this quarterly report on
Form
10-Q.
Acquisitions
We enter into strategic acquisitions from time to time to expand into new
markets, new platforms, and new geographies in an effort to better service
existing customers and attract new ones. In accordance with the acquisition
method of accounting under ASC 805, "Business Combinations," the results of the
acquisitions we completed are reflected in our consolidated financial statements
from the date of acquisition forward.
Seasonality
In a typical year, our operating results are impacted by seasonality.
Historically, sales of our products have been higher in the second and third
quarters of each fiscal year due to various factors, such as multifamily unit
improvement expenditures as a result of turnover trends, which tend to be higher
in the summer months, and increased sales of heating, ventilating, and air
condition ("HVAC") systems in the hotter months.
Fiscal Year
HD Supply's fiscal year is a 52- or 53-week period ending on the Sunday nearest
to January 31 . The fiscal years ending January 31, 2021 ("fiscal 2020") and
February 2, 2020 ("fiscal 2019") both include 52 weeks. The three months ended
November 1, 2020 ("third quarter 2020") and November 3, 2019 ("third quarter
2019") both include 13 weeks. The nine months ended November 1, 2020 and
November 3, 2019 both include 39 weeks.
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Key business metrics Net sales We earn our Net sales primarily from the sale of maintenance, repair and operations, and renovation and improvement-related products and our provision of related services to approximately 300,000 customers, including government entities, maintenance professionals, and industrial businesses. We recognize sales, net of sales tax and allowances for returns and discounts, when an identified performance obligation is satisfied by transfer of the promised goods or services to the customer. Net sales in certain business units fluctuate with the price of commodities as we seek to minimize the effects of changing commodities prices by passing such increases in the prices of certain commodity-based products to our customers.
We ship products to customers by internal fleet and by third-party carriers. Net sales are recognized from product sales when control of the products and services are passed to the customer, which generally occurs at the point of destination.
We include shipping and handling fees billed to customers in Net sales. Shipping and handling costs associated with inbound freight are capitalized to inventories and relieved through Cost of sales as inventories are sold. We account for shipping and handling costs associated with outbound freight as a fulfillment cost. Such costs are included in Selling, general, and administrative expenses. Gross profit Gross profit primarily represents the difference between the product cost from our suppliers (net of earned rebates and discounts), including the cost of inbound freight, and the sale price to our customers. The cost of outbound freight, purchasing, receiving and warehousing are included in Selling, general, and administrative expenses within operating expenses. Our Gross profit may not be comparable to those of other companies, as other companies may include all of the costs related to their distribution networks in Cost of sales. Operating expenses Operating expenses are primarily comprised of Selling, general, and administrative costs, which include payroll expenses (salaries, wages, employee benefits, payroll taxes and bonuses), outbound freight, rent, insurance, utilities, repair and maintenance and professional fees. In addition, operating expenses include depreciation and amortization and restructuring charges.
Adjusted EBITDA, Adjusted net income, and Free cash flow
Adjusted EBITDA, Adjusted net income, and Free cash flow are not recognized terms under generally accepted accounting principles inthe United States of America ("GAAP") and do not purport to be alternatives to Net income or, in the case of Free cash flow, operating activities as a measure of operating performance. We present Adjusted EBITDA and Adjusted net income because each is a primary measure used by management to evaluate operating performance. In addition, we present Adjusted net income to measure our overall profitability as we believe it is an important measure of our performance. We believe the presentation of Adjusted EBITDA and Adjusted net income enhances our investors' overall understanding of the financial performance of our business. We believe Adjusted EBITDA, Adjusted net income, and Free cash flow are helpful in highlighting operating trends, because each excludes the results of decisions that are outside the control of operating management and that can differ significantly from company to company depending on long-term strategic decisions regarding capital structure, the tax jurisdictions in which companies operate, age and book depreciation of facilities and capital investments. We believe that Free cash flow provides investors a better understanding of the Company's liquidity position. 31 Table of Contents
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND HD SUPPLY RESULTS OF OPERATIONS
