OVERVIEW OF THE DEAL
On Monday the 16th of November 2020, Home Depot announced that it has entered a final agreement to acquire HD Supply. The latter would become a fully owned subsidiary of Home Depot, which would buy it for the price of $56 per share. The objective of the acquisition is “to position The Home Depot as a premier provider in the MRO (maintenance, repair, and operations) marketplace” according to Home Depot’s statement.
With this new acquisition, Home Depot affirms its desire to consolidate its place as the largest MRO retailer in the United-States. It had already acquired Interline Brands in 2014 and The Company Store in 2017, two other players in this industry. The acquisition of HD Supply is the next big step in the growth of the two companies as the expected synergies are various. This deal will therefore create a better leader firm in the MRO industry, which presents high growth potential after the end of the Covid-19 crisis.
As mentioned by Joe DeAngelo, Chairman and CEO of HD Supply, the added value for the client is the stated goal of this strategic operation “We look forward to working together to deliver the safest, most dependable and innovative customer experience to the living space maintenance professional”
Company Details: Acquirer – Home Depot
Home Depot is the world’s first retailer in the MRO (maintenance, repair, and operations) industry. It is present mostly in the US (almost 2000 stores), but also in Canada (180 stores) and in Mexico (120 stores). The company has suffered from the Covid-19 crisis and the shutdown, but it has quickly recovered, and its stock price is now higher than it was before the crisis. Home Depot is held at 29.5% by top holders, including The Vanguard Group (7.96%), SSgA Fund Management (4.78%) and Blackrock (4.51%).
Company Details: Target – HD Supply
HD Supply is a US industrial distribution company operating in the MRO market – maintenance, repair, and overhaul. Its activity is ventilated into two large segments: Facilities Maintenance (50.9% of sales) and Construction & Industrial (49.1%). The first segment provides to institutional, healthcare and hospitalities facilities with MRO products and manufactures custom products on demand. Its large scope of products includes electrical devices, plumbing material, ventilating items and various appliances and accessories for kitchens, bathrooms and living room. The second segment focuses on the distribution of materials and facilities for industries and home-building companies.
Its business model is characterized by a centre-based distribution, hence a strong concentration in the North American market, almost in the US (97.4%), and Canada (2.6%). The development of the e-commerce distribution canal is part of the main objectives stated by the company, as it is increasingly challenged by Amazon in the supply of MRO products.
HD Supply is almost exclusively held by top institutional shareholders – only 0.82% of individual investors -, including Fidelity Management & Research (13.3%), The Vanguard Group (9%), Fiduciary Management (5.3%), and The Baupost Group (4.2%).
SYNERGIES
Targeted synergies
Clearly Home Depot expects some synergies from the deal. Indeed, Home Depot expects that the integration of acquired companies into their organization will provide anticipated synergies and benefits of those acquisitions. The growth opportunity in the MRO segment is pointed out by Craig Menear, The Home Depot’s CEO: “the MRO customer is highly valued by The Home Depot, and this acquisition will position the company to accelerate sales growth by better serving both existing and new customers in a highly fragmented $55 billion marketplace”.
Craig Menear also added that this acquisition will allow the company to strengthen its global position in the US and Canada while penetrating a new complementary segment : “HD Supply complements our existing MRO business with a robust product offering and value-added service capabilities, an experienced salesforce that enhances the strong team we have in place, as well as an extensive, MRO-specific distribution network throughout the U.S. and Canada”.
Synergies analysis
Positive synergy effects are to be expected. Indeed, we think that the activities of the two firms complement each other and will allow the new entity to generate both cost and revenue synergies. Gordon Haskett Research Advisors analyst Chuck Grom estimates that the deal could result in $100mn recurring run rate synergies.
On the cost side of synergies, HD Supply’s large distribution scale will allow the new entity to reduce product distribution costs and earn excess returns. Its North American distribution network and the technology they have developed through the years thanks to its e-commerce platform will be a great cost advantage that will prevent other smaller businesses from entering the market and competing. Home Depot already entered the MRO in 2015 with the acquisition of Interline Brands Inc, a large national distributor of broad-line MRO products and facilities maintenance in North America. However, HD supply offers a much larger network of distribution centers and delivery drivers.
This merger allows the two firms to diversify into complementary fields. This pooling of techniques and knowledge is generally a source of value. Cross-selling can cause the creation of economies of scope as Home Depot and HD supply provide a high number of complementary goods and services : the two companies can create new complementary offers taking into account both HD Supply's activity (infrastructure, maintenance, etc.) and Home Depot's activity (appliances, decoration, etc.). Due to broader product assortment, the new entity will have a stronger brand image and a higher customer retention rate which will create revenue synergies.
Finally, both management teams anticipate post-Covid 19 positive trends on the MRO market. HD Supply is forecasted to have $3 billion in sales for the current fiscal year, 2.4% of Home Depot’s estimated sales. Even if the deal is small compared to HD’s base retail, the new MRO branch might help in offsetting the decline of the demand for “Stay at home products” that could occur when the pandemic will be over. The new maintenance services offered by the group in an expected fast-growing market after the pandemic will allow the whole group to benefit from stable cash flow generation.
RISKS AND UNCERTAINTIES
The increasing market share of Amazon in the industrial distribution sector is believed to have drastic effects on many incumbent distributors that might be forced to exit the market due to their lower economies of scale. However, it might be hard for amazon to replicate HD Supply's product expertise and high-touch service offerings. Furthermore, well established distributors that are serving a market niche have usually been able to fend off new entrants quite well.
