HD Supply Holdings, Inc. (HDS) Q2 2018 Earnings Conference Call Transcript

HD Supply Holdings, Inc. (HDS)
Q2 2018 Earnings Conference Call
September 5, 2018, 8:00 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good day, ladies and gentlemen, and welcome to HD Supply's second quarter 2018 earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session and instructions will be provided at that time. If anyone should require operator assistance during today's conference, please press * then 0 on your touchstone telephone. And as a reminder, this conference is being recorded for replay purposes.

I'd now like to turn the call over to Charlotte McLaughlin, Investor Relations. Please go ahead.

Charlotte McLaughlin -- Senior Manager of Investor Relations 

Thank you, James. Good morning, ladies and gentlemen, and welcome to the HD Supply Holdings 2018 second quarter earnings call. A copy of the earnings press release and presentation can be found on the investor relations tab of the company's website, at www.hdsupply.com.

Joe DeAngelo, our CEO, will lead today's call and provide an overview of our 2018 second quarter, as well as comment on our recent execution and outlook. Following Joe's remarks, Evan Levitt, our CFO, will provide an overview of the main areas of interest from the investment community, before going into detail on the 2018 second quarter performance, comment on monthly sales, and provide guidance for the third quarter and full year of 2018.

We will then conduct a Q&A and conclude with Joe's closing remarks. Please note that some of the information you'll hear in today's discussion will include forward-looking statements within the meaning of the Federal Securities Laws. Forward-looking statements are based on management's beliefs and assumptions and information currently available to management, which are subject to known and unknown risks and uncertainties, many of which may be beyond our control.

We caution you that the forward-looking information presented is not a guarantee of future results and that actual results may differ materially from those made in or suggested by the forward-looking information contained in this presentation. For more information, please refer to our risk factors discussed in our earnings report on Form 10-K for the fiscal year ending January 28th, 2018 and those described from time to time in our and HD Supply, Inc.'s other filings with the SEC. Any forward-looking information presented is made only as of the date of this presentation and we do not undertake any obligation to update or revise any forward-looking information.

This presentation contains certain non-GAAP financial metrics. For reconciliation of such metrics to the nearest GAAP metrics and other supplemental information, please see our earnings press release and refer to the appendix of the earnings call presentations. For Q&A, please limit your remarks to one question and one follow-up if necessary. We want to provide an opportunity for as many people as possible to ask a question within our allocated 60 minutes. We appreciate your cooperation.

Thank you for participating on the call and for your continued interest in HD Supply. With that, I will now turn over the call to Joe DeAngelo.

Joseph DeAngelo -- Chairman and Chief Executive Officer

Well, thank you, Charlotte. Good morning, everyone. Thank you for joining us today for our 2018 second quarter earnings call. As always, it is my privilege to share our company's results with you on behalf of the over 11,000 HD Supply associates who work hard every day as one team driving customer success and value creation.

I am proud of the team's second quarter performance. We have continued to build on our momentum from earlier in the year, delivering 18.3% sales growth for the second quarter of Fiscal 2018, 10.1% sales growth on an organic basis. As we highlight on page three of the presentation, we delivered 18.3% adjusted EBITDA growth and 54.7% adjusted net income per diluted share growth versus prior year.

We continue to generate strong free cashflow and delivered $401 million on a trailing 12-month basis. We continue to expect to deliver about $500 million of free cashflow for the full year of Fiscal 2018.

Overall, our second quarter sales and earnings came in above our expectations against an unpredictable macroeconomic backdrop. I am pleased that our facilities maintenance business has continued its mid-single-digit growth, as we see ongoing benefits from our investments designed to make our business easy, accurate, and helpful. Our construction and industrial business continues to grow at a double-digit rate and we continue to see strong construction activity, including many large, multi-year projects across our 15 priority districts. In both businesses, we will continue to focus on what we can control to deliver on our customer and shareholder promises.

The company saw an overall drop in gross margin of 100 basis points versus prior year, primarily due to a charge in the mix of our business with the recent A.H. Harris acquisition and the double-digit organic growth of our construction and industrial business, as well as mix changes within each business.

Rebar continues to pressure our gross margin rate within construction and industrial. As we previously discussed, a late spring shifted lower margin sales from the first quarter into the second quarter within our facilities maintenance business. Evan will provide more detail on gross margins.

The A.H. Harris integration is progressing extremely well. We continue to be pleased with the results from this acquisition and we are slightly ahead of our originally planned integration schedule. We expect to complete the integration by the end of Fiscal 2018. Expected synergies are on track and we are beginning to see the benefits from the integration of our sales and support teams, enhanced sourcing capability, and combined branch networks.

I couldn't be more pleased with the enthusiasm and hard work of the associates working to complete this integration. We continue to execute our second $500 million share repurchase program, announced in August of 2017. We have repurchased approximately $3.5 million shares at an average price of $37.23 per share through August 31st under this program. Evan will provide more detail around this shortly. We remain committed to opportunistically deploying capital to the highest return investments available. This includes acquisitions, share repurchases, and continued investment in our businesses.

