Attached files

file filename
EX-10.6 - LETTER AGREEMENT - HD SUPPLY, INC.dex106.htm
EX-10.7 - NOTICE OF CONSENT - HD SUPPLY, INC.dex107.htm
EX-10.4 - AMEND. NO 3 TO CREDIT AGREEMENT - HD SUPPLY, INC.dex104.htm
EX-10.5 - CONSENT TO AMENDMENT TO CREDIT AGREEMENT - HD SUPPLY, INC.dex105.htm
EX-10.12 - LIMITED CONSENT AND AMENDMENT NO.3 TO ABL CREDIT AGREEMENT - HD SUPPLY, INC.dex1012.htm
EX-10.53 - LETTER OF EMPLOYMENT - HD SUPPLY, INC.dex1053.htm
EX-10.54 - FORM OF STOCK OPTION AGREEMENT - HD SUPPLY, INC.dex1054.htm
EX-32.2 - CERTIFICATION PURSUANT TO SECTION 906 - HD SUPPLY, INC.dex322.htm
EX-21.1 - SUBSIDIARIES OF THE REGISTRANT - HD SUPPLY, INC.dex211.htm
EX-31.2 - CERTIFICATION PURSUANT TO RULE 13A-14(A) - HD SUPPLY, INC.dex312.htm
EX-31.1 - CERTIFICATION PURSUANT TO RULE 13A-14(A) - HD SUPPLY, INC.dex311.htm
EX-23.1 - CONSENT OF KPMG LLP - HD SUPPLY, INC.dex231.htm
EX-10.57 - LETTER OF CONTINUED EMPLOYMENT - HD SUPPLY, INC.dex1057.htm
EX-10.56 - LETTER OF CONTINUED EMPLOYMENT - HD SUPPLY, INC.dex1056.htm
EX-10.55 - LETTER OF CONTINUED EMPLOYMENT - HD SUPPLY, INC.dex1055.htm
EX-32.1 - CERTIFICATION PURSUANT TO SECTION 906 - HD SUPPLY, INC.dex321.htm
EX-12.1 - COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES - HD SUPPLY, INC.dex121.htm
Table of Contents
Index to Financial Statements

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended January 31, 2010

- or -

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transaction period from                  to                 

Commission File number: 333-159809

HD SUPPLY, INC.

(Exact name of registrant as specified in its charter)

 

Delaware   75-2007383

(State or other jurisdiction of

incorporation or organization)

  (I.R.S. Employer Identification Number)

3100 Cumberland Boulevard, Suite 1480,

Atlanta, Georgia

(Address of principal executive offices)

 

30339

(Zip Code)

(770) 852-9000

(Registrant’s telephone number, including area code)

 

(Former name, former address and former fiscal year, if changed since last report)

Securities registered pursuant to Section 12 (b) of the Act:

 

Debt securities issued by HD Supply, Inc.

12.0% Senior Notes due 2014

13.5% Senior Subordinated PIK Notes due 2015

 

New York Stock Exchange

 

(Title of each class)   (Name of each exchange on which registered)

Securities registered pursuant to Section 12 (g) of the Act:

 

None

(Title of Class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    ¨  Yes    x  No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    ¨  Yes    x  No

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    x  Yes    ¨  No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  ¨  Yes    ¨  No

Indicate by check mark if disclosure of delinquent filers in response to Item 405 of Regulation S-K (§229.405) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.      x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  ¨        Accelerated filer  ¨        Non-accelerated filer  x       Smaller reporting company  ¨

(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    ¨  Yes    x  No

As of April 9, 2010, there were 1,000 shares of common stock of HD Supply, Inc. outstanding.

 

 

 

 


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Index to Financial Statements

INDEX TO FORM 10-K

 

          Page
   Background Information and Glossary of Certain Defined Terms    1
   Forward-looking statements and information    2
Part I      
Item 1.    Business    4
Item 1A.    Risk Factors    9
Item 2.    Properties    27
Item 3.    Legal Proceedings    28
Part II      
Item 6.    Selected Financial Data    29
Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations    34
Item 7A.    Quantitative and Qualitative Disclosures about Market Risk    69
Item 8.    Financial Statements and Supplementary Data    70
Item 9A(T).    Controls and Procedures    118
Part III      
Item 10.    Directors, Executive Officers and Corporate Governance    119
Item 11.    Executive Compensation    125
Item 12.    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters    138
Item 13.    Certain Relationships and Related Transactions, and Director Independence    141
Item 14.    Principal Accounting Fees and Services    143
Part IV      
Item 15.    Exhibits and Financial Statement Schedules    144
Signatures       152


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Index to Financial Statements

Background Information and Glossary of Certain Defined Terms

The Transactions

On August 30, 2007, investment funds associated with Bain Capital Partners, LLC, The Carlyle Group and Clayton, Dubilier & Rice, Inc. (collectively, the “Equity Sponsors”) formed HDS Investment Holding, Inc. (“Holding”) and entered into a stock purchase agreement with The Home Depot, Inc. (“Home Depot” or “THD”) pursuant to which Home Depot agreed to sell to Holding or to a wholly owned subsidiary of Holding certain intellectual property and all the outstanding common stock of HD Supply, Inc. and the Canadian subsidiary CND Holdings, Inc. On August 30, 2007, through a series of transactions, Holding’s direct wholly owned subsidiary, HDS Holding Corporation, acquired direct control of HD Supply through the merger of its wholly owned subsidiary, HDS Acquisition Corp., with and into HD Supply (the “Company”). Through these transactions (the “Transactions”), Home Depot was paid cash of $8.2 billion and 12.5% of Holding’s common stock worth $325 million for certain intellectual property and all of the outstanding common stock of HD Supply and CND Holdings, Inc., including all dividends and interest payable associated with those shares. During the first quarter of fiscal 2009, the Company received $22 million from Home Depot for the working capital adjustment and settlement of other items finalizing the purchase price of the Transactions.

Description of Indebtedness

In connection with the Transactions, the Company entered into a senior secured credit facility (the “Senior Secured Credit Facility”) comprised of a $1 billion term loan (the “Term Loan”) and a $300 million revolving credit facility (the “Revolving Credit Facility”). The Senior Secured Credit Facility was amended in March 2010. Under the amendment, the maturity date of approximately $873 million of the Term Loan was extended from August 30, 2012 to April 1, 2014. On the date of the amendment, we also agreed to prepay $30 million of the Term Loan.

Also, in connection with the Transaction, the Company entered into a $2.1 billion asset based lending credit agreement (the “ABL Credit Facility”) subject to borrowing base limitations, a portion of which may be used for letters of credit or swing-line loans. The Company amended the ABL Credit Facility in March 2010 to, among other things, (i) convert approximately $214 million of commitments under the ABL Credit Facility into a term loan (the “ABL Term Loan”), (ii) extend the maturity date of approximately $1,537 million of the commitments from August 30, 2012 to April 1, 2014, and (iii) reduce the total commitments under the facility by approximately $45 million. Giving effect to the amendment, the ABL Credit Facility is comprised of the $1,841 million asset based revolving credit facility (the “ABL Revolving Credit Facility”) and the $214 million ABL Term Loan.

We refer to the Senior Secured Credit Facility and the ABL Credit Facility as our “Senior Credit Facilities.”

In connection with the Transactions, Home Depot agreed to guarantee our payment obligations for principal and interest under the Term Loan under the Senior Secured Credit Facility (“THD Guarantee”). The THD Guarantee, among other things, restricts our ability to incur secured debt and pay dividends. Home Depot extended the THD Guarantee in connection with the March 2010 amendments to our Senior Secured Credit Facility and our ABL Credit Facility and agreed to the prospective extension of the remaining $104 million of the Term Loan. In addition, in connection with the amendments we agreed that, while the THD Guarantee is outstanding, the Company would not voluntarily repurchase our outstanding notes, directly or indirectly, without Home Depot’s prior written consent, subject to certain exceptions.

The Company issued $2.5 billion of Senior Notes bearing interest at a rate of 12.0% (the “12.0% Senior Notes”) and $1.3 billion of Senior Subordinated Notes bearing interest at a rate of 13.5% (the “13.5% Senior Subordinated Notes”) in connection with the Transactions. During first quarter 2009, we repurchased $252 million principal amount, plus accrued interest of $15 million, of the 13.5% Senior Subordinated Notes due 2015 for $62 million.

Our Senior Credit Facilities, the THD Guarantee, the 12% Senior Notes and the 13.5% Senior Subordinated Notes are discussed in greater detail under “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources – External Financing.”