Adjusted EBITDA is based on ''Consolidated EBITDA,'' a measure which is defined in our Senior Term Facility (the "Senior Term Facility") and Senior Asset Based Lending Facility due 2022 (the "SeniorABL Facility " and, together with the Senior Term Facility, the "Senior Credit Facilities") and used in calculating financial ratios in several material debt covenants. Borrowings under these facilities are a key source of liquidity and our ability to borrow under these facilities depends upon, among other things, our compliance with such financial ratio covenants. In particular, both facilities contain restrictive covenants that can restrict our activities if we do not maintain financial ratios calculated based on Consolidated EBITDA. Our SeniorABL Facility requires us to maintain a minimum fixed charge coverage ratio of 1:1 if our specified excess availability (including an amount by which our borrowing base exceeds the outstanding amounts) under the SeniorABL Facility falls below the greater of$100 million and 10% of the lesser of (A) the Borrowing Base and (B) the Total Facility Commitment (both as defined in the SeniorABL Facility agreement). Adjusted EBITDA is defined as Net income (loss) less Income from discontinued operations, net of tax, plus (i) Interest expense and Interest income, net, (ii) Provision for income taxes, (iii) Depreciation and amortization and further adjusted to exclude loss on extinguishment of debt, non-cash items and certain other adjustments to Consolidated Net Income, including costs associated with capital structure enhancements permitted in calculating Consolidated EBITDA under our Senior Credit Facilities. We believe that presenting Adjusted EBITDA is appropriate to provide additional information to investors about how the covenants in those agreements operate and about certain non-cash and other items. The Term Loan Facility and SeniorABL Facility permit us to make certain additional adjustments to Consolidated Net Income in calculating Consolidated EBITDA, such as projected net cost savings, which are not reflected in the Adjusted EBITDA data presented in this quarterly report on Form 10-Q. We may in the future reflect such permitted adjustments in our calculations of Adjusted EBITDA. These covenants are important to the Company as failure to comply with certain covenants would result in a default under our Senior Credit Facilities. The material covenants in our Senior Credit Facilities are discussed in our annual report on Form 10-K for the fiscal year endedFebruary 2, 2020 . Adjusted net income is defined as Net income less Income from discontinued operations, net of tax, further adjusted for loss on extinguishment of debt and certain non-cash, non-recurring, non-operational, or unusual items, net of tax. Effective with the second quarter of fiscal 2020 reporting, we modified the definition of Adjusted net income to remove the exclusions of the tax provision and amortization of acquisition-related intangible assets (other than software) and addition of cash tax payments. We believe this revised presentation is more useful since we have exhausted our federal net operating loss carryforwards and become a regular taxpayer. All periods presented have been revised to reflect the modified definition.
Free cash flow is defined as cash flow provided by operating activities less capital expenditures.
We believe that Adjusted EBITDA, Adjusted net income, and Free cash flow are frequently used by securities analysts, investors and other interested parties in their evaluation of companies, many of which present an Adjusted EBITDA, Adjusted net income, and Free cash flow measure when reporting their results. We compensate for the limitations of using non-GAAP financial measures by using them to supplement GAAP results to provide a more complete understanding of the factors and trends affecting the business than GAAP results alone. Because not all companies use identical calculations, our presentation of Adjusted EBITDA, Adjusted net income , and Free cash flow may not be comparable to other similarly titled measures of other companies.
Adjusted EBITDA and Adjusted net income have limitations as analytical tools and should not be considered in isolation or as substitutes for analyzing our results as reported under GAAP. Some of these limitations are:
? Adjusted EBITDA, Adjusted net income , and Free cash flow do not reflect
changes in, or cash requirements for, our working capital needs;
? Adjusted EBITDA does not reflect our interest expense, or the requirements
necessary to service interest or principal payments on our debt;
? Adjusted EBITDA does not reflect our income tax expenses or the cash
requirements to pay our taxes;
Adjusted EBITDA and Adjusted net income do not reflect historical cash
? expenditures or future requirements for capital expenditures or contractual
commitments; and
although depreciation and amortization charges are non-cash charges, the assets
? being depreciated and amortized will often have to be replaced in the future,
and Adjusted EBITDA does not reflect any cash requirements for such
replacements.
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The following table presents a reconciliation of Net Income, the most directly comparable financial measure under GAAP, to Adjusted EBITDA for the periods presented (amounts in millions):
Three Months Ended Nine Months Ended
November 1, 2020 November 3, 2019 November 1, 2020 November 3, 2019
Net income $ 1,608.2 $ 131.9 $ 1,811.2 $ 373.7
Less income from discontinued operations,
net of tax 1,572.7 58.5 1,677.3 161.3
Income from continuing operations 35.5
73.4 133.9 212.4
Interest expense, net 22.0 27.4 71.1 83.4
Provision for income taxes 14.4 25.1 46.6 71.1Depreciation and amortization 17.7 15.5 52.1 45.2 Loss on extinguishment & modification of debt(1) 5.5 - 5.5 - Loss on voluntary interest rate swap termination(2) 43.6 - 43.6 - Restructuring and separation charges(3) 3.9 1.3 7.6 (0.4) Stockbased compensation 5.3 3.6 13.8 11.9 Acquisition and integration costs(4) -
1.2 - 1.3
Other 0.1 - - -
Adjusted EBITDA $ 148.0 $ 147.5 $ 374.2 $ 424.9
Represents the loss on extinguishment of debt, including the write-off of (1) unamortized deferred financing costs, original issue discount, and other
assets or liabilities associated with such debt.