We will remain focused on growing our business organically while also identifying opportunities to consolidate in markets that remain highly fragmented. We will be disciplined at identifying potential accretive acquisitions for both facilities maintenance and construction and industrial in an effort to maximize shareholder return and cultural fit.

Talent continues to be our most fundamental differentiator. We recently held our first investor day in our Atlanta Leadership Development Center on June 21st. I was proud to showcase our talent to our investors and sell side analysts. We hope that you enjoyed the event as much as the team did. I would encourage anyone who was unable to attend the event in Atlanta to review the investor day documents that are published on the investor relations section of our website.

We continue to be proud of the performance of each of the 11,000 HD Supply associates who work hard every day to deliver on our promises to our customers, fellow associates, and shareholders.

I'll provide some closing comments following Q&A but I will now turn the call over to Evan for a review of topics of recent investor interest and an overview of our financial performance.

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

Thank you, Joe, and good morning, everyone. As we normally do on page four, we highlight areas of recent investor focus and share with you our latest perspective on these topics.

First, the tariff impact on rebar -- we have seen the impact of various tariffs on imported rebar throughout 2017 and into 2018. The impact of these tariffs has dramatically increased the cost of rebar. During the second quarter and first half of 2018, we've successful adjusted our pricing to recover the year over year increase in the cost of rebar.

However, in order to ensure that we provide value to our customers, we have not raised prices sufficient to maintain our rebar gross margin rate. Therefore, we are earning the same or slightly higher gross margin dollars on our rebar sales, but we are continuing to see gross margin rate compression. During the second quarter of 2018, rebar compressed our overall construction and industrial gross margins by approximately 40 basis points.

Next, proprietary brands -- we primarily source our proprietary plans from Asia with about three-quarters of it coming from China. Proprietary brands account for around 17% of facilities maintenance sales. The current tariffs being charged on Chinese products do not have a significant impact on our sourcing.

Freight costs -- similar to many of our peers, we've seen an increase in third-party freight costs. We've been able to mitigate some of the impact of increasing freight costs through productivity enhancements stemming from investments within our supply chain. Additionally, we operate our own fleet for customer delivery, which enables us to more effectively manage our outbound freight costs and leverage our freight costs per unit as we deliver more to our existing customers.

Inflation -- there has been concern regarding an increase in inflationary pressures, including tariffs, freight and fuel, and labor costs. Like others, we are seeing these inflationary pressures. As always, we do our best to offset inflation through our category management initiatives, productivity, and leverage of fixed costs as we go. This enables us to continue to provide compelling value to our customers. We do, however, expect to pass on unavoidable cost increases as market prices rise.

The non-residential construction end market -- we focus our construction and industrial business on supporting 15 priority districts, which comprise 15 of the largest MSAs across North America that we believe have the ability to generate strong construction activity for many years. We are currently seeing strong activity across all priority districts.

Last year, we spoke of a gap in large, multi-year construction projects, as a number of large projects reached completion. Since last year, we've seen that gap fill with the start of several large new construction projects that will continue for multiple years. We estimate the overall market continues to grow in the low to mid-single-digits, which is a favorable environment for HD Supply.

Now, turning to page five, I'll cover our second quarter results. We delivered sales of $1.6 billion, an increase of $248 million or 18.3% over the second quarter of 2017. Our organic sales in that period increased 10.1% over the second quarter of 2017. Gross profit increased $83 million or 15.4% to $622 million.

Our gross margin rate of 38.9% was down 100 basis points from the second quarter of 2017. Of that, approximately 40 basis points is attributable to the acquisition of A.H. Harris. The double-digit organic growth rate of our construction and industrial business creates additional gross margin mix headwinds, as does the mix of business within each of our segments, which I will detail shortly.

Our selling, general, and administrative costs were up $46 million or 13.6% over the second quarter of 2017. As a percentage of sales, selling general and administrative costs were 24%, a decrease of 100 basis points from the second quarter of 2017.

Adjusted EBITDA for the second quarter of 2018 was $246 million, up $38 million or 18.3%. Adjusted net income for the second quarter was $182 million, up $55 million or 43.3% compared with the second quarter of 2017. This represents adjusted net income per diluted share of $0.99 compared to adjusted net income per diluted share of $0.64 in the second quarter of 2017.

The increase in adjusted net income and adjusted net income per diluted share reflects improved operating performance, the reduction in our interest expense from improvements in our capital structure, and a reduction in weighted average shares outstanding. There are $184 million diluted weighted average shares outstanding during the second quarter of 2018. I will now discuss the specific performance of our individual business units on page six.

Net sales for our facilities maintenance business were $820 million during the second quarter of 2018, up $51 million or 6.6% from the second quarter of 2017. We estimate that the MRO market grew approximately 1% to 2% in the second quarter of 2018. Facilities maintenance gross margins declined approximately 50 basis points from a difficult comparison in 2017.