 

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Glossary of Other Terms

 

ASC    Accounting Standards Codification
Canada    HD Supply Canada
CTI    Creative Touch Interiors
DCF    Discounted cash flow
DOT    U.S. Department of Transportation
Exchange Act    Securities Exchange Act of 1934
Fiscal 2008    Fiscal year ended February 1, 2009
Fiscal 2009    Fiscal year ended January 31, 2010
Fiscal 2010    Fiscal year ending January 30, 2011
Gross margin    Gross profit as a percentage of net sales
HDPE    High-density polyethylene
IPVF    Industrial Pipe, Valves and Fittings
MRO    Maintenance, repair and operations
NOLs    Net operating losses
PIK    Paid-in-kind
Predecessor 2007    Predecessor period from January 29, 2007 to August 29, 2007
Pro forma 2007    Period from January 29, 2007 to February 3, 2008
PVC    Polyvinyl chlorides
SKU    Stock-keeping unit
SFAS    Statement of Financial Accounting Standard
Successor 2007    Successor period from August 30, 2007 to February 3, 2008
U.S. GAAP    Generally accepted accounting principles in the United States of America
SEC    U.S. Securities and Exchange Commission
Vendor rebates    Vendors providing for inventory purchase rebates

Forward-looking statements and information

This annual report on Form 10-K includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Some of the forward-looking statements can be identified by the use of forward-looking terms such as “believes,” “expects,” “may,” “will,” “should,” “could,” “seeks,” “intends,” “plans,” “estimates,” “anticipates” or other comparable terms. These forward-looking statements include all matters that are not historical facts. They appear in a number of places throughout this report and include statements regarding our intentions, beliefs or current expectations concerning, among other things, our results of operations, financial condition, liquidity, prospects, growth strategies and the industries in which we operate.

Forward-looking statements are subject to known and unknown risks and uncertainties, many of which may be beyond our control. We caution you that forward-looking statements are not guarantees of future performance and that our actual results of operations, financial condition and liquidity, and the development of the industries in which we operate may differ materially from those made in or suggested by the forward-looking statements contained in this report. In addition, even if our results of operations, financial condition and liquidity, and the development of the industries in which we operate are consistent with the forward-looking statements contained in this report, those results or developments may not be indicative of results or developments in subsequent periods. A number of important factors could cause actual results to differ materially from those contained in or implied by the forward-looking statements, including those reflected in forward-looking statements relating to our operations and business, the risks and uncertainties discussed in this annual report on Form 10-K (See “Risk Factors”) and those described from time to time in our other filings with the U.S. Securities and Exchange Commission. Factors that could cause actual results to differ from those reflected in forward-looking statements relating to our operations and business include:

 

   

Inherent risks of the residential, non-residential and public infrastructure construction and facility maintenance and repair markets;

 

   

Wind down of the emergency actions of the U.S. government, the U.S. Treasury, Federal Reserve and other governmental and regulatory bodies;

 

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Our ability to achieve profitability;

 

   

Our ability to service our debt and to refinance all or a portion of our indebtedness;

 

   

Our substantial indebtedness and our ability to incur additional indebtedness;

 

   

Limitations and restrictions in the agreements governing our indebtedness;

 

   

Our ability to obtain additional financing on acceptable terms;

 

   

Increases in interest rates;

 

   

Rating agency actions with respect to our indebtedness;

 

   

The interests of the Equity Sponsors;

 

   

Changes in our business as a result of the Transactions;

 

   

The competitive environment in which we operate and demand for our products and services in highly competitive and fragmented industries;

 

   

Goodwill and other impairment charges;

 

   

Our obligations under long-term, non-cancelable leases;

 

   

Consolidation among our competitors;

 

   

The loss of any of our significant customers;

 

   

Failure to collect monies owed from customers, including on credit sales;

 

   

Competitive pricing pressure from our customers;

 

   

Variability in our revenues and earnings;

 

   

Cyclicality and seasonality of the residential, non-residential and infrastructure construction and facility maintenance and repair markets;

 

   

Fluctuations in commodity and energy prices;

 

   

Our ability to identify and develop relationships with a sufficient number of qualified suppliers and to maintain our supply chains;

 

   

Our ability to manage fixed costs;

 

   

Changes in our product mix;

 

   

The impairment of financial institutions;

 

   

The development of alternatives to distributors in the supply chain;

 

   

Our ability to manage our product purchasing and customer credit policies;

 

   

Inclement weather, anti-terrorism measures and other disruptions to the transportation network;

 

   

Interruptions in the proper functioning of information technology (“IT”) systems;

 

   

Our ability to implement our technology initiatives;

 

   

Changes in U.S. federal, state or local regulations;

 

   

Exposure to construction defect and product liability claims and other legal proceedings;

 

   

Potential material liabilities under our self-insured programs;

 

   

Our ability to attract, retain and retrain highly qualified associates and key personnel;

 

   

Fluctuations in foreign currency exchange rates;

 

   

Inability to protect our intellectual property rights;

 

   

Significant costs related to compliance with environmental, health and safety regulations, including new climate change legislation;

 

   

Our ability to achieve and maintain effective disclosure controls and internal control over our financial reporting; and

 

   

Increased costs related to our becoming an SEC registrant.

You should read this annual report on Form 10-K completely and with the understanding that actual future results may be materially different from expectations. All forward-looking statements made in this report are

 

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qualified by these cautionary statements. These forward-looking statements are made only as of the date of this annual report on Form 10-K, and we do not undertake any obligation, other than as may be required by law, to update or revise any forward-looking statements to reflect changes in assumptions, the occurrence of unanticipated events, changes in future operating results over time or otherwise. Comparisons of results for current and any prior periods are not intended to express any future trends or indications of future performance, unless expressed as such, and should only be viewed as historical data.

PART I

ITEM 1.  BUSINESS

HD Supply, Inc. (“HD Supply” or the “Company”) is one of the largest wholesale distributors based on sales serving the highly fragmented U.S. and Canadian Infrastructure & Energy, Maintenance, Repair & Improvement and Specialty Construction market sectors. Through approximately 800 locations across the United States and Canada, we operate a diverse portfolio of distribution businesses that provide over 1 million stock-keeping units (“SKUs”) to over 450,000 professional customers, including contractors, government entities, maintenance professionals, home builders and industrial businesses. Our Company is organized in three distinct market sectors, each of which offers different products and services to the end customer.

Our history

In March 1997, The Home Depot, Inc. (“Home Depot”), our former parent, acquired Maintenance Warehouse / America Corp., a Texas corporation organized on January 26, 1985, and a leading direct marketer of maintenance, repair and operations (“MRO”) products to the hospitality and multifamily housing markets. Since 1997, our business has grown rapidly, primarily through the acquisition of more than 40 businesses. We changed our name to HD Supply, Inc. on January 1, 2007 and converted to a Delaware corporation on August 31, 2007.

From fiscal 2000 to fiscal 2004, we extended our presence into new categories while growing existing businesses through 10 acquisitions. New businesses included plumbing and HVAC (through the acquisition of Apex Supply), flooring products and installation (Floors Inc., Floor Works, Arvada Hardwood Floor Co.) and specialty hardware, tools and materials for construction contractors (White Cap).

Growth at existing businesses was driven organically and through “tuck-in” acquisitions, expanding our presence in the MRO segment (N-E Thing Supply, Economy Maintenance Supply) and flooring and design services for professional homebuilders (Creative Touch Interiors). In fiscal 2005, we accelerated the pace of consolidation by acquiring 18 businesses, the largest of which was National Waterworks, a leading distributor of products used to build, repair and maintain water and wastewater transmission systems. In fiscal 2006, we transformed our business with the acquisition of Hughes Supply, which doubled our Net sales and further established our market leadership in a number of our largest businesses, which we supplemented with 11 other strategic acquisitions.

In 2007, through a series of transactions (the “Transactions”), investment funds associated with Bain Capital Partners LLC, The Carlyle Group and Clayton, Dubilier & Rice, Inc. (the “Equity Sponsors”) formed HDS Investment Holding, Inc. and purchased HD Supply from Home Depot. In connection with the Transactions, Home Depot obtained a 12.5% interest in the common stock of HDS Investment Holding, Inc.

Since 2007, we have focused on extending our presence in key growth sectors and exiting unattractive sectors. In February 2008, we sold our Lumber and Building Materials operations to ProBuild Holdings. In June 2009, we purchased substantially all of the assets of ORCO Construction Supply, the second largest construction materials distributor in the U.S., through our White Cap business.

Our sectors

Through ten wholesale distribution companies in the U.S. and a Canadian operation, we provide products and services to professional customers in the Infrastructure & Energy, Maintenance, Repair & Improvement and Specialty Construction market sectors. Most of our businesses operate in markets with a high degree of customer and supplier fragmentation, which typically demand a high level of service and availability of a broad set of complex products from a large number of suppliers. These factors drive the importance of the distributor within the value chain and create barriers to entry for suppliers to sell directly to customers.

 

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The following table sets forth the relationship among our three market sectors, our ten businesses and our seven financial reporting segments.