Represents the loss incurred to voluntarily terminate
value of the Company's interest rate swap during the three months ended
further information, see "Note 4 - Derivative Instruments" in the Notes to
Consolidated Financial Statements within Item 1 of this quarterly report on
Form 10-Q.
Represents the costs related to separation activities and personnel changes,
primarily severance and other employee-related costs, and costs related to (3) deferring certain projects during the separation preparations. In the nine
months ended
of the lease for its former corporate headquarters.
(4) Represents the costs incurred in the acquisition and integration of business
acquisitions.
The following table presents a reconciliation of Net Income, the most directly
comparable financial measure under GAAP, to Adjusted net income for the periods
presented (amounts in millions):
Three Months Ended Nine Months Ended
November 1,2020 November 3, 2019 November 1,2020 November 3, 2019
Net income $ 1,608.2 $ 131.9 $ 1,811.2 $ 373.7
Less income from discontinued operations,
net of tax 1,572.7 58.5 1,677.3 161.3
Income from continuing operations 35.5 73.4 133.9 212.4
Plus: Restructuring and separation
charges(1) 3.9 1.3 7.6 (0.4)
Plus: Loss on extinguishment &
modification of debt(2) 5.5 - 5.5 -
Plus: Loss on voluntary interest rate swap
termination(3) 43.6 - 43.6 -
Plus: Acquisition and integration costs(4) -
1.2 - 1.3
Plus: Tax on adjustments(5) (13.7) (0.6) (14.7) (0.2)
Adjusted Net Income $ 74.8 $ 75.3 $ 175.9 $ 213.1
Represents the costs related to separation activities and personnel changes,
primarily severance and other employee-related costs, and costs related to (1) deferring certain projects during the separation preparations. In the nine
months ended
of the lease for its former corporate headquarters.
Represents the loss on extinguishment of debt, including the write-off of (2) unamortized deferred financing costs, original issue discount, and other
assets or liabilities associated with such debt.
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Represents the loss incurred to voluntarily terminate
value of the Company's interest rate swap during the three months ended
further information, see "Note 4 - Derivative Instruments" in the Notes to
Consolidated Financial Statements within Item 1 of this quarterly report on
Form 10-Q.
(4) Represents the costs incurred in the acquisition and integration of business
acquisitions.
Adjustments to Net income have been tax effected at the Company's combined (5) annual federal and statutory tax rates of 25.8% for the three and nine
months ended
Consolidated results of operations
Dollars in millions
Percentage Percentage
Three Months Ended Increase Nine Months Ended Increase
November 1, 2020 November 3, 2019 (Decrease) November 1, 2020 November 3, 2019 (Decrease)
Net sales $ 827.5 $ 825.2 0.3 % $ 2,269.0 $ 2,426.0 (6.5) %
Gross Profit 348.3 352.0 (1.1) 958.0 1,037.6 (7.7)
Operating expenses:
Selling, general, and
administrative 205.7 209.3 (1.7) 597.6 625.9 (4.5)
Depreciation and amortization 17.7 15.5 14.2 52.1 45.2 15.3
Restructuring and separation 3.9 1.3 * 7.6 (0.4) *
Total operating expenses 227.3 226.1 0.5 657.3 670.7 (2.0)
Operating Income 121.0 125.9 (3.9) 300.7 366.9 (18.0)
Interest expense 22.0 27.4 (19.7) 71.1 83.4 (14.7)
Loss on extinguishment &
modification of debt 5.5 - * 5.5 - *
Other (income) expense, net 43.6 - * 43.6 - *
Income Before Provision for Income
Taxes 49.9 98.5 (49.3) 180.5 283.5 (36.3)
Provision for income taxes 14.4 25.1 (42.6) 46.6 71.1 (34.5)
Income from Continuing Operations 35.5 73.4 (51.6) 133.9 212.4 (37.0)
Income from discontinued
operations, net of tax 1,572.7 58.5 * 1,677.3 161.3 *
Net Income $ 1,608.2 $ 131.9 * $ 1,811.2 $ 373.7 *
NonGAAP financial data:
Adjusted EBITDA $ 148.0 $ 147.5 0.3 $ 374.2 $ 424.9 (11.9)
Adjusted net income $ 74.8 $ 75.3 (0.7) $ 175.9 $ 213.1 (17.5)
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RESULTS OF OPERATIONS
% of Net Sales % of Net Sales
Three Months Ended Basis Point Nine Months Ended Basis Point
November 1, November 3, Increase November 1, November 3, Increase
2020 2019 (Decrease) 2020 2019 (Decrease)
Net sales 100.0 % 100.0 % - 100.0 % 100.0 % -