As we expected, we saw a shift in lower margin business from the first quarter of 2018 to the second quarter of 2018 as a result of the late start to the warmer spring weather. Specifically, our property improvement business grew double-digits in the second quarter and within the property improvement business, we did more installation work than normal, further compressing gross margins.

Also pressuring margins, HVAC had a strong second quarter after a slow start to the year. On a year to date basis, our facilities maintenance gross margin rate is up approximately 30 basis points from Fiscal 2017. We continue to expect facilities maintenance gross margin rate to be flat to slightly up for the full year of 2018.

Facilities maintenance's adjusted EBITDA for the second quarter of 2018 was $150 million, an increase of $5 million or 3.4% from the second quarter of 2017. Net sales for our construction and industrial business were $781 million during the second quarter of 2018, up $197 million or 33.7%. On an organic basis, excluding the sales of the recently acquired A.H. Harris, our construction and industrial business grew 14.7%. We estimate the overall market was up approximately 6% for the quarter.

Construction and industrial gross margins decreased approximately 60 basis points. Approximately 30 basis points of the decline was due to the mix associated with the acquisition of A.H. Harris. An additional 40 basis points of decline is from the reduction in gross margin rate of rebar.

As I indicated previously, we have recovered all of the year over year tariff-related cost increase through price, but we have not charged an additional markup on this cost increase. Therefore, we earn the same or slightly higher gross margin dollars on each unit we sell, but we do see some compression in rebar gross margin rate.

We also continue to see a shift toward larger jobs, which tend to have larger gross margin rates associated with them. Our construction and industrial team performed well, executing on category management initiatives to offset some of these margin pressures. Construction and industrial's adjusted EBITDA for the second quarter was $96 million, up $33 million or 52.4%.

Turning to page seven, as of the end of the second quarter of 2018, our remaining gross federal net operating loss carry forwards approximated $495 million. On a tax effective basis, our federal and state net operating loss carry forwards were approximately $161 million, representing the majority of our net-deferred tax assets. We expect these net operating losses carry forwards and various tax credits to continue to reduce the amount of cash taxes we pay going forward through the middle of 2019.

During the second quarter of 2018, we paid cash taxes of approximately $3 million, primarily US state and Canadian taxes. We expect we will pay cash taxes of approximately $10 million to $12 million during the full year of Fiscal 2018. We expect our GAAP tax rate to be approximately 25% to 26% in Fiscal 2018.

Over the last 12 months, we generated $401 million of free cashflow. During Fiscal 2018, we expect to generate approximately $500 million of free cashflow. Our capital allocation strategy remains the same. We will opportunistically deploy capital to the most attractive return opportunities available. These include organic investments in the business, tuck-in acquisitions, and a return of cash to shareholders, currently through our existing share repurchase authorization.

Through August 31st, 2018, we have purchased 3.5 million shares of HD Supply stock for an average price of $37.23 or a total of approximately $129 million under our second $500 million share repurchase authorization announced in August of 2017. We have approximately $371 million remaining under this authorization. We expect to continuously opportunistically purchase shares of HD Supply stock through open market purchases under our 10b5-1 plan based on market conditions.

Including the completion of our initial $500 million share repurchase authorization, we have purchased a total of 19.4 million shares of HD Supply stock for an average price of $32.41 or a total of approximately $629 million. Through these share repurchase programs, we have reduced our outstanding share count by nearly 10% since the first quarter of 2017.

As of the end of the second quarter, our net debt to adjusted EBITDA leverage is 2.4 times within our targeted range of 2.3 times. We invested $28 million in capital expenditures in the second quarter of 2018.

On page eight, we provide second quarter 2018 monthly sales trend performance as well as the 2017 comparable. In May of 2018, we delivered sales of $488 million, an increase in average daily sales of approximately 18.7% versus May of 2017. Organic sales growth in the same period was 10.6%. In June 2018, we delivered sales of $486 million, an increase in average daily sales of approximately 18.7% versus June 2017. Organic sales growth in the same period was 10.4%.

In July of 2018, we delivered sales of $626 million, an increase in average daily sales of approximately 17.8% versus July of 2017. Organic sales growth in the same period was 9.7%. In both years, there were 20 selling days in May, 19 selling days in June, and 24 selling days in July.

August 2018, the first month of our fiscal third quarter of 2018 ended on August 26th. So, we can provide our preliminary sales results. We will not comment on August results beyond sales. There were 20 selling days in both August 2018 and August 2017. August sales were approximately $513 million, which represents average daily sales growth of approximately 17.7% versus 2017.

Organic sales growth for August was 10.2%. Average daily sales growth versus prior year by business was approximately 33.1% for construction in industrial and approximately 6% for facilities maintenance. Construction and industrial's organic sales growth for August was approximately 15.7%.

On page nine, we share a perspective on our third quarter 2018 guidance. For our third quarter 2018, we anticipate net sales to be in the range of $1.56 billion and $1.61 billion, adjusted EBITDA in the range of $239 million and $249 million, and adjusted net income per diluted share in the range of $0.95 and $1.00.