 

Market sector

  

Business

  

Financial reporting segment

    Infrastructure & Energy

  

    Waterworks

 

    Utilities

 

    Industrial Pipe, Valves and Fittings

 

      (“IPVF”)

 

    Electrical

  

    Waterworks

 

    Utilities

 

    IPVF

 

    Other

    Maintenance, Repair &

      Improvement

  

    Facilities Maintenance

 

    Crown Bolt

 

    Repair & Remodel

  

    Facilities Maintenance

 

    Other

 

    Other

    Specialty Construction

  

    White Cap

 

    Plumbing

 

    Creative Touch Interiors (“CTI”)

  

    White Cap

 

    Plumbing

 

    CTI

For segment information, including Net sales, Operating income, Total assets of each financial reporting segment, and financial geographic data see Note 17 to the consolidated financial statements appearing elsewhere in this annual report on Form 10-K.

Customers and suppliers

We maintain a customer base of greater than 450,000 customers, the majority of which represent long-term relationships. Home Depot is our largest customer, accounting for 3.9% of fiscal 2009 Net sales. We are subject to very low customer concentration with no customer, other than Home Depot, representing more than 1% of fiscal 2009 Net sales, reducing our exposure to any single customer.

We have developed relationships with more than 17,000 strategic suppliers, many of which are long-standing relationships. These supplier relationships provide us with reliable access to inventory, volume purchasing benefits and the ability to deliver a diverse product offering on a cost-effective basis. We maintain multiple suppliers for a substantial number of our products, thereby limiting the risk of product shortage for customers.

Competition

We operate in a highly fragmented industry and hold a leading position in multiple sectors. Our national competitors include Wolseley (Ferguson Enterprises), Rexel, Grainger, Wesco, Fastenal, Watsco, Interline, and McJunkin Redman Corporation. The majority of our competitors, however, are mid-size regional distributors and small, local distributors.

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 favorable weather and longer daylight conditions during these periods. Seasonal variations in operating results may also be significantly impacted by inclement weather conditions, such as cold or wet weather, which can delay construction projects.

Infrastructure & Energy market sector

We serve customers in the Infrastructure & Energy market sector by meeting their demand for the critical supplies and services required to support established infrastructure and promote economic growth. The Waterworks, Utilities, IPVF and Electrical businesses serve this sector. Their broad geographic presence, through a regionally organized distribution network of branches, reduces our exposure to economic factors in any single region.

 

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Products

Waterworks: Pipes, fittings, valves, hydrants and meters for use in the construction, maintenance and repair of water and waste-water systems as well as fire-protection systems.

Utilities: Conductors (wire and cable), transformers, overhead transmission and distribution hardware, switches, protective devices and underground distribution and connectors used in the construction or maintenance and repair of electricity transmission and substation distribution infrastructure.

IPVF: Stainless and carbon steel and special alloy pipe, plate, sheet, flanges, fittings, high performance valves and actuators, as well as high-density polyethylene (“HDPE”) pipe and fittings with primary applications in high temperature, high pressure and high corrosion processing environments.

Electrical: Electrical wire and cable, switchgear, supplies, lighting and conduit used in residential and commercial construction.

Maintenance, Repair & Improvement market sector

We serve customers in the Maintenance, Repair & Improvement market sector by delivering supplies and services needed to maintain and upgrade facilities across multiple industries. Our businesses serving customers in this market sector include Facilities Maintenance, Repair & Remodel and Crown Bolt. These businesses are our only non-branch based operating models. Facilities Maintenance and Crown Bolt are distribution center based models, while the Repair & Remodel business is a retail outlet primarily serving cash and carry customers.

Products

Facilities Maintenance: Kitchen and bathroom plumbing products, HVAC, tools and repair materials, appliances, cabinet and drawer hardware, door hardware and locksets, fasteners, lighting, electrical maintenance supplies, safety products, guest amenities, textiles, healthcare maintenance and janitorial supplies for the maintenance, repair and ongoing operations of multifamily, hospitality, healthcare, institutional and commercial properties.

Crown Bolt: Fasteners, builders hardware, rope and chain, audio-visual accessories and plumbing accessories primarily consumed in home improvement, do-it-yourself projects and residential construction.

Repair & Remodel: Lumber, kitchen cabinets, windows, plumbing materials, masonry, electrical equipment, flooring and tools and tool rentals for small remodeling, home improvement and do-it-yourself residential projects.

Specialty Construction market sector

We serve customers in the Specialty Construction market sector by delivering distinct, targeted products and services for commercial, residential and industrial applications. Our businesses serving this market sector include White Cap, Plumbing and Creative Touch Interiors. Their broad geographic presence, through a regionally organized distribution network of branches, reduces our exposure to economic factors in any single region.

Products

White Cap: Tilt-up brace systems, forming and shoring systems, concrete chemicals, hand and power tools, rebar, ladders, safety and fall arrest equipment, specialty screws and fasteners, sealants and adhesives, drainage pipe, geo-synthetics, and erosion and sediment control used broadly across all types of residential and non-residential construction.

Plumbing: Plumbing fixtures, faucets and finishes, HVAC equipment, pipes, valves, fittings and water heaters used in the construction and repair of residential and non-residential properties.

CTI: Flooring, cabinets, countertops and window coverings for the interior finish of residential and non-residential construction projects.

HD Supply Canada

HD Supply Canada (“Canada”) is an industrial wholesale distributor and primarily focuses on servicing specialty lighting, full-line electrical and fasteners/industrial supplies markets. Canada operates across nine provinces in 60 locations, from which it supports a base of approximately 18,000 customers. In the Canadian electrical and

 

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specialty lighting distribution market, Canada competes with other large national players as well as regional distributors. In the fasteners market, Canada’s key competitors are a few large, national players, including Fastenal and Acklands-Grainger, as well as regional competitors.

Operations

Intellectual property

Our trademarks and those of our subsidiaries, certain of which are material to our business, are registered or otherwise legally protected in the United States, Canada and elsewhere. We, together with our subsidiaries, own over 100 federally registered trademarks in the United States. We also rely upon trade secrets and know-how to develop and maintain our competitive position. We protect intellectual property rights through a variety of methods, including trademark, patent, copyright and trade secret laws, in addition to confidentiality agreements with suppliers, employees, consultants and others who have access to our proprietary information. Generally, registered trademarks have a perpetual life, provided that they are renewed on a timely basis and continue to be used properly as trademarks. We intend to maintain our material trademark registrations so long as they remain valuable to our business. We have also registered certain copyrightable works in the United States and have patents, or patent applications pending in the United States and Canada. Other than the trademarks HD Supply (and design), Crown Bolt, National Waterworks (and design), USABluebook and White Cap, we do not believe our business is dependent to a material degree on trademarks, patents, copyrights or trade secrets. Other than commercially available software licenses, we do not believe that any of our licenses to third-party intellectual property are material to our business, taken as a whole. See “Risk factors–If we are unable to protect our intellectual property rights, or we infringe on the intellectual property rights of others, our ability to compete could be negatively impacted.”

Employees

In domestic and international operations, we had approximately 15,000 employees as of January 31, 2010, consisting of approximately 9,400 hourly personnel and 5,900 salaried employees. As of January 31, 2010, less than one percent of our hourly workforce was covered by three separate collective bargaining agreements.

Regulation

Our operations are affected by various statutes, regulations and laws in the markets in which we operate, which historically have not had a material effect on our business. While we are not engaged in a “regulated” industry, we are subject to various laws applicable to businesses generally, including laws affecting land usage, zoning, the environment, health and safety, transportation, labor and employment practices (including pensions), competition, immigration and other matters. Additionally, building codes may affect the products our customers are allowed to use, and consequently, changes in building codes may affect the saleability of our products. The transportation and disposal of many of our products are also subject to federal regulations. The U.S. Department of Transportation (“DOT”) regulates our operations in domestic interstate commerce. We are subject to safety requirements governing interstate operations prescribed by the DOT. Vehicle dimensions and driver hours of service also remain subject to both federal and state regulation. See “Risk factors—Our costs of doing business could increase as a result of changes in U.S. federal, state or local regulations.”

Environmental, health and safety matters

We are subject to a broad range of foreign, federal, state and local environmental, health and safety laws and regulations, including those pertaining to air emissions, water discharges, the handling, disposal and transport of solid and hazardous materials and wastes, the investigation and remediation of contamination and otherwise relating to health and safety and the protection of the environment and natural resources. As our operations, and those of many of the companies we have acquired, to a limited extent involve and have involved the handling, transport and distribution of materials that are or could be classified as toxic or hazardous, there is some risk of contamination and environmental damage inherent in our operations and the products we handle, transport and distribute. Our environmental, health and safety liabilities and obligations may result in significant capital expenditures and other costs, which could negatively impact our business, financial condition and results of operations. We may be fined or penalized by regulators for failing to comply with environmental, health and safety laws and regulations or we may be held responsible for such failures by companies we have acquired. In

 

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addition, contamination resulting from our current or past operations, and those of many of the companies we have acquired, may trigger investigation or remediation obligations, which may have a material adverse effect on our business, financial condition and results of operations.

Available Information

We are subject to the reporting and information requirements of the Exchange Act and, as a result, we file periodic reports and other information with the SEC. In addition, the indentures pursuant to which our 12% Senior Notes and our 13.5% Senior Subordinated Notes are issued require us to distribute to the holders of the notes annual reports containing our financial statements audited by our independent auditors as well as other information, documents and other information we file with the SEC under Sections 13(a) or 15(d) of the Securities Exchange Act of 1934.