Gross Profit 42.1 42.7 (60) 42.2 42.8 (60)
Operating expenses:
Selling, general, and administrative 24.9 25.3 (40) 26.3 25.8 50 Depreciation and amortization 2.1 1.9 20 2.3 1.9 40 Restructuring and separation 0.5 0.2 30 0.3 - 30 Total operating expenses 27.5 27.4 10 28.9 27.7 120 Operating Income 14.6 15.3 (70) 13.3 15.1 (180) Interest expense 2.6 3.4 (80) 3.2 3.4 (20) Loss on extinguishment & modification of debt 0.7 - 70 0.2 - 20 Other (income) expense, net 5.3 - * 1.9 - 190 Income Before Provision for Income Taxes 6.0 11.9 * 8.0 11.7 * Provision for income taxes 1.7 3.0 (130) 2.1 2.9 (80) Income from Continuing Operations 4.3 8.9 * 5.9 8.8 * Income from discontinued operations, net of tax 190.0 7.1 * 73.9 6.6 * Net Income 194.3 16.0 * 79.8 15.4 * NonGAAP financial data: Adjusted EBITDA 17.9 17.9 - 16.5 17.5 (100) Adjusted net income 9.0 9.1 (10) 7.8 8.8 (100) * Not meaningful Highlights Net sales in third quarter 2020 increased$2.3 million , or 0.3%, as compared to third quarter 2019. Operating income in third quarter 2020 decreased$4.9 million , or 3.9%, as compared to third quarter 2019. Net income in third quarter 2020 increased$1,476.3 million to$1,608.2 million as compared to third quarter 2019, primarily due to the completion of the sale of the Construction & Industrial business. Adjusted EBITDA in third quarter 2020 increased$0.5 million , or 0.3%, as compared to third quarter 2019. Adjusted net income in third quarter 2020 decreased$0.5 million , or 0.7%, as compared to third quarter 2019. As ofNovember 1, 2020 , our total liquidity was$2.8 billion . See "Liquidity and capital resources - External Financing" of this Item 2 of this quarterly report on Form 10-Q for further information. Net sales Net sales increased$2.3 million , or 0.3%, in third quarter 2020 as compared to third quarter 2019 and decreased$157.0 million , or 6.5%, in the first nine months of fiscal 2020 as compared to the same period in fiscal 2019. The decrease in Net sales in in the first nine months of fiscal 2020 as compared to the same period in fiscal 2019 was primarily due to declines in the hospitality and multifamily industries related to the response by governmental and other regulatory authorities to the COVID-19 pandemic during the first two quarters of fiscal 2020. As the markets in which we operate began easing these restrictions during second quarter 2020, we generated improving sales volume. All of our verticals showed increased sales in third quarter 2020 as compared to the second quarter of fiscal 2020. Average year-over-year daily sales changes for fiscal 2020 by months was as follows: Fiscal Month: February March April May June July August September October Daily Sales Change 4.1 % (0.4) % (31.9) % (13.4) % (9.0) % (4.4) % 1.1 % (0.7) % 0.3 % Selling Days 20 20 25 19
20 24 19 19 25
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The most prominent impact of the decline in Net sales was in the hospitality
industry, which historically represents approximately 16-18% of sales. The
decline in travel due to the COVID-19 pandemic resulted in the closing of many
hotels, with the remaining open hotels experiencing a significant reduction in
occupancy. Hospitality sales improved in third quarter 2020 as compared to
second quarter 2020 as occupancy began to increase and we increased our share in
serving the hospitality industry. In third quarter 2020 and the first nine
months of fiscal 2020, hospitality sales decreased approximately 14.1% and
27.3%, respectively, as compared to the same periods in fiscal 2019.
Many of our multifamily customers limited their purchases to emergency repair
and maintenance items in order to preserve cash and to keep maintenance
professionals from entering tenant units unnecessarily in an attempt to maintain
social distancing. Multifamily customers may also be affected by the steps taken
by state and local governments to minimize the impact of the COVID-19 pandemic
on tenants, including placing moratoriums on evictions and prohibiting late fees
for up to three months. Finally, multifamily customers are seeing fewer unit
turns as tenants are less likely to move their residence during the pandemic.