Our adjusted net income per diluted share range assumes a fully diluted weighted average share count of approximately 184 million. At the midpoint of the ranges, our third quarter net sales and adjusted EBITDA translate into approximately 16% growth and approximately 14% growth, respectively. On an organic basis, the midpoint of our third quarter 2018 sales range represents growth of approximately 8%.

On page 10, we update our guidance walk for the full year. We are raising our 2018 guidance of net sales to now be in the range of $5.9 billion to $6 billion. Adjusted EBITDA is now expected to be in the range of $845 million to $870 million. Adjusted net income per diluted share in the range of $3.22 to $3.35, which does not include any additional incremental share repurchases for the remainder of 2018.

Our adjusted net income per diluted share range assumes a fully diluted weighted average share count of approximately 184 ml. At the midpoint of the ranges, our full-year net sales and adjusted EBITDA translate into approximately 16% growth and 17% growth, respectively. Guidance for both the third quarter 2018 and full-year 2018 includes our best thinking around the timing and scope of tariffs and other inflationary pressures.

On page 11, we reiterate our end market outlook for 2018. As previously shared, we believe the MRO market will continue to grow approximately 1% to 2%. We expect the non-residential construction end market to grow low to mid-single-digits and the residential construction market will continue to grow approximately mid-single-digits. These specific end market estimates imply an approximately 3% end market growth estimate for HD Supply's end markets in 2018.

On page 12, we summarize and consolidate our third quarter and Fiscal Year 2018 outlook views. To summarize, the teams are intensely executing across the company and are focused on achieving our financial and operational goals.

I'd like to thank you for your continued interest in HD Supply. James, we are now ready to take some questions.

Questions and Answers:

Operator

Excellent. Ladies and gentlemen, if you'd like to ask a question at this time, please press * then 1 on your touchstone telephone. If your question has been answered or you wish to remove yourself from the queue, you may press the # key. Once again, to ask a question that is * then 1.

Our first question comes from Ryan Merkel with William Blair. Your line is now open.

Ryan Merkel -- William Blair -- Analyst

Hey, good morning, guys. Nice quarter. So, I want to start with some clarification questions on the FM business. If I heard you right, Evan, it sounds like there was a gross margin in timing shift from 1Q, which was kind of driving why the EBITDA margin in FM was down year over year. Is that right?

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

That's right. The slow start to the spring weather shifted some of our HVAC sales from the first quarter to the second quarter. We also had a very strong property improvement business. As you know, property improvement is an area of growth for the company, but it is slightly lower gross margins. Then we had our normal mix headwinds with the hospitality business growing slightly faster than the core business as well.

Ryan Merkel -- William Blair -- Analyst

And then as we get into the fiscal third quarter, should we be getting back to normalized operating leverage in FM at that 1.2-1.3 range or do the margins still kind of stay weak into the third quarter?

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

The mix pressures that we saw in the second quarter we are seeing continue in the third quarter. We still have a strong HVAC business here in the third quarter. Property improvement is growing well, as is the hospitality business. So, we will continue to see some of these margin pressures in the third quarter and that is reflected in our guidance.

Ryan Merkel -- William Blair -- Analyst

Alright. Got it. So, temper operating leverage in the FM business and then the C&I business continues strong and sort of makes up.

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

That's right. We're confident over the cycle we delivered about that 1.5 times operating leverage on the core growth of 300 basis points in excess of market. We do want to make sure that we don't let that operating leverage metric prevent us from growing faster than 300 basis points in excess of market because in many cases, that additional growth is in lower margin business but still profitable business. In any given quarter, obviously, we have a variation as we see the mix of the business evolve and some of the inflationary pressures that we talked about.

Ryan Merkel -- William Blair -- Analyst

Got it. Just lastly, August organic growth up 10%, it's very strong. Guidance sort of implies a moderation in September and October. Can you guys clarify for us -- is that just tough comparisons versus any kind of slowdown in demand? Is the moderation going to happen both in FM and C&I at the same time?

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

That is primarily because of difficult comparisons. Beginning in the month of September, we lapped the double-digit organic growth rates of construction and industrial. So, those comparisons get more difficult. So, that slowdown that's implied in the guidance is primarily in the construction and industrial.

Ryan Merkel -- William Blair -- Analyst

Got it. Thanks so much.

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

Thank you.

Operator

Thank you. Our next question comes from Evelyn Chow with Goldman Sachs. Your line is now open.

Evelyn Chow -- Goldman Sachs -- Analyst

Good morning, guys. Maybe just a quick question first on non-res -- so, you have been sounding increasingly positive on the end market. You noted there were several multi-year projects you could potentially benefit from. Help us think about the potential addition to your growth rate over the next few years and also the mix of projects, what that entails for your profitability.

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

Yeah. So, Evelyn, we always commit to 300 basis points of growth in excess of market, then we operate as hard as we can to deliver growth in excess of that. The construction and industrial team has done a fabulous job over the last 12 months in executing on that. We've now essentially had four quarters of double-digit organic growth. So, real strong performance by the construction and industrial business.