The public may read and copy any reports or other information that we file with the SEC. Such filings are available to the public over the internet at the SEC’s website at http://www.sec.gov. The SEC’s website is included in this annual report on Form 10-K as an inactive textual reference only. You may also read and copy any document that we file with the SEC at its public reference room at 100 F Street, N.E., Washington D.C. 20549. You may obtain information on the operation of the public reference room by calling the SEC at 1-800-SEC-0330. You may also obtain a copy of any information that we file with the SEC at no cost by calling us or writing to us at the following address:

HD Supply, Inc.

3100 Cumberland Boulevard, Suite 1480

Atlanta, Georgia 30339

Attn: General Counsel

(770) 852-9000

 

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ITEM 1A.  RISK FACTORS

You should carefully consider the risk factors set forth below as well as the other information included in this annual report on Form 10-K in evaluating our business. The risks described below are not the only risks that we face. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial may also impair our business operations. Any of these risks may have a material adverse effect on our business, financial condition, results of operations and cash flows. In such a case, you may lose all or part of your investment in the securities of the Company.

We are subject to inherent risks of the residential, non-residential and public infrastructure construction and facility maintenance and repair markets, including risks related to general economic conditions.

Demand for our products and services depends to a significant degree on spending in the residential, non-residential and infrastructure construction and facility maintenance and repair markets. The level of activity in these end markets depends on a variety of factors that we cannot control. In the residential construction market these factors include:

 

   

changes in interest rates;

 

   

unemployment;

 

   

unsold new housing inventory;

 

   

periods of economic slowdown or recession;

 

   

availability of mortgage financing (including the impact of recent disruption in the mortgage markets);

 

   

adverse changes in local or regional economic conditions;

 

   

a decrease in the affordability of homes;

 

   

more stringent lending standards for home mortgages;

 

   

local, state and federal government regulation; and

 

   

shifts in populations away from the markets that we serve.

Historically, both new housing starts and residential remodeling decrease in slow economic periods. The level of activity in the nonresidential construction market depends largely on vacancy rates, interest rates, the availability of financing, capital spending, the industrial economic outlook, corporate profitability, capacity utilization, commercial investment and regional and general economic conditions. In addition, residential construction activity can impact the level of non-residential construction activity. In the infrastructure construction market, the level of activity depends largely on interest rates, availability and commitment of public funds for municipal spending and general economic conditions. In the facility maintenance and repair market, the level of activity depends largely on occupancy and vacancy rates within multifamily, hospitality, healthcare and institutional facilities markets. Because all of our markets are sensitive to changes in the economy, downturns (or lack of substantial improvement) in the economy in any region in which we operate have adversely affected and could continue to adversely affect our business, financial condition and results of operations. For example, we distribute many of our products to waterworks contractors in connection with residential, commercial and industrial construction projects. The water and wastewater transmission products industry is affected by changes in economic conditions, including national, regional and local standards in construction activity, and the amount spent by municipalities on waterworks infrastructure. While we operate in many markets in the United States, our business is particularly impacted by changes in the economies of California, Texas and Florida, which represented approximately 15%, 14%, and 10%, respectively, in net sales by branch for fiscal 2009.

In addition, the residential, non-residential and public infrastructure construction and facility maintenance and repair markets in which we compete are sensitive to general business and economic conditions in the United States and worldwide, including availability of credit, interest rates, fluctuations in capital, credit and mortgage markets, and business and consumer confidence. There has been a significant decline in economic growth, both in the U.S. and globally, that began in 2008 and continued through 2009. In addition, volatility and disruption in the capital and credit markets has reached unprecedented levels, with stock markets falling dramatically and credit becoming very expensive or unavailable to many companies without regard to those companies’ underlying financial strength. As a result of these developments, many lenders and institutional investors have reduced, and in some cases, ceased to provide funding to borrowers. Continuing adverse developments in global

 

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financial markets and general business and economic conditions, including through recession, ongoing downturn or otherwise, could continue to have a material adverse effect on business, financial condition, results of operations and cash flows, including our ability and the ability of our customers and suppliers to access capital.

We have been and expect to continue to be adversely impacted by the decline in the new residential construction market.

Most of our businesses are dependent to varying degrees upon the new residential construction market. The homebuilding industry is undergoing a significant and sustained downturn. According to the U.S. Census Bureau, actual single family housing starts in the U.S. during 2009 declined 28.5% from 2008 levels and declined 57.5% from 2007 to 2009. We believe that the market downturn is attributable to a variety of factors including: the ongoing economic recession; limited credit availability; excess home inventories; a substantial reduction in speculative home investment; a decline in consumer confidence; higher unemployment; and an industry-wide softening of demand. The downturn in the homebuilding industry has resulted in a substantial reduction in demand for our products and services, which in turn had a significant adverse effect on our business and operating results during fiscal years 2008 and 2009.

In addition, beginning in 2007, the mortgage markets experienced substantial disruption due to increased defaults, primarily as a result of credit quality deterioration. The disruption has continued to date and has precipitated evolving changes in the regulatory environment and reduced availability of mortgages for potential homebuyers due to an illiquid credit market and more restrictive standards to qualify for mortgages. During 2008 and 2009, the conditions in the credit markets continued to worsen and the economy fell into a recession. In addition, the credit markets and the financial services industry recently experienced a significant crisis characterized by the bankruptcy or failure of various financial institutions and severe limitations on credit availability. As a result, the credit markets have become highly illiquid as financial and lending institutions severely restricted lending in order to conserve cash and protect their balance sheets. Although Congress and applicable regulatory authorities have enacted legislation and implemented programs designed to protect financial institutions and free up the credit markets, it is unclear whether these actions have been effective to date or will be effective in the future. As the housing industry is dependent upon the economy as well as potential homebuyers’ access to mortgage financing and homebuilders’ access to commercial credit, it is likely there will be further damage to an already weak housing industry until conditions in the economy and the credit markets substantially improve.

We cannot predict the duration of the current market conditions, or the timing or strength of any future recovery of housing activity in our markets. We also cannot provide any assurances that the homebuilding industry will not weaken further, or that the operational strategies we have implemented to address the current market conditions will be successful. Continued weakness in the new residential construction market would have a significant adverse effect on our business, financial condition and operating results. In addition, because of these factors, there may be fluctuations in our operating results, and the results for any historical period may not be indicative of results for any future period.

The non-residential construction industry is currently experiencing a downturn which, if sustained, could materially and adversely affect our business, liquidity and results of operations.

Many of our businesses are dependent on the non-residential construction industry and the slowdown and volatility of the United States economy in general is having an adverse effect on our businesses that serve this industry. According to Moody’s Economy.com, the non-residential construction industry is expected to decline in 2010 at a rate of 10.5%, as office vacancy rates continue to increase, rental costs decrease, the availability of financing continues to be limited and clarity on the strength of the economy remains uncertain. From time to time, our businesses that serve the non-residential construction industry have also been adversely affected in various parts of the country by declines in non-residential construction starts due to, among other things, changes in tax laws affecting the real estate industry, high interest rates and the level of residential construction activity. Continued uncertainty about current economic conditions will continue to pose a risk to our businesses that serve the non-residential construction industry as participants in this industry may postpone spending in response to tighter credit, negative financial news and/or declines in income or asset values, which could have a continued material negative effect on the demand for our products.

 

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We cannot predict the duration of the current market conditions, or the timing or strength of any future recovery of non-residential construction activity in our markets. We also cannot provide any assurances that the non-residential construction industry will not weaken further. Continued weakness in the non-residential construction market would have a significant adverse effect on our business, financial condition and operating results. In addition, because of these factors, there may be fluctuations in our operating results, and the results for any historical period may not be indicative of results for any future period.

Residential renovation and improvement activity levels are experiencing a downturn which may negatively impact our business, liquidity and results of operations.

Certain of our businesses rely on residential renovation and improvement (including repair and remodeling) activity levels. Unlike most previous cyclical declines in new home construction in which we did not experience comparable declines in our home improvement businesses, the current economic decline is adversely affecting our home improvement businesses as well. According to Moody’s Economy.com, residential improvement project spending in the United States declined 3.4% in 2009. Sharply declining home prices that are expected to continue to decline in 2010, increasing mortgage delinquency and foreclosure rates, reduction in the availability of mortgage and home improvement financing and significantly lower housing turnover, have limited and may continue to limit consumers’ spending, particularly on discretionary items, and affect their confidence level leading to further reduced spending on home improvement projects. The impact of these economic factors specific to the home improvement industry is exacerbated by rising unemployment in a weak job market.

We cannot provide any assurances that current market conditions will not deteriorate further and we cannot predict the timing or strength of a recovery in these markets. Continued depressed activity levels in consumer spending for home improvement and new home construction will continue to adversely affect our results of operations and our financial position. Furthermore, continued economic turmoil may cause unanticipated shifts in consumer preferences and purchasing practices and in the business models and strategies of our customers. Such shifts may alter the nature and prices of products demanded by the end consumer and our customers and could adversely affect our operating performance.