Fewer turns reduce both maintenance and improvement expenditures. Sales to
multifamily customers historically account for approximately 60% of sales.
Multifamily sales also improved in third quarter 2020 as compared to second
quarter 2020. In third quarter 2020 and the first nine months of fiscal 2020,
our multifamily sales increased approximately 2.1% and decreased approximately
3.3%, as compared to the same periods in fiscal 2019.
The following table provides Gross Sales after Returns ("GSAR") (which excludes
customer rebates, discounts, and allowances) as a percentage of total GSAR by
vertical sales channel:
Three Months Ended Nine Months Ended
Basis Point Basis Point
November 1, November 3, Increase November 1, November 3, Increase
2020 2019 (Decrease) 2020 2019 (Decrease)
Sales Vertical
Multifamily 62.3 % 61.1 % 120 62.2 % 60.3 % 190
Hospitality 14.0 % 16.4 % (240) 13.2 % 17.1 % (390)
Healthcare 7.0 % 7.0 % - 7.4 % 7.0 % 40
Institutional 8.9 % 7.8 % 110 8.6 % 7.8 % 80
Other 7.8 % 7.7 % 10 8.6 % 7.8 % 80
Total 100.0 % 100.0 % - 100.0 % 100.0 % -
Gross profit
Gross profit decreased
Gross profit as a percentage of Net sales ("gross margin") decreased approximately 60 basis points to 42.1% in third quarter 2020 as compared to 42.7% in third quarter 2019 and approximately 60 basis points to 42.2% in the first nine months of fiscal 2020 as compared to 42.8% in the same period in fiscal 2019.
The decline in gross margins resulted from an increase in sales of lower-margin safety products, appliances, HVAC, and janitorial products. We expect gross margin to fluctuate as our customers within different industries recover from the impacts of the COVID-19 pandemic at different rates and with new product requirements. Operating expenses
Operating expenses increased
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Selling, general, and administrative expenses decreased in both periods of fiscal 2020 as compared to the same periods in fiscal 2019 primarily due to decreases in variable costs including personnel, travel and other controllable costs. During third quarter 2020, the decrease also included a reduction in insurance and safety claims. During the first nine months of fiscal 2020, these decreases were partially offset by an increase in fixed facility and equipment costs and charges for expected credit losses. Depreciation and amortization expense increased in both periods due to investments in facilities and technology during fiscal 2019. Restructuring and separation expenses in third quarter 2020 and the first nine months of fiscal 2020 were primarily due to severance, other employee-related costs, and the costs of deferring certain projects during the separation preparations. Restructuring and separation expenses in the first nine months of fiscal 2019 included the reversal of$1.7 million of restructuring expenses incurred in fiscal 2018. The reversal resulted from the favorable termination of the lease associated with the Company's former corporate headquarters, which was exited in fiscal 2018. Operating expenses as a percentage of Net sales increased approximately 10 basis points to 27.5% in third quarter 2020 as compared to third quarter 2019 and approximately 120 basis points to 28.9% in the first nine months of fiscal 2020 as compared to the same period in fiscal 2019. Selling, general, and administrative expenses as a percentage of Net sales, decreased approximately 40 basis points to 24.9% in third quarter 2020 as compared to third quarter 2019. The decrease in third quarter 2020 as compared to third quarter 2019 was primarily due to the decrease in travel and other controllable costs and favorable insurance and safety claims, partially offset by performance bonuses as a percentage of Net sales. Selling, general, and administrative expenses as a percentage of Net sales increased approximately 50 basis points to 26.3% in the first nine months of fiscal 2020 as compared to the same period in fiscal 2019. The increase was primarily a result of the decline in net sales and increased charges for expected credit losses. Beginning inmid-March 2020 , the economic impact of the response to the COVID-19 pandemic was swift and significant. As a result, the initial reduction in Net sales outpaced our efforts to reduce fixed costs. Restructuring and separation expenses as a percentage of Net sales increased approximately 30 basis points in both third quarter 2020 as compared to third quarter 2019 and the first nine months of fiscal 2020 as compared to the same period in fiscal 2019. Operating income
Operating income decreased$4.9 million , or 3.9%, during third quarter 2020 as compared to third quarter 2019 and$66.2 million , or 18.0%, during the first nine months of fiscal 2020 as compared to the same period in fiscal 2019. The decrease in third quarter 2020 as compared to third quarter 2019 was due to the decline in gross profit as a result of a decrease in gross margins and the increase in operating expenses. The decrease in the first nine months of fiscal 2020 as compared to the same period in fiscal 2019 was due to the decrease in Net sales and gross profit, partially offset by the decrease in operating expenses. Operating income as a percentage of Net sales decreased approximately 70 basis points to 14.6% during third quarter 2020 as compared to third quarter 2019 and approximately 180 basis points to 13.3% during the first nine months of fiscal 2020 as compared to the same period in fiscal 2019. The decrease in third quarter 2020 as compared to third quarter 2019 was due to the decline in gross margins and the increase in operating expenses as a percentage of Net sales. The decrease in the first nine months of fiscal 2020 as compared to the same period in fiscal 2019 periods was primarily due to the increase in operating expenses as a percentage of Net sales, and to a lesser extent, the decline in gross
margins. Interest expense Interest expense decreased$5.4 million , or 19.7%, during third quarter 2020 as compared to third quarter 2019 and$12.3 million , or 14.7%, during the first nine months of fiscal 2020 as compared to the same period in fiscal 2019. The decrease in both periods was primarily due to declining interest rates and
a reduction in indebtedness.