We'll continue to work hard to execute and deliver at that level, but our commitment is 300 basis points faster than the market. In terms of the mix of projects, large projects are great because they give us confidence in projecting out more than a couple of quarters. We do see good activity in large projects, but we are lapping some pretty difficult numbers starting here in the third quarter.

Evelyn Chow -- Goldman Sachs -- Analyst

Got it. That makes sense, Evan. Then maybe just turning to your slide four where you noted some of your topics of recent interest. I know on the rebar side of things, you're saying that what you're getting now from price doesn't quite make doesn't quite make up the same GM rate as you used to get. Is that sort of a similar picture for the rest of how price and inflation works across the other pieces of your portfolio?

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

That's the way we are looking at it and we're expecting. When we look at potential tariffs that are being discussed by the administration, these are pretty significant increases in cost on certain products that these tariffs would imply. If you think about a 25% tariff, if you pass along that 25% cost increase to your customer, that's one thing. In order to maintain your gross margin rate, you'd need to pass on an increase more likely of 35% to 40% to maintain your gross margin rate, essentially passing on a markup on the tariff. I don't think that is realistic.

Evelyn Chow -- Goldman Sachs -- Analyst

That makes sense. Then maybe last question from me -- I know at the analyst day you mentioned the possibility you might take on some actions related to your debt. Can you refresh us on your thinking of that?

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

Yeah. So, we've got $1 billion of senior notes that become callable in April of 2019. The current interest rate on that debt is 5.75%. The rate does rise to 7% in April of 2019. So, we are incentivized to do something with that debt between now and April of 2019. But we look at it as an opportunistic refinancing opportunity. So, we continue to monitor the markets. You may see us yet enter the credit markets in the balance of the year to refinance that debt prior to April of 2019 with the intent of lowering the rate from 5.75% to something less than that and avoid the step up to 7%.

Evelyn Chow -- Goldman Sachs -- Analyst

Great. I'll get back in queue.

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

Thanks, Evelyn.

Joseph DeAngelo -- Chairman and Chief Executive Officer

Thank you.

Operator

Thank you. Our next question comes from Ronnie Weiss with Barclays. Your line is open.

Ronald Weiss -- Barclays Capital -- Analyst

Hey, good morning, guys. Just going back to the mix for a second, I wondered if you could quantify how big the impact was to both business for FM and the large projects on C&I.

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

So, for FM, both the property improvement business and the HVAC business were growing about double-digits relative to the core business, obviously growing in total about 6%, so absent property improvement and HVAC, a little less than that. So, it was a significant mix issue for property improvement and HVAC. Similar for hospitality -- we normally see hospitality grow faster than the core business. So, that's not new, but it is a gross margin mix headwind that we regularly face.

I'll point out within property improvement, we had an increase in the amount of installations that we did this year versus last year. So, the installation work that labor is particularly lower margin activity that we do. The installation business was up significantly even within property improvement.

On the construction and industrial side, we don't specifically disclose our mix of large projects versus small projects, but this is a trend that we've seen over the last year. It hasn't meaningfully changed that trend.

Ronald Weiss -- Barclays Capital -- Analyst

Got it. In FM, I'm just trying to boil down to what else may have weighed on the margin Q2. I guess was the full decline year on year due to the mix or was there some -- I guess the second part of that question is on the $12 million of investments, how much have you spent year to date and kind of what that was in Q2 as well.

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

So, we are still spending about $3 million a quarter on those investments. That continued in the second quarter. The gross margin rate decline in facilities maintenance was entirely from mix, the property improvement business, the HVAC business, primarily.

Ronald Weiss -- Barclays Capital -- Analyst

Got it. Thanks, guys.

Operator

Thank you. Our next question comes from Ryan Cieslak with Northcoast Research. Your line is now open.

Ryan Cieslak -- Northcoast Research -- Analyst

Hey, good morning, guys. I guess the first question -- you guys called our freight as being certainly a cost headwind. It seems like that's happening for most distributors and most companies right now. Can you just dissect that a little bit as it relates to how that impacted the second quarter for you versus the first? Is it mostly related to your third-party costs? Are you seeing some inflation as well with some of your drivers for your internal fleet as well?

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

Yeah. That's a good question, Ryan. So, certainly, we do see some increase in cost in what I'll call freight in. That's the freight to deliver the product to its first HD Supply facility. That freight in cost is included in our gross margin. That's the pressure within the gross margin rate in both businesses. The freight out is primarily on our own trucks.

So, these are the deliveries to our customers. We do see some inflation in freight out related to fuel and related to driver wage rates as well as third-party carriers that we use, to a lesser extent. At cost, the freight out cost is included in our SG&A. So, we do not include freight out in gross margin. That's included in selling, general, and administrative expenses and is creating some pressure there.

But we do see pressure in both areas. We work hard to mitigate as much of that as we can through the supply chain initiatives that we've undertaken, driving tighter routes on deliveries than some of the logistics investments we've made and by delivering more to existing customers because the more we deliver to an existing customer, the more we can put on a truck that's running the same number of miles, the lower the cost per unit of that delivery.