Emergency actions of the U.S. government, the U.S. Treasury, Federal Reserve and other governmental and regulatory bodies for the purpose of stabilizing the financial markets, or market response to those actions are beginning to wind down.

In response to the financial issues affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions, the Emergency Economic Stabilization Act of 2008, or the EESA, was enacted. Additionally, in response to the decline in economic growth in the U.S. brought about by the subprime mortgage crisis and the resulting “credit crunch,” the American Recovery and Reinvestment Act of 2009, or the ARRA, was enacted, which was intended to provide a stimulus to the U.S. economy and includes federal tax cuts, expansion of unemployment benefits and other social welfare provisions, and domestic spending in education, health care and infrastructure, including the energy sector.

Some of these programs have begun to expire and the impact of the winding down of these programs on the financial sector and on the economic recovery is unknown. A continuation or worsening of current financial market conditions could materially and adversely affect our business and results of operations.

We may be unable to achieve or maintain profitability.

We have set goals to progressively improve our profitability over time by increasing our gross margin and reducing our expenses. For the fiscal years 2009 and 2008 we had net losses of $514 million and $1,255 million, respectively. There can be no assurance that we will achieve our enhanced profitability goals. Factors that could significantly adversely affect our efforts to achieve these goals include, but are not limited to, the following:

 

   

failure to integrate the businesses we have acquired;

 

   

failure to improve our revenue mix by investing (including through acquisitions) in businesses that provide higher margins than we have been able to generate historically;

 

   

failure to achieve improvements in purchasing or to increase our rebates from vendors through our vendor consolidation and/or low-cost country initiatives;

 

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failure to improve our gross margins through the utilization of improved pricing practices and technology and sourcing savings;

 

   

failure to reduce our overhead and support expenses following the full implementation of our new advanced distribution, operating and financial management systems;

 

   

delays in implementing, or unexpected costs associated with, the continued rationalization of our branch distribution and support network;

 

   

failure to effectively evaluate future inventory reserves; and

 

   

inability to maintain vendor rebates at historical levels.

Any of these failures or delays may adversely affect our ability to increase our profitability.

Our ability to generate the significant amount of cash needed to pay interest and principal on our 12% Senior Notes and our 13.5% Senior Subordinated Notes and service our other debt and our ability to refinance all or a portion of our indebtedness or obtain additional financing depends on many factors beyond our control.

As a holding company, we have no independent operations or material assets other than our ownership of equity interests in our subsidiaries and invested cash, and we depend on our subsidiaries to distribute funds to us so that we may pay our obligations and expenses, including to satisfy our obligations under the notes and our senior secured credit facility (“Senior Secured Credit Facility”) and our asset based lending credit agreement (“ABL Credit Facility” and collectively with the “Senior Secured Credit Facility,” the “Senior Credit Facilities”). Our ability to make scheduled payments on, or to refinance our obligations under, our debt depends on the ability of our subsidiaries to make distributions and dividends to us, which, in turn, depends on their operating results, cash requirements and financial condition, general business conditions, and any legal and regulatory restrictions on the payment of dividends to which they may be subject, many of which may be beyond our control. If we do not receive sufficient distributions from our subsidiaries, we may not be able to meet our obligations to fund general corporate expenses or service our debt obligations, including our 12% Senior Notes and our 13.5% Senior Subordinated Notes.

If our cash flow and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay capital expenditures, sell assets, seek to obtain additional equity capital or refinance our debt. We cannot assure you that we will be able to refinance our debt on terms acceptable to us, or at all. In the future, our cash flow and capital resources may not be sufficient for payments of interest on and principal of our debt, and such alternative measures may not be successful and may not permit us to meet our scheduled debt service obligations.

Significant amounts of our outstanding indebtedness will mature in 2012, 2013 and 2014. As discussed in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity, capital resources and financial condition— External financing,” we amended and extended certain of our outstanding debt on March 19, 2010. The table below summarizes amounts outstanding as of March 28, 2010 under our Senior Credit Facilities, and the maturity dates of such indebtedness, giving effect to the amendment and extension (amounts in millions).

 

             August 30,        
2012
           August 30,        
2013
           April 1,        
2014

Senior Secured Credit Facility

        

  Term Loan

   $74    $    –    $874

  Revolving Credit Facility

      –       300         –

ABL Credit Facility

        

  ABL Term Loan

      –          –      214

  ABL Revolving Credit Facility

    60          –      315

As a result, we may be required to refinance any outstanding amounts under those facilities prior to the maturity date of our 12% Senior Notes and our 13.5% Senior Subordinated Notes. We cannot assure you that we will be able to refinance any of our indebtedness or obtain additional financing, particularly because of our anticipated high levels of debt and the debt incurrence restrictions imposed by the agreements governing our debt, as well as prevailing market conditions. In the absence of such operating results and resources, we could face substantial liquidity problems and might be required to dispose of material assets or operations to meet our debt service and

 

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other obligations. Our debt facilities and the indentures governing our outstanding notes restrict our ability to dispose of assets and use the proceeds from any such dispositions. We cannot assure you we will be able to consummate those dispositions, or if we do, what the timing of the dispositions will be or whether the proceeds that we realize will be adequate to meet debt service obligations, including under our outstanding notes, when due.

We have substantial debt and may incur substantial additional debt, which could adversely affect our financial health and our ability to obtain financing in the future, react to changes in our business and make payments on the notes.

As of March 28, 2010, we had an aggregate principal amount of $5,832 million of outstanding debt and $353 million available under our ABL Revolving Credit Facility (after giving effect to the borrowing base limitations and approximately $69 million in letters of credit issued). For fiscal 2009, our earnings were insufficient to cover our fixed charges by $716 million. In addition, under our 13.5% Senior Subordinated Notes, we are required to pay interest in kind through 2011. Our debt will increase by the amount of such paid in kind (“PIK”) interest.

Our substantial debt could have important consequences to holders of our 12% Senior Notes and our 13.5% Senior Subordinated Notes. Because of our substantial debt:

 

   

our ability to engage in acquisitions without raising additional equity or obtaining additional debt financing may be impaired in the future;

 

   

our ability to obtain additional financing for working capital, capital expenditures, acquisitions, debt service requirements or general corporate purposes and our ability to satisfy our obligations with respect to our outstanding notes may be impaired in the future;

 

   

a substantial portion of our cash flow from operations must be dedicated to the payment of principal and interest on our indebtedness, thereby reducing the funds available to us for other purposes;

 

   

we are exposed to the risk of increased interest rates because a portion of our borrowings, including under our debt facilities, is at variable rates of interest;

 

   

it may be more difficult for us to satisfy our obligations to our creditors, resulting in possible defaults on and acceleration of such indebtedness;

 

   

we may be more vulnerable to general adverse economic and industry conditions, including the ongoing economic downturn;

 

   

we may be at a competitive disadvantage compared to our competitors with less debt or with comparable debt at more favorable interest rates and that, as a result, may be better positioned to withstand economic downturns;

 

   

our ability to refinance indebtedness may be limited or the associated costs may increase; and

 

   

our flexibility to adjust to changing market conditions and our ability to withstand competitive pressures could be limited, or we may be prevented from carrying out capital spending that is necessary or important to our operations in general, growth strategy and efforts to improve operating margins of our businesses.

Despite current indebtedness levels, we and our subsidiaries may be able to incur substantially more debt, including secured debt. This could further exacerbate the risks associated with our substantial indebtedness.

We and our subsidiaries may be able to incur substantial additional indebtedness in the future. The terms of the indentures governing our 12% Senior Notes and our 13.5% Senior Subordinated Notes do not prohibit us or our subsidiaries from doing so. As of March 28, 2010, our ABL Revolving Credit Facility provided us with availability for additional borrowings of up to $353 million (after giving effect to the borrowing base limitations and approximately $69 million in letters of credit issued). All of those borrowings and any other secured indebtedness permitted under the agreements governing our Senior Credit Facilities and the indentures governing our outstanding notes would be effectively senior to the notes to the extent of the value of the assets securing such indebtedness. In addition, under the 13.5% Senior Subordinated Notes, we are required to pay interest in kind through 2011, which will increase our debt by the amount of such PIK interest. If new debt is added to our current debt levels, the debt-related risks that we now face would increase, and we may not be able

 

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to meet all our debt obligations, including the repayment of the notes. In addition, the indentures governing our outstanding notes do not prevent us from incurring obligations that do not constitute indebtedness.

The agreements and instruments governing our debt contain restrictions and limitations that could significantly impact our ability to operate our business and adversely affect the holders of our 12% Senior Notes and our 13.5% Senior Subordinated Notes.

