Industrials

Brooke Sutherland is a Bloomberg Gadfly columnist covering deals. She previously wrote an M&A column for Bloomberg News.

Gillian Tan is a Bloomberg Gadfly columnist covering deals and private equity. She previously was a reporter for the Wall Street Journal. She is a qualified chartered accountant.

HD Supply Holdings Inc. may regret turning off the Waterworks.

The company on Tuesday announced it would sell its Waterworks unit -- a distributor of sewer pipes, water-meter systems and manholes -- to private equity firm Clayton, Dubilier & Rice for $2.5 billion. That leaves HD Supply with a maintenance-services business and a division that supplies drywall accessories, concrete additives and other construction tools. The company's subsequent drop of about 19 percent probably had more to do with its concurrent first-quarter earnings miss and disappointing profit forecast, but it's likely the decline also reflects some doubt about the wisdom of this split.  

Waterfall
HD Supply tumbled roughly 20 percent, the largest one-day fall since its 2013 initial public offering, after delivering disappointing earnings and announcing the sale of its Waterworks arm
Source: Bloomberg

HD Supply has been on the (long) list of industrial breakup candidates for a while, especially after activist holder Jana Partners significantly increased its stake in the company last fall and said it may pursue options to create shareholder value. And there's some logic to it: there's not much customer overlap between Waterworks and the other parts of HD Supply. Getting rid of this lower-margin division will improve profitability and help the company reduce its debt load. The caveat is that in spite of all this, Waterworks wasn't necessarily a drag on HD Supply's valuation. Based on some estimates, the company was already getting full credit for all its disparate businesses before Jana's increased attention.  

The fact that HD Supply went ahead with a split anyway adds further fuel to the argument that sum-of-the-parts analyses may not be the deciding factor in how much value can be created via a breakup. Even companies that are well run, such as Honeywell International Inc., are getting pressured to slim down. There's something to be said for simpler businesses and the earnings power that can be unlocked just by allowing management teams to be more focused. I'm just not so sure simpler is necessarily going to be better for HD Supply.

The actual price HD Supply is getting for the Waterworks business is fine. It's about 10 times the division's projected 2017 Ebitda, which RBC analyst Deane Dray characterized as "reasonable" given its exposure to economic swings. The deal makes loads of sense for Clayton, Dubilier & Rice; the firm has spent more than $6 billion in the past six years buying unloved industrial carve-outs, with acquisitions from Deere & Co. and Ingersoll-Rand Plc among its success stories.

Carve-Out King
Clayton, Dubilier & Rice has been a big buyer of non-core divisions from U.S. and European industrial companies
Source: Bloomberg

In fact, Clayton, Dubilier & Rice participated in the carve-out of HD Supply from Home Depot in 2007. Its return to ownership amounts to a bet that President Donald Trump's $1 trillion infrastructure spending pledge will generate some sort of investment boom, of which Waterworks' sewer facilities and storm-drain business should be a direct beneficiary. That won't help HD Supply as much now.

Slimming down also gives HD Supply less cover for the supply-chain issues that have plagued its facilities-maintenance division, a big reason for this latest earnings disappointment. HD Supply's second quarter guidance excluding Waterworks implies an Ebitda margin decline, according to Bloomberg Intelligence analyst Christopher Ciolino. That means it will need significant improvement in the back half of the year to reach its overall targets,  he says. Digital investments to help fend off Amazon.com Inc.'s foray into industrial distribution are another pressure point.

Moving Pieces
Adjusted Ebitda margins at HD Supply's facilities maintenance business have been pressured by investments to correct supply chain missteps
Source: Bloomberg

Jana's ultimate endgame for HD Supply may be a sale of the remainder of the company, something partner Scott Ostfeld alluded to in April. A nice premium could help increase the company's value beyond its sum of the parts, if it can get one. Former parent Home Depot and Lowe's Cos. have been speculated as potential suitors. W.W. Grainger Inc. is another and could benefit from HD Supply's more defensible specialized-services offerings as it tries to stave off Amazon's encroachment. But there are also reasons why those companies would stay away; Lowe's for one just agreed to buy a maintenance-services business for $512 million last month and may not need another.

For what it's worth, Jana cut its stake in HD Supply by about 60 percent in the first quarter. Other investors will have to decide if they want to ride out this test case in simplification. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

  1. These deals have made or will make the firm roughly five times their initial investment, or more.

To contact the authors of this story:
Brooke Sutherland in New York at bsutherland7@bloomberg.net
Gillian Tan in New York at gtan129@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net