Ryan Cieslak -- Northcoast Research -- Analyst

Okay. Appreciate the color there. And then for my follow-up, the FM segment organic growth, really good to see that sustaining, again, 400-500 basis points above market into August, certainly with a more difficult comp. It looks like the underlying trend within that business is continuing to move higher.

Is there anything -- you called out HVAC sales being seasonably strong or maybe some of that coming into the second from the first and maybe even less and some into August -- is there anything that's one-time in nature that maybe suggests that underlying trend starts to plateau into the back-half of this year or do you still think there's a lot of momentum in this business to maybe take it even higher?

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

I don't know if I would characterize any of it as one-time. Certainly, those mix issues hit us particularly hard this quarter. As I indicated, some of that mix issue we're going to see again in the third quarter. That's not necessarily bad. It means we're growing share in those categories and we do want to grow share in those categories and in those businesses. It's up to us as a team to sell the full basket to maintain margins and to, again, pass on cost increases to the extent they're unavoidable. So, I wouldn't characterize it as one-time, but it was a particularly difficult quarter from a mix standpoint.

Joseph DeAngelo -- Chairman and Chief Executive Officer

I would say that our service model is out there winning and all of our investments are targeted in how do we make that service model win more.

Ryan Cieslak -- Northcoast Research -- Analyst

Okay. Fair enough. I'll go back in queue. Thanks, guys.

Operator

Thank you. Our next question comes from Patrick Baumann with J.P. Morgan. Your line is now open.

Patrick Baumann -- J.P. Morgan -- Analyst

Hey, guys. Thanks for taking my question. Following up on Ryan's question earlier, on the FM gross margins, they're up, I guess you said 30 basis points year to date and you noted expectation has it flat to slightly higher for the year. I'm just curious how we think about overall operating leverage for the business this year in the context of that gross margin guidance.

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

So, within the earnings deck -- I believe it's on page ten -- we've walked forward our earnings guidance for the year starting with the 1.5 times operating leverage on the core business and then we layer in the one-time items or events that impact us here in Fiscal 2018, including the raising of guidance that we did at the end of the first quarter and at the end of the second quarter here.

So, for total company, we still do expect the 1.5 times operating leverage on the core growth with those one-time items. The facilities maintenance business, again, right now is being impacted a bit by mix, but we're confident in that business that it's 1.5 operating leverage business on core growth through the second.

Patrick Baumann -- J.P. Morgan -- Analyst

Okay. Makes sense. You noted no impact on proprietary brands from the current tariffs. I just wanted to clarify whether this includes the proposed lists as well and if not, have you analyzed the potential impacts from any of that stuff.

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

Yeah. Good question. Good clarification opportunity on that one. We've seen very minimal impact on the current tariffs on the $50 billion of products that are currently in place. The additional $200 billion that's being proposed and is open to public comment is open to public comment through tomorrow and then the President will make his decision. Those tariffs will have an impact on our sourcing. It's a little early to say how much. Again, even when we see those tariffs, it's our job to offset as much of it as we can, but our expectation is that the unavoidable cost increase will be passed on.

Patrick Baumann -- J.P. Morgan -- Analyst

Got it. Okay. Thank you.

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

Patrick, I'll just add one more point on that. Our best thinking on that is currently reflected in both our third quarter and full-year guidance.

Patrick Baumann -- J.P. Morgan -- Analyst

What is your best thinking on that? Have you quantified it? Is there kind of a number you've dialed in for inflationary pressures related to that $200 billion?

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

Yeah. Without seeing what it is yet, I'm not comfortable sharing that. It's a pretty wide range.

Operator

Our next question comes from Deane Dray with RBC Capital Markets. Your line is now open.

Deane Dray -- RBC Capital Markets -- Managing Director

Thank you. Good morning, everyone. Just to circle back on SG&A came in lower versus expectations -- you addressed it in your earlier comments, but what was driving that? Just like when you gave the expectation about the freight out, that would be adding to SG&A. So, I just was surprised to see it coming in lower this quarter.

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

You're right. The freight out pressure was in SG&A that we offset. We did a real nice job of leveraging fixed costs. The business grew 10% organically. It gives us an opportunity to leverage those fixed costs. Particularly at construction and industrial growing organically in the low to mid-teens gives you an opportunity to really leverage. That's the key to the business model. That's the key to our ability to generate operating leverage.

Deane Dray -- RBC Capital Markets -- Managing Director

Okay. That's helpful. Then on A.H. Harris, you said the integration is going well. You're ahead of plan. Can you share with us a bit about more clarity on this 40-basis point hit to margins? How much of that is the mix and what specifically is it about their mix. Might there still be some inefficiencies in the business in how it's being integrated and just hasn't yet reflected in the profit improvement there? How do we look at that 40 basis points at this stage?