Loss on extinguishment & modification of debt
During third quarter 2020 and the first nine months of fiscal 2020, our debt extinguishment and modification activities resulted in charges of$5.5 million , recorded in accordance with ASC 470-50, "Debt - Modifications and Extinguishments." OnOctober 20, 2020 , HDS reduced itsU.S. and Canadian borrowing capacities under its SeniorABL Facility by$340.0 million and$60.0 million , respectively. As a result, the Company incurred a$0.8 million loss on modification of debt for the write-off of unamortized deferred financing costs. 37
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OnOctober 20, 2020 , HDS paid$524.3 million to reduce its aggregate principal of$1,070.0 million tranche of Term Loans (the "Term B-5 Loans"), incurring a$4.7 million loss on extinguishment of debt, which included write-offs of$1.2 million and$3.5 million of unamortized original issue discount and unamortized deferred financing costs, respectively. Other (income) expense, net
During third quarter 2020 and the first nine months of fiscal 2020, we
recognized a
Provision for income taxes The provision for income taxes during the period is calculated by applying an estimated annual tax rate for the full fiscal year to pre-tax income for the reported period plus or minus unusual or infrequent discrete items occurring within the period. The provision for income taxes from continuing operations in third quarter 2020 was$14.4 million compared to$25.1 million in third quarter 2019. The provision for income taxes for the first nine months of fiscal 2020 was$46.6 million as compared to$71.1 million in the first nine months of fiscal 2019. The effective rate for third quarter 2020 and the first nine months of fiscal 2020 was 28.9% and 25.8%, respectively. The effective rate for third quarter 2019 and the first nine months of fiscal 2019 was 25.5% and 25.1%, respectively. OnMarch 27, 2020 , the Coronavirus Aid, Relief, and Economic Security Act ("CARES Act") was signed into law. The CARES Act contains significant business tax provisions, including modifications to the rules limiting the deductibility of net operating losses ("NOLs"), expensing of qualified improvement property and business interest in Internal Revenue Code Sections 172(a) and 163(j), respectively. The effects of the new legislation are recognized upon enactment. The Company did not recognize any significant impact to income tax expense for third quarter 2020 or the first nine months of fiscal 2020 related to the CARES Act.
We regularly assess the realization of our net deferred tax assets and the need for any valuation allowance. This assessment requires management to make judgments about the benefits that could be realized from future taxable income, as well as other positive and negative factors influencing the realization of deferred tax assets. As ofNovember 1, 2020 andFebruary 2, 2020 , the Company's valuation allowance on itsU.S. deferred tax assets was approximately$5.4 million and$6.0 million , respectively.
Income from discontinued operations, net of tax
On
Excluding the gain on sale, Income from discontinued operations, net of tax
during third quarter 2020 and third quarter 2019 was
Excluding the gain on sale, Income from discontinued operations, net of tax
during the first nine months of fiscal 2020 and fiscal 2019 was
For additional information, see "Note 2 - Discontinued Operations" in the Notes to Consolidated Financial Statements within Item 1 of this quarterly report
on
Form 10-Q.