The Senior Credit Facilities contain covenants that, among other things, restrict our ability to:

 

   

dispose of assets;

 

   

incur additional indebtedness (including guarantees of additional indebtedness);

 

   

prepay the notes or amend other specified debt instruments;

 

   

pay dividends and make certain payments;

 

   

create liens on assets;

 

   

engage in certain asset sales, mergers, acquisitions, consolidations or sales of all or substantially all of our assets;

 

   

engage in certain transactions with affiliates; and

 

   

permit restrictions on our subsidiaries’ ability to pay dividends.

The indentures governing our 12% Senior Notes and our 13.5% Senior Subordinated Notes also contain restrictive covenants that, among other things, limit our ability and the ability of our restricted subsidiaries to:

 

   

incur additional debt;

 

   

pay dividends, redeem stock or make other distributions;

 

   

make certain investments;

 

   

create liens;

 

   

transfer or sell assets;

 

   

merge or consolidate with other companies; and

 

   

enter into certain transactions with our affiliates.

THD guarantees payment of the Term Loan (the “THD Guarantee”) under the Senior Secured Credit Facility. The THD Guarantee also contains restrictive covenants that limit our ability to and the ability of our restricted subsidiaries to:

 

   

incur additional secured debt; and

 

   

pay dividends.

The restrictions in the indentures governing our outstanding notes, the THD Guarantee, and the Senior Credit Facilities may prevent us from taking actions that we believe would be in the best interest of our business and may make it difficult for us to execute our business strategy successfully or effectively compete with companies that are not similarly restricted. We may also incur future debt obligations that might subject us to additional restrictive covenants that could affect our financial and operational flexibility.

Our ability to comply with the covenants and restrictions contained in the Senior Credit Facilities and the indentures governing our outstanding notes may be affected by economic, financial and industry conditions beyond our control. The breach of any of these covenants or restrictions could result in a default under either the Senior Credit Facilities or the indentures that would permit the applicable lenders or noteholders, as the case may be, to declare all amounts outstanding thereunder to be due and payable, together with accrued and unpaid interest. If we are unable to repay debt, lenders having secured obligations, such as the lenders under the Senior Credit Facilities, could proceed against the collateral securing the secured obligations. In any such case, we may be unable to borrow under the Senior Credit Facilities and may not be able to repay amounts due under such facilities and the notes. This could have serious consequences to our financial condition and results of operations and could cause us to become bankrupt or insolvent.

 

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We may have future capital needs and may not be able to obtain additional financing on acceptable terms.

Although we believe that the additional committed funding available under our ABL Revolving Credit Facility is sufficient for our current operations, any reductions in our available borrowing capacity, or our inability to renew or replace our debt facilities, when required or when business conditions warrant, could have a material adverse effect on our business, financial condition and results of operations. The economic conditions, credit market conditions, and economic climate affecting our industry, as well as other factors, may constrain our financing abilities. Our ability to secure additional financing, if available, and to satisfy our financial obligations under indebtedness outstanding from time to time will depend upon our future operating performance, the availability of credit generally, economic conditions and financial, business and other factors, many of which are beyond our control. The prolonged continuation or worsening of the current market and the macroeconomic conditions that affect our industry could have a material adverse effect on our ability to secure financing of favorable terms, if at all.

We may be unable to secure additional financing or financing on favorable terms or our operating cash flow may be insufficient to satisfy our financial obligations under indebtedness outstanding from time to time. Furthermore, if financing is not available when needed, or is available on unfavorable terms, we may be unable to take advantage of business opportunities or respond to competitive pressures, any of which could have a material adverse effect on our business, financial condition and results of operations. If additional funds are raised through the issuance of additional equity securities, our stockholders may experience significant dilution.

Increases in interest rates would increase the cost of servicing our debt and could reduce our profitability.

A significant portion of our outstanding debt, including under the Senior Credit Facilities, bears interest at variable rates. As a result, increases in interest rates would increase the cost of servicing our debt and could materially reduce our profitability and cash flows. Each one percentage point change in interest rates would result in a $12 million change in the annual cash interest expense on our term loans outstanding under our Senior Credit Facilities before any principal payment or effect of interest rate swap agreements based on balances as of March 28, 2010. Assuming all revolving loans were fully drawn, each one percentage point change in interest rates would result in a $21 million change in annual cash interest expense on our Senior Credit Facilities. The impact of increases in interest rates could be more significant for us than it would be for some other companies because of our substantial indebtedness.

A downgrade, suspension or withdrawal of the rating assigned by a rating agency to the notes or our Senior Credit Facilities, if any, could cause the liquidity or market value of the notes to decline.

Our 12% Senior Notes and our 13.5% Senior Subordinated Notes have been rated by Standard & Poor’s Corporation and Moody’s Investor Services. Our Senior Credit Facilities have also been rated by Standard & Poor’s and Moody’s. In determining our credit ratings, the rating agencies consider a number of both quantitative and qualitative factors. These factors include earnings, fixed charges such as interest, cash flows, total debt outstanding, total secured debt, off balance sheet obligations and other commitments, total capitalization and various ratios calculated from these factors. Our outstanding notes and our debt facilities may in the future be rated by additional rating agencies. We cannot assure you that any rating so assigned will remain for any given period of time or that a rating will not be lowered or withdrawn entirely by a rating agency if, in that rating agency’s judgment, circumstances relating to the basis of the rating, such as adverse change to our business, so warrant. During the third quarter of fiscal 2009, Standard & Poor’s reaffirmed our B rating, but lowered its outlook to negative and Moody’s Investors Service lowered our rating to CAA1, with a stable outlook, from B3. Both agencies cited our exposure to the ongoing weakness in U.S. construction as well as high leverage levels as the primary pressures on the ratings. Any lowering or withdrawal of a rating by a rating agency could reduce the liquidity or market value of our outstanding notes or increase the cost of borrowing funds under our debt facilities and make our ability to raise new funds or renew maturing debt more difficult.

Goodwill is subject to impairment testing and may affect fair value of reporting units and future cash flows.

As of January 31, 2010, goodwill represented approximately 40% of our total assets. Goodwill is no longer amortized and is subject to impairment testing at least annually using a fair value based approach. The identification and measurement of impairment involves the estimation of the fair value of reporting units.

 

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Accounting for impairment contains uncertainty because management must use judgment in determining appropriate assumptions to be used in the measurement of fair value. The estimates of fair value of reporting units are based on the best information available as of the date of the assessment and incorporate management assumptions about expected future cash flows and contemplate other valuation techniques. Future cash flows can be affected by changes in industry or market conditions among other things.

The recoverability of goodwill is evaluated at least annually and when events or changes in circumstances indicate that the carrying amount of goodwill may not be recoverable. During fiscal 2009 and fiscal 2008, we recorded goodwill impairment charges of $224 million and $1,053 million, respectively, driven by a reduction in expected future cash flows for certain businesses primarily as a result of the decline in the residential construction market.

In view of the general economic downturn in the U.S., we may be required to take additional impairment charges relating to our operations or close under-performing locations.

During fiscal 2009, we recorded impairment charges related to the carrying value of goodwill for four of our reporting units. In addition, during fiscal 2008, we recorded impairment charges related to the carrying value of goodwill for six of our reporting units and some of our assets. If weakness in the homebuilding industry continues, we may need to take additional goodwill and/or asset impairment charges relating to certain of our reporting units and asset groups. Any such non-cash charges would have an adverse effect on our financial results.

In addition, we have closed certain branches in under-performing markets. As of January 31, 2010, approximately 225 branches have been closed and approximately 4,700 employees have been terminated since the Transactions. We may have to close additional branches in certain of our markets. Such facility closures could have a significant adverse effect on our financial condition, operating results and cash flows.

We occupy most of our facilities under long-term non-cancelable leases. We may be unable to renew leases at the end of their terms. If we close a facility, we remain obligated under the applicable lease.

Most of our facilities are located in leased premises. Many of our current leases are non-cancelable and typically have terms ranging from 3 to 10 years and most provide options to renew for specified periods of time. We believe that leases we enter into in the future will likely be long-term and non-cancelable and have similar renewal options. If we close or idle a facility, we generally remain committed to perform our obligations under the applicable lease, which would include, among other things, payment of the base rent for the balance of the lease term. Over the course of the last three fiscal years, we closed or idled a number of facilities for which we remain liable on the lease obligations. Our obligation to continue making rental payments in respect of leases for closed or idled facilities could have a material adverse effect on our business and results of operations.

The industries in which we operate are highly competitive and fragmented, and demand for our products and services could decrease if we are not able to compete effectively.

The industries in which we operate are fragmented, including the residential, non-residential and public infrastructure construction and facility repair and maintenance markets. There is significant competition in each of our businesses. Our competition includes other wholesalers and manufacturers that sell products directly to their respective customer base and some of our customers that resell our products. To a limited extent, retailers of plumbing, electrical fixtures and supplies, building materials, maintenance repair and operations supplies, and contractors’ tools also compete with us. We also expect that new competitors may develop over time as internet-based enterprises become more established and reliable and refine their service capabilities. Competition varies depending on product line, customer classification and geographic area. The principal competitive factors in our business include, but are not limited to:

 

   

availability and cost of materials and supplies;

 

   

technical product knowledge and expertise as to application and usage;

 

   

advisory or other service capabilities;

 

   

ability to build and maintain customer relationships;

 

   

effective use of technology to identify sales and operational opportunities;

 

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same-day delivery capabilities in certain product lines; and

 

   

pricing of products and provisions of credit.