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

Certainly, the A.H. Harris business has a mix issue for all of HD supply given that its margin rates are more similar to our construction business than the facilities maintenance business. But then even within construction and industrial, it creates mix issues at the gross margin level. We do get some benefit in SG&A. So, when you asked about the SG&A rate leveraging those fixed costs in SG&A, we also do get a little bit of benefit from the A.H. Harris mix. They tend to have lower gross margin and lower SG&A rate.

Some of that is just the nature of the business. The Kenseal business that we acquired as part of A.H. Harris, that's the waterproofing and sealant business. That product generally has lower gross margins but then also has lower SG&A associated with.

Deane Dray -- RBC Capital Markets -- Managing Director

Just to clarify, how much of that 40 basis points would be addressed through the integration efforts reducing redundant expenses and so forth?

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

Yeah. Certainly, there is some benefit in densing out the Northeast, where in the past, we were inefficient in the Northeast from the perspective that we didn't have a lot of density. When you do have density in a region in distribution, your SG&A rate goes down significantly because you can run your deliveries with full trucks and shorter routes. So, we're not prepared to share the specifics in terms of how much we save in the SG&A rate, but we are starting to see some of that and there is more to come.

Deane Dray -- RBC Capital Markets -- Managing Director

Got it. Thank you.

Operator

Thank you. Our next question comes from David Manthey with Baird. Your line is now open.

David Manthey -- Robert W. Baird & Co. -- Managing Director

Hi, good morning, everyone. First of all, assuming when you talk about mix within segments related to PI and HVAC timing, I assume that should normalize. Are you implying that FM and overall gross margins should uptick slightly from the second quarter to the third quarter then?

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

Yeah. So, David, what I shared is we are continuing to see a strong HVAC and PI business into the third quarter. So, I do expect those gross margins -- that gross margin pressure that we saw in the second quarter to ease. But we still do have significant mix issues in the third quarter.

David Manthey -- Robert W. Baird & Co. -- Managing Director

Okay. I assume obviously A.H. Harris will remain constant and C&I, if that continues to be strong, will have a downward effect as well.

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

Right. The A. H. Harris business, again, is dilutive to gross margin for C&I, but not necessarily dilutive to EBITDA margin and C&I.

David Manthey -- Robert W. Baird & Co. -- Managing Director

Okay. And then thinking a little bit longer term, as you look out over the next two or three years or more, is there a point at which you'll have to adjust your 1.5 times operating leverage expectation? What I mean by that is should we assume that as the reported margins of the company rise, contribution margins will have a diminishing leverage effect at some point? I'm just wondering in terms of messaging how you plan on approaching that topic as we get out there.

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

Your point is a relevant point, that the further you go on and the longer and higher we raise our EBITDA margins, the more difficult it is to maintain the 1.5 times operating leverage. But we do believe we can maintain that level of profitability on core growth. Again, the core growth being market growth plus 300 basis points of outgrowth.

Additional outgrowth beyond that likely will be in businesses that could have lower gross margins and lower EBITDA margins. Now, still profitable, still adding to earnings, still adding to cashflow, but could put pressure on an overall 1.5 times operating leverage rate.

David Manthey -- Robert W. Baird & Co. -- Managing Director

Okay. Alright.

Joseph DeAngelo -- Chairman and Chief Executive Officer

I think the key is here that we're going to focus 100% on how we have consistent through the cycle double-digit earnings-per-share growth. That's what you solve for from an operating perspective. You don't constrain yourself in terms of how you operate the business. Every business decision grows earnings per share.

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

That's a big point. We talk a lot about operating leveraging on these calls, but I'll tell you, we certainly look at operating leverage when we set our targets, but once those targets are set, the teams are focused on beating their earnings number, beating sales, beating earnings, beating cashflow. That's what they're driving toward. They're not really driving toward an operating leverage number after the target is set.

David Manthey -- Robert W. Baird & Co. -- Managing Director

That's helpful perspective. Thank you.

Operator

Thank you. Our next question comes from Keith Hughes with SunTrust. Your line is now open.

Keith Hughes -- SunTrust Robinson Humphrey -- Managing Director

Thank you. Just a question on [inaudible]...

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

Good morning, Keith?

Keith Hughes -- SunTrust Robinson Humphrey -- Managing Director

Yes, can you hear me?

Operator

Mr. Hughes, you sound a little distant.

Keith Hughes -- SunTrust Robinson Humphrey -- Managing Director

Sorry. Is that better?

Operator

Yes, sir.

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

We can hear you.

Keith Hughes -- SunTrust Robinson Humphrey -- Managing Director

Okay. Sorry about that. My question is on rebar prices. In the last 30 days or so, there are some rebar indices that have kind of come off here in price. I just wanted to see if you've seen that in your business. When prices, as they will, eventually fall, how quickly will that flow through the income statement at C&I?

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

Yeah. So, changes in rebar price flow through pretty quickly. We turn rebar particularly quickly. We normally keep about 30 days of supply of rebar on hand. In some cases, we expand that to about 60 days to ensure that we can meet some of these larger projects that our customers are working on. So, it does flow through quickly.