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Adjusted EBITDA
Adjusted EBITDA increased
Adjusted EBITDA as a percentage of Net sales was flat in third quarter 2020 as compared to third quarter 2019 and decreased approximately 100 basis points to 16.5% in the first nine months of fiscal 2020 as compared to the same period in fiscal 2019. The flat rate in third quarter 2020 was driven by the decline in gross margin, offset by the decrease in Selling, general, and administrative expenses as a percentage of Net sales. The decrease in the first nine months of fiscal 2020 as compared to fiscal 2019 was due to the decline in gross margin and the increase in Selling, general, and administrative expenses as a percentage of Net sales. Adjusted net income
Adjusted net income decreased$0.5 million , or 0.7%, in third quarter 2020 as compared to third quarter 2019 and$37.2 million , or 17.5%, in the first nine months of fiscal 2020 as compared to the same period in fiscal 2019. The decrease in Adjusted net income in both periods was primarily attributable to the decline in operating income, partially offset by lower interest expense. In addition, Adjusted net income in third quarter 2020 reflected a higher tax provision than third quarter 2019 and Adjusted net income in the first nine months of fiscal 2020 reflected a lower tax provision than the first nine months of fiscal 2019.
Liquidity and capital resources
Sources and uses of cash
Our sources of funds, primarily from operations, cash on-hand, and, to the
extent necessary, from readily available external financing arrangements, are
sufficient to meet all current obligations on a timely basis. We believe, based
on our current business plan, that these sources of funds will be sufficient to
meet the operating needs of our business for at least the next twelve months. We
are continuously evaluating our cash positions and have taken prudent actions to
reduce costs and spending across our organization. This includes reducing hiring
activities, adjusting pay programs, negotiating rent payment deferrals at our
leased facilities, and limiting discretionary spending. We have also reduced
anticipated spending on certain capital investment projects.
The CARES Act allows employers to defer the payment of the employer share of
Federal Insurance Contributions Act ("FICA") taxes for the period from March 27,
2020 and ending December 31, 2020 . During the first nine months of fiscal 2020,
the Company deferred FICA payments of $21.7 million under the CARES Act and will
continue to defer FICA payments through December 31, 2020 . The deferred amount
will be payable as follows: (1) 50% of the deferred amount will be due December
31, 2021 and (2) the remaining 50% of the deferred amount will be due December
31, 2022 .
During the first nine months of fiscal 2020, our cash inflow was primarily
driven by cash provided by the sale of the Construction & Industrial business,
and, to a lesser extent, cash flow from operations, partially offset by net debt
repayments and capital expenditures.
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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND HD SUPPLY RESULTS OF OPERATIONS
As ofNovember 1, 2020 , our combined liquidity of approximately$2.8 billion was comprised of$2.3 billion in cash and cash equivalents and$436.7 million of additional available borrowings (excluding$139.4 million of borrowings on available cash balances) under our SeniorABL Facility , based on qualifying inventory and receivables. OurNovember 1, 2020 combined liquidity increased approximately$2.1 billion as compared to our fiscal 2019 year-end combined liquidity of$628.4 million .
Information about our cash flows, by category, is presented in the Consolidated Statements of Cash Flows and is summarized as follows:
Amounts in millions Nine Months Ended
November 1, 2020 November 3, 2019 Increase (Decrease)
Net cash provided by (used for):
Operating activities $ 523.9 $ 496.6 $ 27.3
Investing activities 2,791.2 (95.8) 2,887.0
Financing activities (1,034.6) (402.3) (632.3)
Free cash flow:
Operating activities $ 523.9 $ 496.6 $ 27.3Less: Capital expenditures (54.6)
(89.1) 34.5 Free cash flow $ 469.3 $ 407.5 $ 61.8 Working capital Working capital, excluding cash and cash equivalents, was$6.4 million as ofNovember 1, 2020 , decreasing$847.2 million as compared to$853.6 million as ofNovember 3, 2019 . Working capital, excluding the impact of discontinued operations and cash and cash equivalents decreased$427.6 million . The decrease in working capital, excluding the impact of discontinued operations and cash and cash equivalents, was attributable to accrued income taxes of approximately$282.3 million primarily related to the sale of the Construction & Industrial business, declines in Accounts receivable and Inventory due to declining sales as a result of the COVID-19 pandemic, and an increase in Accounts payable due to timing of payments. Operating activities During the first nine months of fiscal 2020, cash provided by operating activities was$523.9 million compared to$496.6 million in the first nine months of fiscal 2019. During the first nine months of fiscal 2020, cash flows provided by operating activities for discontinued operations were$266.5 million as compared to$251.5 million during the first nine months of fiscal 2019. Cash flows provided by operating activities from continuing operations increased$12.3 million to$257.4 million in the first nine months of fiscal 2020 as compared to the same period in fiscal 2019. Cash interest paid in the first nine months of fiscal 2020 was$77.5 