The rising consolidation and disintermediation in the MRO industry is likely to increase customer and supplier bargaining power. This could have a negative impact on HD Supply's profitability. However, we think HD Supply has a relatively diverse customer and supplier base that damps bargaining power. HD Supply has approximately 500,000 customers, and the top 10 account for about 13% of consolidated sales. The company has 7,000 suppliers and seeks multiple vendors for each of the products it carries. The Home Depot company, due to this deal, will also help reinforce and consolidate HD Supply’s customer base.
FINANCIAL CONSEQUENCES
As the merger is an all-cash deal, meaning that The Home Depot will not issue new shares in order to acquire HD Supply, the control of the acquirer over the target company will be more important since it is a much bigger company, with a market capitalization more than four times higher. The Home Depot will be granted a stronger power over the decision making of the new entity and its shareholders control, despite a slight decline, will remain great. On the opposite, HD Supply former shareholders will see their control on the company drop significantly after the merger with The Home Depot. For example, The Home Depot major shareholders like The Vanguard Group that owns 7,8% of the company and BlackRock (6,7%) will still have a great influence over the new group whereas firms like Fiduciary Management and The Baupost Group which respectively own 5,3% and 4,2% of HD Supply will be diluted. It is interesting to notice that The Vanguard Group and BlackRock are also major shareholders of HD Supply (they own respectively an 8.81% and a 3.93% stake of the company), which is not a surprise considering the fact that the company used to be a subsidiary of The Home Depot. But it means that the control of both The Vanguard Group and BlackRock on the new entity created by the merger between The Home Depot and HD Supply will be unchanged, or even bigger.
Moreover, in terms of leverage, The Home Depot will not benefit from this operation, yet it is not an issue. Indeed, as the buyout of HD Supply is an all-cash deal, The Home Depot’s debt level will naturally increase. The firm has a current net debt to EBITDA ratio of 1.62x; it is due to the fact that it generates a lot of cash. For instance, in 2019, Home Depot’s cash flows from operating activities were about $14 billion (exactly $13,72B). The company’s cash and equivalents are also important, evaluated at $2,13 billion in 2019. So, with the acquisition of HD Supply (net debt to EBITDA of 2,37x), The Home Depot will reach a ratio of 2.12x, which remains quite low. Consequently, because of the amount of cash that The Home Depot generates and possesses as reserves, the deal payment structure will not shake investor’s trust all the more since rating agencies are really confident in the company’s future performances. Besides, a few days ago, Fitch affirmed The Home Depot's IDR (Issuer Default Rating) at A following proposed HD Supply acquisition.
Furthermore, The Home Depot will benefit from an earnings per share accretion as the new entity with HD Supply should have an EPS of $11.07, which represents a 5.98% increase to the company’s current EPS of $10.44. This projection is based on the $76.4 million post-tax synergies that should be generated by the deal according to Gordon Haskett Research Advisors. According to our estimations, the deal would still be accretive if synergies were equal to zero with a new EPS of $10.99.
IS THIS DEAL FAIRLY PRICED?
The tender offer, including the 25% premium paid on HD SUPPLY’s equity value, added to the $2.012bn net financial debt, leads to a total enterprise value of $11.084bn for the target company. Considering the $849mn LTM EBITDA of HD SUPPLY, the final EV/EBITDA transaction multiple is worth 13.1x. Both premium and transaction multiple seem to be in line with past transactions in the home building sector. Indeed, the $9.3bn merger between Lennar Corp and CalAtlantic Group in 2018, was made on the basis of a 13.1x EV/EBITDA and a 27% premium. This past transaction is quite similar as the one that we are studying as the target company CalAtlantic operates in the home building market - part of the MRO segment - in the US and Canada.
Let us now compare the market value of synergies and the premium paid. As a reminder, the deal should be considered as profitable for Home Depot as long as the premium paid does not exceed the market value of synergies estimated. The 25% premium corresponds to $1.815bn in value. The amount of synergies estimated has not been publicly released by either company. Yet, our analysis will be based on quantitative estimates from Gordon Haskett Research Advisors analyst Chuck Grom. He thinks that the deal could result in $100mn synergies, coming from the expansion of its customer base especially among lucrative professional contractors. We decided to select a range of HD Supply’s peers operating in the US and Canadian MRO market, in order to determine a relevant multiple to asset the market value of synergies. We chose the following companies: Fastenal Co, MSC Industrial Direct Co, Watsco, Home Depot, Grainger, W W Grainger and Wesco International. The average daily time series EV/EBITDA multiple of these companies, data provided by Reuters, as of close 11/19/20, is worth 17.7x. Applying this multiple to the $100mn synergies leads to a market value of synergies equal to $1.77bn, which is quite consistent with the $1.815bn premium. Thus, this deal seems to be fairly valued, based on data we have.
PROBABILITY OF DEAL COMPLETION
This deal between HD Supply and Home Depot is very likely to be achieved. Indeed, comments from both CEOs clearly suggests that the deal is “friendly”, all the more so as the deal seems to be fairly priced as we have seen before. Given the historical good relations between the two groups - taking into account that this deal is a “buy-back”, since HD Supply has already been a subsidiary of Home Depot -, the deal appears to be well under way.
The stock market reaction after the announcement of the acquisition is also strongly unequivocal. HD Supply’s stock jumped 24.5% on the 16th of November trading day, just 0.5% less than the 25% premium announced. It means that traders anticipate a deal completion shortly, leaving very little space for merger arbitrage opportunities as it is commonly the case for more uncertain and complex deals.
Hector de Vergeron, Dongho Shin, Philippe Cardinaletti, Ethan Stofize & Leo Clément