I will say in terms of the rebar markets themselves. They are volatile. We've seen periods over the last year where rebar prices have pulled back a little bit. Actually, we were hopefully each time that occurred that we'd see a more normalization or at least a stabilization of rebar prices. But each time, we've been disappointed and rebar has increased again. So, we'll see if we do get some stabilization. If we get stabilization of the rebar market, that would certainly be a good thing, but we're comfortable operating in any environment.

Like I shared, the team has done a nice job now in being able to pass on the year over year cost increase. So, while it does contribute more to the topline growth, we don't necessarily earn a significant amount more in gross margin dollars, but we're not earning any less. So, we get a little bit of topline growth, similar profitability. That was driving some of the outgrowth at C&I. The outgrowth or the organic growth of C&I was close to 15%. Absent rebar, it was closer to 12%.

Keith Hughes -- SunTrust Robinson Humphrey -- Managing Director

Thank you.

Operator

Thank you. Our next question comes from Hamzah Mazari with Macquarie Capital. Your line is now open.

Hamzah Mazari -- Macquarie Group -- Analyst

Good morning. Thank you. My first question is just on tariffs. I know you gave a lot of color on current tariffs and rebar and sort of how you've baked it into guidance on the incremental $200 billion. My question is specifically sort of how fungible is your supply chain on the proprietary product side.

If the incremental $2 billion of tariffs does hit, how much of a lag is there from tariffs increasing your cost base to when you can pass it through. I know you don't give detail on national account contracts, but given how your contracts are structured, what's the lag on the pass through and then just the supply chain, any comments around that too? Thank you.

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

Yeah. Hamzah, those are great questions. So, first, on the supply chain, as I said, we produce about 75% of our proprietary branded product in China. We don't have any permanent investments in China. So, we could look to source that product in other countries. To do so does take some time. Obviously, there is a little bit of disruption in doing so. So, you don't do so without significant thought. It would take a period of months. It's not weeks. It's months. But it could be done in many cases.

In terms of the timing of when the tariffs on the $200 billion of imports hits and then when we would see it, there is certainly a lag in terms of when those tariffs are placed on the product and when it hits our DCs. Now, when the tariffs go into place, we would pay the duty when it hits our shore on the West Coast.

So, you're talking a few weeks at most before it's hitting our distribution centers. Then obviously, we've got our existing inventory, which we turn generally four to five times a year. That cost would start flowing through potentially the latter half of the third quarter, more so the fourth quarter of 2019.

Now, on the domestic side, it's harder for us to say as to when domestic manufacturers or, I should say, domestic suppliers that we buy from who may be importing from China, how that flows through. We could potentially see that sooner.

Hamzah Mazari -- Macquarie Group -- Analyst

Great. That's very helpful color. And then my follow-up question is just around pricing -- I know you mentioned pricing is in line with the market, but anymore color as to sort of do you view the market pricing as rational or do you view market pricing as more than covering inflationary costs at this stage in the cycle or do you view market pricing as still has room to go versus prior cycles when demand has been solid, inflation is in the system and your suppliers are raising price? So, just any color around pricing -- I know you don't specifically quantify price.

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

Yeah. We are seeing some rational activity within the markets on pricing. So, it is our expectation that we will be able to pass on unavoidable inflationary costs, be it from tariffs or otherwise. That being said, as I shared with Evelyn on her question, when you've got a very significant increase in price or in cost, passing on that cost gives you some additional topline growth, protects your gross margin and your profitability, does compress your gross margin and EBITDA margin rates. Depending on the level of tariffs we see and the level of cost increase we see in the marketplace, that may be the case, but it is our expectation to pass on cost.

Hamzah Mazari -- Macquarie Group -- Analyst

Great. Thanks a lot.

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

Thank you.

Operator

Thank you. That concludes our question and answer session. So, I'd like to turn it back over to Mr. DeAngelo for concluding remarks.

Joseph DeAngelo -- Chairman and Chief Executive Officer

Great. Thank you for your questions. In summary, on page 14, the team is focused and energized to continue to deliver on our customer, associate, and shareholder promises. Thank you for your continued support and interest in HD Supply.

Operator

Thank you. Ladies and gentlemen, that does conclude today's conference. Thank you very much for your participation. You may all disconnect. Have a wonderful day.

Duration: 56 minutes

Call participants:

Charlotte McLaughlin -- Senior Manager of Investor Relations 

Joseph DeAngelo -- Chairman and Chief Executive Officer

Evan Levitt -- Senior Vice President, Chief Financial Officer, and Chief Administrative Officer

Ryan Merkel -- William Blair -- Analyst

Evelyn Chow -- Goldman Sachs -- Analyst

Ronald Weiss -- Barclays Capital -- Analyst

Ryan Cieslak -- Northcoast Research -- Analyst

Patrick Baumann -- J.P. Morgan -- Analyst

Deane Dray -- RBC Capital Markets -- Managing Director

David Manthey -- Robert W. Baird & Co. -- Managing Director

Keith Hughes -- SunTrust Robinson Humphrey -- Managing Director

Hamzah Mazari -- Macquarie Group -- Analyst

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