million , compared to$89.2 million in the first nine months of fiscal 2019. Cash flows from operating activities in the first nine months of fiscal 2020 included a payment of$43.6 million to voluntarily terminate$500 million notional value of the Company's interest rate swap. Cash income taxes paid in the first nine months of fiscal 2020 was$83.5 million , compared to$35.3 million in the first nine months of fiscal 2019. Investing activities During the first nine months of fiscal 2020, cash provided by investing activities was$2,791.2 million , primarily comprised of$2.8 billion of net cash proceeds from the sale of the Construction & Industrial business, partially offset by$54.6 million of capital expenditures. During the first nine months of fiscal 2019, cash used by investing activities was$95.8 million , primarily comprised of$89.1 million of capital expenditures. 40 Table of Contents
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND HD SUPPLY RESULTS OF OPERATIONS
Financing activities During the first nine months of fiscal 2020, cash used in financing activities was$1,034.6 million , primarily due to net debt repayments of$791.8 million , purchases of treasury shares of$246.9 million , and tax withholdings on stock-based awards of$3.8 million , partially offset by proceeds from employee stock option exercises of$8.9 million . During the first nine months of fiscal 2019, cash used in financing activities was$402.3 million , primarily due to purchases of treasury shares of$320.5 million , the payment of the corporate headquarters financing liability of$87.9 million , and tax withholdings on stock-based awards of$5.5 million , partially offset by proceeds from employee stock option exercises of$6.8 million and net debt borrowing of$5.7 million . External financing As ofNovember 1, 2020 , we had an aggregate principal amount of$1,261.5 million of outstanding indebtedness, net of unamortized discounts and unamortized deferred financing costs of$1.2 million and$11.6 million , respectively, and$576.1 million of additional available borrowings under our SeniorABL Facility (after giving effect to the borrowing base limitations and approximately$23.8 million in letters of credit issued and including$139.4 million of borrowings available on qualifying cash balances). From time to time, depending on market conditions and other factors, we may seek to repay, redeem, repurchase or otherwise acquire or refinance all or a portion of our indebtedness. We may make such repurchases in privately negotiated transactions or otherwise. OnOctober 20, 2020 , HDS reduced itsU.S. and Canadian borrowing capacities under its SeniorABL Facility by$340.0 million and$60.0 million , respectively. The total borrowing capacity under the SeniorABL Facility is now$600.0 million (subject to availability under a borrowing base). As a result, the Company incurred a$0.8 million loss on modification of debt for the write-off of unamortized deferred financing costs, in accordance with ASC 470-50, "Debt - Modifications and Extinguishments." OnOctober 20, 2020 , HDS used a portion of the net proceeds from the sale of the Construction & Industrial business to repay$524.3 million aggregate principal of its Term Loans in an original aggregate principal amount of$1,070.0 million . As a result, the Company incurred a$4.7 million loss on extinguishment of debt, which includes write-offs of$1.2 million and$3.5 million of unamortized original issue discount and unamortized deferred financing costs, respectively, in accordance with ASC 470-50, "Debt - Modifications and Extinguishments."
For additional information, see "Note 3 - Debt," in the Notes to Consolidated Financial Statements within Item 1 of this quarterly report on Form 10-Q.
Critical accounting policies
Our consolidated financial statements have been prepared in accordance with GAAP. Preparation of these statements requires management to make judgments and estimates. Some accounting policies have a significant impact on amounts reported in these consolidated financial statements. The Company's critical accounting policies have not changed from those reported in Management's Discussion and Analysis of Financial Condition and Results of Operations in our annual report on Form 10-K for the fiscal year endedFebruary 2, 2020 , with the exception of the Company's adoption of Accounting Standard Update ("ASU") 2016-13, "Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments" ("ASU 2016-13") onFebruary 3, 2020 (the first day of fiscal 2020). Pursuant to the implementation of ASU 2016-13, the Company establishes an allowance for credit losses using estimations of loss rates based upon historical loss experience and adjusted for factors that are relevant to determining the expected collectability of trade receivables. These estimations and factors require assumptions and judgments regarding matters that are inherently uncertain, including the impact that the COVID-19 pandemic may have on the liquidity, credit, and solvency status of our customers or their industries. For further discussion on the Company's allowances for credit losses, see "Note 9 - Supplemental Balance Sheet and Cash Flow Information" in the Notes to Consolidated Financial Statements within Item 1 of this quarterly report on Form 10-Q. 41 Table of Contents
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Recent accounting pronouncements
See "Note 13 - Recent Accounting Pronouncements" in the Notes to Consolidated Financial Statements within Item 1 of this quarterly report on Form 10-Q.
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