[Premium Unlocked] Maintaining All Options
Discover more from Nongaap Investing
[Premium Unlocked] Maintaining All Options
Evaluating strategic alternatives before committing to significant buybacks?
Welcome to the Nongaap Newsletter! I’m Mike, an ex-activist investor who writes about tech, corporate governance, the power & friction of incentives, strategy, board dynamics, and the occasional activist fight.
If you’re reading this but haven’t subscribed, I hope you consider joining me on this journey.
Premium Unlocked: Now that HD has acquired HD Supply, I’m unlocking this post.
Original Post Below
Disclaimer: This is a highly speculative write-up, and I don’t have any direct knowledge of what’s going on. That said, I’m going to share why I think HD Supply (ticker: HDS) is currently evaluating strategic alternatives. I can be completely wrong, but I think it’s an interesting thought exercise in examining activism, strategic alternatives, and capital allocation planning.
Event-Driven Trade Opportunity?
On Monday, November 9, 2020, Bloomberg reported Lowe’s was in preliminary talks to buy building products distributor HD Supply (ticker: HDS). While this news initially popped HDS stock 16% (into the $50s) in after-hours trading, Lowe’s would quickly deny the rumor, and the market would erase much of the pop.
This isn’t an investment recommendation, but the price reaction (or lack thereof) caught my attention and after some thought I think there’s an interesting (albeit highly speculative) event-driven trade opportunity here.
Specifically, I believe the Bloomberg story signals HD Supply is seriously evaluating strategic alternatives (regardless of interest by Lowe’s), and the stock isn’t appropriately pricing in the possibility a transaction may happen sooner rather than later.
If you’re considering this trade (please do your own homework), I would anticipate “pay off” (if it were to happen) to occur within ~30 days.
30-Day Window to Evaluate Strategic Alternatives
HD Supply’s management and Board have some significant decisions to make over the next ~30 days:
HDS reports fiscal Q3 results in early December (~30 days), and there’s an expectation the company will announce their specific plans for deploying the $2.5 billion in cash they received selling their Construction & Industrial business to Clayton, Dubilier & Rice (announced August 11, 2020 and completed October 19, 2020).
Before committing to any material return of capital to shareholders or significant changes to capital structure, HDS has a window to evaluate strategic alternatives and assess buyer interest.
For potential buyers, pursuing a deal now gives the buyer a well capitalized balance sheet to work with before HDS deploys the excess capital. The buyer may have different views on how to deploy the excess cash versus what HDS intends to do as a standalone public company.
For HDS, now is a good time to evaluate strategic alternatives and determine if doing a transaction is a superior risk-adjusted outcome to remaining public. Once the excess cash is deployed, the next opportunity to sell the company may be months - if not years - later, especially if an acquisition is pursued down the road that requires meaningful integration.
With substantial excess capital sitting on the balance sheet, the Board needs to be decisive with the direction they take the company and not strategically hedge. Focus is very important, and trying to dual track strategic decisions is distracting to management and risks a mediocre outcome for shareholders.
I believe the choice is either sell the company now or give management the multi-year runway necessary to focus and thoughtfully allocate the excess capital.
Again, this is all speculation on my part, but conducting a strategic alternatives review aligns nicely with HD Supply finally cleaning up the company (via divestitures) and activist directors entering the “exit” stage of their engagement.
Frankly, if the Board isn’t reviewing strategic alternatives right now, they should be.
Interesting Risk-Reward
If you believe the Board is “on the clock” to make a decision on strategic alternatives before deploying $2.5 billion in cash, the risk-reward is interesting:
If there are serious buyers/compelling bids, the company publicly announces a strategic alternatives review within the next ~30 days which pushes the stock back into the $50s. The company could also potentially announce a deal.
If there aren’t serious buyers/compelling bids, the company (expectedly) announces a significant buyback to return excess capital to shareholders which offers downside price support.
Also, the current stock price (in my opinion) isn’t pricing in strategic alternatives (thanks to Lowe’s quick denial) which helps mitigate downside tied to “no deal” disappointment. If the stock remained elevated in the high $40s, low $50s following the Bloomberg article, I probably wouldn’t have written this note.
The company could defer on a major buyback and not announce strategic alternatives, but that would (in my opinion) effectively signal the company is in an ongoing process.
Given the timing of the Bloomberg report, I lean towards the company having serious buyer interest and is considering a deal over remaining public. In my opinion, that story doesn’t come out unless the company has legitimate acquisition interest and is looking to escalate prospective bids/interest as the sales process moves along in earnest.
HD Supply’s Long History of Strategic Alternatives
For those not familiar with HD Supply’s history, the company and this CEO is no stranger to strategic alternatives.
The company was originally founded in 1974 as Maintenance Warehouse and acquired by Home Depot in 1997 who would change the company’s name to HD Supply in 2004.
In 2007, shortly after activist fund Relational Investors joined Home Depot’s Board and pushed to company to re-focus on the retail business, Home Depot sold HD Supply to private equity buyers.
The timing was unfortunate as the financial crisis soon hit, but the company survived the daunting challenge and returned to public markets in 2013.
HD Supply’s public market tenure to-date has essentially been a sequence of divestitures to clean up the business:
2014: Sold Hardware Solutions business to Home Depot
2015: Sold Power Solutions business to Anixter for $825 million
2016: Sold Interior Business Solutions business to Interior Specialists
Fast forward to late 2016 and HD Supply would see activist fund Jana Partners escalate their involvement in the company:
In September [2016], HD Supply issued downbeat earnings and revenue forecasts for its quarter as it reported preliminary sales for August were flat in its facilities-maintenance segment.