We compete with many local, regional and, in several markets and product categories, other national distributors. Several of our competitors in one or more of our businesses, such as Wolseley (Ferguson Enterprises) in our plumbing/HVAC or WESCO Distribution in our electrical business, have substantially greater financial and other resources than us. No assurance can be given that we will be able to respond effectively to such competitive pressures. Increased competition by existing and future competitors could result in reductions in sales, prices, volumes and gross margins that could materially adversely affect our business, financial condition and results of operations. Furthermore, our success will depend, in part, on our ability to maintain our market share and gain market share from competitors.

In addition, our contracts with municipalities are often awarded and renewed through periodic competitive bidding. We may not be successful in obtaining or renewing these contracts. Our inability to replace a significant number of contracts lost through competitive bidding processes with other revenue sources within a reasonable time could be harmful to our business and financial performance.

Our competitors in the residential, non-residential and infrastructure construction and facility maintenance and repair distribution markets are consolidating, which could cause these markets to become more competitive and could negatively impact our business.

Our competitors in the residential, non-residential and infrastructure construction and facility maintenance and repair distribution markets in the United States and Canada are consolidating. This consolidation is being driven by customer needs and supplier capabilities, which could cause the industries to become more competitive as greater economies of scale are achieved by distributors. Customers are increasingly aware of the total costs of fulfillment and of the need to have consistent sources of supply at multiple locations. We believe these customer needs could result in fewer distributors as the remaining distributors become larger and capable of being a consistent source of supply.

There can be no assurance that we will be able in the future to take advantage effectively of the trend toward consolidation. The trend in our industry toward consolidation could make it more difficult for us to maintain operating margins and could also increase competition for our acquisition targets and result in higher purchase price multiples. Furthermore, as our industrial and construction customers face increased foreign competition, and potentially lose business to foreign competitors or shift their operations overseas in an effort to reduce expenses, we may face increased difficulty in growing and maintaining our market share and growth prospects.

The loss of any of our significant customers or the failure to collect monies owed from customers could adversely affect our financial health.

Our ten largest customers generated approximately 7.9% of our Net sales in fiscal 2009, and our largest customer accounted for 3.9% of our Net sales in that same period. We cannot guarantee that we will maintain or improve our relationships with these customers or that we will continue to supply these customers at historical levels. Due to the economic downturn, some of our customers have reduced their operations. For example, some homebuilder customers have exited or severely curtailed building activity in certain of our markets. A prolonged economic downturn could continue to have a significant adverse effect on our financial condition, operating results and cash flows.

In addition, consolidation among customers could also result in a loss of some of our present customers to our competitors. The loss of one or more of our significant customers or deterioration in our relations with any of them could significantly affect our financial condition, operating results and cash flows. Furthermore, our customers are not required to purchase any minimum amount of products from us. The contracts into which we have entered with most of our customers typically provide that we supply particular products or services for a certain period of time when and if ordered by the customer. Should our customers purchase our products in significantly lower quantities than they have in the past, such decreased purchases could have a material adverse effect on our financial condition, operating results and cash flows.

In addition, if the financial condition of our customers declines, our credit risk could increase. Significant contraction in the construction and industrial markets, coupled with tightened credit availability and financial

 

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institution underwriting standards, could adversely affect certain of our customers. Should one or more of our larger customers declare bankruptcy, it could adversely affect the collectability of our accounts receivable, bad debt reserves and net income.

The majority of our net sales are credit sales which are made primarily to customers whose ability to pay is dependent, in part, upon the economic strength of the industry and geographic areas in which they operate.

The majority of our Net sales volume in fiscal 2009 was facilitated through the extension of credit to our customers whose ability to pay is dependent, in part, upon the economic strength of the construction industry in the areas where they operate. Our businesses offer credit to customers, either through unsecured credit that is based solely upon the creditworthiness of the customer, or secured credit for materials sold for a specific job where the security lies in lien rights associated with the material going into the job. The type of credit offered depends both on the financial strength of the customer and the nature of the business in which the customer is involved. End users, resellers and other non-contractor customers generally purchase more on unsecured credit than secured credit. The inability of our customers to pay off their credit lines in a timely manner, or at all, would adversely affect our financial condition, operating results and cash flows. Furthermore, our collections efforts with respect to non-paying or slow-paying customers could negatively impact our customer relations going forward.

We are subject to competitive pricing pressure from our customers.

Certain of our largest customers, for example in our CTI business, historically have exerted significant pressure on their outside suppliers to keep prices low because of their market share and their ability to leverage such market share in the highly fragmented building products supply industry. The economic downturn has resulted in increased pricing pressures from our customers. If we are unable to generate sufficient cost savings to offset any price reductions, our financial condition, operating results and cash flows may be adversely affected.

We may not continue to achieve the acquisition component of our growth strategy.

Acquisitions will continue to be an essential component of our growth strategy; however, there can be no assurance that we will be able to continue to grow our business through acquisitions as we have done historically or that any businesses acquired will perform in accordance with expectations or that business judgments concerning the value, strengths and weaknesses of businesses acquired will prove to be correct. Future acquisitions may result in the incurrence of debt and contingent liabilities and an increase in interest expense and amortization expenses and significant charges relative to integration costs. Our strategy will be impeded if we do not identify suitable acquisition candidates and our financial condition and results of operations will be adversely affected if we overpay for opportunities.

Acquisitions involve a number of special risks, including:

 

   

problems implementing disclosure controls and procedures;

 

   

unforeseen difficulties extending internal control over financial reporting and performing the required assessment at the newly-acquired business;

 

   

potential adverse short-term effects on operating results through increased costs or otherwise;

 

   

diversion of management’s attention, failure to recruit new, and retain existing, key personnel of the acquired business;

 

   

failure to successfully implement infrastructure, logistics and system integration;

 

   

our business growth could outpace the capability of our systems;

 

   

unforeseen liabilities inherent in the acquired business that manifest themselves after the acquisition is completed; and

 

   

the risks inherent in the systems of the acquired business and risks associated with unanticipated events or liabilities, any of which could have a material adverse effect on our business, financial condition and results of operations.

In addition, in light of the disruptions in the credit markets, we may not be able to obtain financing necessary to complete acquisitions on attractive terms or at all.

 

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A range of factors may make our quarterly revenues and earnings variable.

We have historically experienced, and in the future will continue to experience, variability in revenues and earnings on a quarterly basis. The factors expected to contribute to this variability include, among others: (i) the cyclical nature of some of the markets in which we compete, including the new residential and commercial construction markets, (ii) general economic conditions in the various local markets in which we compete, (iii) the pricing policies of our competitors, (iv) the production schedules of our customers, and (v) the effects of the weather. These factors, among others, make it difficult to project our operating results on a consistent basis, which may affect the price of our securities.

The residential, non-residential and infrastructure construction and facility maintenance and repair markets are cyclical and seasonal.

Although weather patterns affect our operating results throughout the year, adverse weather historically has reduced construction and maintenance and repair activity in the fourth and first quarters in our markets. In contrast, our highest volume of net sales historically has occurred in our second fiscal quarter. To the extent that hurricanes, severe storms, floods, other natural disasters or similar events occur in the markets in which we operate, our business may be adversely affected. In addition, most of our businesses experience seasonal variation as a result of the dependence of our customers on suitable weather to engage in construction, maintenance and renovation and improvement projects. For example, White Cap sells products used primarily in the residential and non-residential construction industry. Generally, during the winter months, construction activity declines due to inclement weather and shorter daylight hours. As a result, operating results for the businesses that experience such seasonality may vary significantly from period to period. We anticipate that fluctuations from period to period will continue in the future.

Fluctuating commodity prices may adversely impact our results of operations.

The cost of steel, aluminum, copper, nickel, polyvinyl chlorides (“PVC”) and other commodities used in products we distribute can be volatile. For example, the price of nickel declined significantly during 2008. In our IPVF business, approximately 50% of our Net sales are attributable to nickel-based products. Although we attempt to resist cost increases by our suppliers and to pass on increased costs to our customers, we are not always able to do so quickly or at all. In addition, if prices decrease for commodities used in products we distribute, we may have inventories purchased at higher prices than prevailing market prices. Significant fluctuations in the cost of the commodities used in products we distribute have in the past adversely affected, and in the future may adversely affect, our results of operations and financial condition.

If petroleum prices increase, our results of operations could be adversely affected.