Jana said in regulatory filings that it believes the shares are undervalued and represent an attractive investment opportunity and that it held discussions with company management over potential strategic alternatives and financial and operational means of increasing shareholder value.
Activist activity would continue to persist in 2017, leading to Lauren Taylor Wolfe of Blue Harbour (now Impactive Capital) joining the Board in March 2017 and Scott Ostfeld of Jana Partners joining the Board in September 2017. Both remain directors at the company.
In 2017, the company would continue divesting businesses and sold HD Supply Waterworks (rebranded as Core & Main) to Clayton, Dubilier & Rice for $2.5 billion:
Core & Main was acquired from HD Supply for $2.5 billion, leaving HD Supply with two business units — Facilities Maintenance, and Construction & Industrial - White Cap. The sale followed the company's two other divestments over the past two years of Interior Solutions in 2016, and Power Solutions in 2015.
In September 2019, the company would announce their intention to separate the Facilities Maintenance and Construction & Industrial businesses into two independent publicly traded companies through a spin-off, but would subsequently change plans and announce in August 2020 they were selling the Construction & Industrial business to Clayton, Dubilier & Rice for $2.9 billion.
It’s been a long journey of divestitures for HD Supply, and the company is now at point where they can focus solely on operating the Facilities Maintenance business which is arguably the crown jewel of HD Supply’s once expansive business portfolio.
When Home Depot sold HD Supply back in 2007, Facilities Maintenance was a business Home Depot wanted to retain but needed to include to make the deal happen:
Because Facilities Maintenance is considered a wonderful business with a lot of financial and strategic value, it would (in my opinion) attract many interested suitors if HD Supply decided to sell itself.
I think that’s the current question being answered by the Board and management.
Should HD Supply (i.e. Facilities Maintenance) be a standalone public company or should they sell themselves?
Cleaned Up Business + Exiting Activists = Sell Company?
If you were to ask long time watchers/investors of HD Supply what they thought about the company, I think most would tell you the end game was tied to the Facilities Maintenance business. Clean things up, divest non-core businesses, and set the company up to finally sell the Facilities Maintenance business.
I suspect that was Jana Partners’ “North Star” when they joined the Board in 2017.
Back in 2017, there was already plenty of chatter that HD Supply was a major acquisition target:
William Blair analyst Ryan Merkel believes Lowe's (LOW) acquisition of Maintenance Supply Headquarters could set up a potential bidding war for HD Supply Holdings (HDS). Maintenance Supply is the number three player in maintenance, repair and operations supplies, well behind HD Supply and Home Depot's (HD) Interline Brands, Merkel tells investors in a research note. He continues to believe that either Lowe's or Home Depot could be a strategic acquirer of HD Supply. The analyst's bull case values HD Supply at $52 per share. The stock in afternoon trading is up 63c to $40.14.
The challenge was buyers weren’t exactly enthusiastic about acquiring HD Supply’s entire business portfolio (for the price HDS would want to sell everything), and it has taken years to clean things up business-by-business.
Now that HD Supply is down to the Facilities Maintenance business, I’d say activist directors Lauren Taylor Wolfe and Scott Ostfeld are in the “exit” stage of their engagement.
Three years on the Board is typically more than enough time to complete most/all of the key agenda items you’d expect an activist to pursue here. I suspect both are now seriously thinking about transitioning out of the stock and the Board.
The last lever left remaining is to either sell the company or sell shares into a buyback.
From a portfolio returns perspective, I’m sure both directors would prefer a year-end deal and are highly incentivized to advocate strategic alternatives if there is strong interest from buyers offering acceptable takeout offers.
Signaling Strategic Alternatives Through the Media
Putting it all together, the timing of Bloomberg reporting makes a lot of sense:
HDS completed their Construction & Industrial divestiture to Clayton, Dubilier & Rice (CDR) in October 2020 and are flush with cash.
If the Board was considering strategic alternatives, it would make sense to start it after the October quarter and Presidential election. See who is interested in early November and decide by mid November whether or not the company should seriously pursue a deal.
I’m sure CDR inquired about acquiring the Facilities Maintenance business when they discussed acquiring the Construction & Industrial business, and I would not be surprised if HD Supply already has a decent list of serious buyers.
The Bloomberg article serves as a signal boost. Following the release of the story, you have to believe any-and-all parties remotely interested in doing a deal called HD Supply “just in case” there was a process happening.
While we don’t know who the source was for the Bloomberg article, I tend to trust Bloomberg’s judgement on this kind of reporting, and believe they wouldn’t run a story like this unless there was a quality source involved. And if there was a quality source involved, I don’t think that source would tip the story to Bloomberg unless HD Supply was ok with it.
Remember, Lowe’s was quick to deny the report when it came out, but we don’t see a similar disavowal from HD Supply. Silence says a lot and really does make me think HD Supply is more than ok with this story being out there.
It certainly doesn’t hurt them if they’re indeed running a strategic alternatives process and are serious about doing a transaction.
The next 30 days should be interesting.
[Premium Unlocked] Maintaining All Options
Nice work Mike. Congrats!
Nailed it Mike! Great work on HDS.