Petroleum prices have fluctuated significantly in recent years. Prices and availability of petroleum products are subject to political, economic and market factors that are generally outside our control. Political events in petroleum-producing regions as well as hurricanes and other weather-related events may cause the price of fuel to increase. Within several of our principal and other businesses, we deliver a significant volume of products to our customers by truck. Our operating profit will be adversely affected if we are unable to obtain the fuel we require or to fully offset the anticipated impact of higher fuel prices through increased prices or fuel surcharges to our customers. Besides passing fuel costs on to customers, we have not entered into any hedging arrangements that protect against fuel price increases and we do not have any long-term fuel purchase contracts. In addition, we estimate that PVC products, which are manufactured from plastic resin derived from petroleum, represented approximately 15% of our fiscal 2009 Net sales in our Waterworks business. If shortages occur in the supply of necessary petroleum products or a sharp increase in the price of petroleum results in higher PVC prices and we are not able to pass along the full impact of increased PVC prices to our customers, our results of operations would be adversely affected.

Product shortages and cyclicality in the residential, non-residential and infrastructure construction and facility maintenance and repair markets may impair our operating results.

Our ability to offer a wide variety of products to our customers is dependent upon our ability to obtain adequate product supply from manufacturers or other suppliers. Generally, our products are obtainable from various

 

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sources and in sufficient quantities. However, the loss of, or substantial decrease in the availability of, products from our suppliers, or the loss of our key supplier agreements, could adversely impact our financial condition, operating results and cash flows. In addition, supply interruptions could arise from shortages of raw materials (including petroleum products), labor disputes or weather conditions affecting products or shipments, transportation disruptions or other factors beyond our control. Short and long-term disruptions in our supply chain would result in a need to maintain higher inventory levels as we replace similar product domestically, a higher cost of product and ultimately a decrease in our net sales and profitability. A disruption in the timely availability of our products by our key suppliers would result in a decrease in our revenues and profitability, especially in our businesses with supplier concentration, such as our Waterworks business. Although in many instances we have agreements with our suppliers, these agreements are generally terminable by either party on limited notice. Failure by our suppliers to continue to supply us with products on commercially reasonable terms, or at all, would put pressure on our operating margins and have a material adverse effect on our financial condition, operating results and cash flows. Short-term changes in the cost of these materials, some of which are subject to significant fluctuations, are sometimes, but not always passed on to our customers. Our delayed ability to pass on material price increases to our customers could adversely impact our financial condition, operating results and cash flows.

In addition, the residential, non-residential and infrastructure construction and facility maintenance and repair markets are subject to cyclical market pressures. The length and magnitude of these cycles have varied over time and by market. Prices of the products we sell are historically volatile and subject to fluctuations arising from changes in supply and demand, national and international economic conditions, labor costs, competition, market speculation, government regulation and trade policies, as well as from periodic delays in the delivery of our products. We have limited ability to control the timing and amount of changes to prices that we pay for our products. In addition, the supply of our products fluctuates based on available manufacturing capacity. A shortage of capacity or excess capacity in the industry can result in significant increases or declines in market prices for those products, often within a short period of time. Such price fluctuations can adversely affect our financial condition, operating results and cash flows.

We rely on third party suppliers and long supply chains, and if we fail to identify and develop relationships with a sufficient number of qualified suppliers or if there is a significant interruption in our supply chains, our ability to timely and efficiently access products that meet our standards for quality could be adversely affected.

We buy our products and supplies from suppliers located throughout the world and they manufacture or purchase in the United States and abroad the products we buy from them. Our ability to continue to identify and develop relationships with qualified suppliers who can satisfy our standards for quality and our need to access products and supplies in a timely and efficient manner is a significant challenge. We may be required to replace a supplier if their products do not meet our quality or safety standards. In addition, our suppliers could discontinue selling products manufactured in foreign countries at any time for reasons that may or may not be in our control or the suppliers’ control. Our operating results and inventory levels could suffer if we are unable to promptly replace a supplier who is unwilling or unable to satisfy our requirements with a supplier providing equally appealing products. Our suppliers’ ability to deliver products may also be affected by financing constraints caused by credit market conditions, which could negatively impact our revenue and cost of products sold, at least until alternate sources of supply are arranged. In addition, since a portion of the products that we distribute is produced in foreign countries, we are dependent on long supply chains for the successful delivery of many of our products. The length and complexity of these supply chains make them vulnerable to numerous risks, many of which are beyond our control, which could cause significant interruptions or delays in delivery of our products. Factors such as political instability, the financial instability of suppliers, suppliers’ noncompliance with applicable laws, trade restrictions, labor disputes, currency fluctuations, changes in tariff or import policies, severe weather, terrorist attacks and transport capacity and cost may disrupt these supply chains and our ability to access products and supplies. As we increase the percentage of our products that are sourced from lower-cost countries, these risks will be amplified. Moreover, these risks will be amplified by our efforts to consolidate our supplier base across our businesses. We expect more of our products will be imported in the future, which will further increase these risks. A significant interruption in our supply chains caused by any of the above factors could result in increased costs or delivery delays and result in a decrease in our net sales and profitability.

 

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We have substantial fixed costs and, as a result, our operating income is sensitive to changes in our net sales.

A significant portion of our expenses are fixed costs (including personnel), which do not fluctuate with net sales. Consequently, a percentage decline in our net sales could have a greater percentage effect on our operating income if we do not act to reduce head count or take other cost reduction actions. Any decline in our net sales would cause our profitability to be adversely affected. Moreover, a key element of our strategy is managing our assets, including our substantial fixed assets, more effectively, including through sales or other disposals of excess assets. Our failure to rationalize our fixed assets in the time and within the costs we expect could have an adverse effect on our results of operations and financial condition.

A change in our product mix could adversely affect our results of operations.

Our results may be affected by a change in our sales mix. Our outlook, budgeting and strategic planning assume a certain volume mix of sales as well as a product mix of sales. If actual results vary from this projected volume and product mix of sales, our financial results could be negatively impacted.

The impairment or failure of financial institutions may adversely affect us.

We have exposure to counterparties with which we execute transactions, including U.S. and foreign commercial banks, insurance companies, investment banks, investment funds and other financial institutions, some of which may be exposed to bankruptcy, liquidity, default or similar risks, especially in connection with recent financial market turmoil. Many of these transactions could expose us to risk in the event of the bankruptcy, receivership, default or similar event involving a counterparty. For example, one of the financial institutions that is committed to fund each of our Revolving Credit Facility and our ABL Revolving Credit Facility failed in the third quarter of 2008. While we have not realized any significant losses to date, the bankruptcy, receivership, default or similar event involving one of our financial institution counterparties could have a material adverse impact on our access to funding or our ability to meet our financing agreement obligations.

The development of alternatives to distributors in the supply chain could cause a decrease in our sales and operating results and limit our ability to grow our business.

Our customers could begin purchasing more of their product needs directly from manufacturers, which would result in decreases in our net sales and earnings. Our suppliers could invest in infrastructure to expand their own local sales force and sell more products directly to our customers, which also would negatively impact our business. For example, multiple municipalities may outsource their entire waterworks systems to a single company, thereby increasing such company’s leverage in the marketplace and its ability to buy directly from suppliers, which may have a material adverse effect on our operating results.

In addition to these factors, our customers may: (i) seek to purchase some of the products that we currently sell directly from manufacturers, (ii) elect to establish their own building products manufacturing and distribution facilities, or (iii) give advantages to manufacturing or distribution intermediaries in which they have an economic stake. These changes in the supply chain could adversely affect our financial condition, operating results and cash flows.

Because our business is working-capital intensive, we rely on our ability to manage our product purchasing and customer credit policies.

Our operations are working-capital intensive, and our investments in inventories, accounts receivable and accounts payable are significant components of our net asset base. We manage our inventories and accounts payable through our purchasing policies and our accounts receivable through our customer credit policies. If we fail to adequately manage our product purchasing or customer credit policies, our working capital and financial condition may be adversely affected.

Inclement weather, anti-terrorism measures and other disruptions to the transportation network could impact our distribution system.

Our ability to provide efficient distribution of products to our customers is an integral component of our overall business strategy. Disruptions at distribution centers or shipping ports, due to events such as the hurricanes of 2005 and the longshoreman’s strike on the West Coast in 2002, may affect our ability to both maintain key

 

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products in inventory and deliver products to our customers on a timely basis, which may in turn adversely affect our results of operations.

Furthermore, in the aftermath of terrorist attacks in the United States, federal, state and local authorities have implemented and are implementing various security measures that affect many parts of the transportation network in the United States and abroad. Our customers typically need quick delivery and rely on our on-time delivery capabilities. If security measures disrupt or impede the timing of our deliveries, we may fail to meet the needs of our customers, or may incur increased expenses to do so.

Interruptions in the proper functioning of IT systems could disrupt operations and cause unanticipated increases in costs or decreases in revenues, or both.

Because we use our information systems to, among other things, manage inventories and accounts receivable, make purchasing decisions and monitor our results of operations, the proper functioning of our IT systems is critical to the successful operation of our business. Although our IT systems are protected through physical and software safeguards and remote processing capabilities exist, IT systems are still vulnerable to natural disasters, power losses, unauthorized access, telecommunication failures and other problems. If critical IT systems fail or are otherwise unavailable, our ability to process orders, track credit risk, identify business opportunities, maintain proper levels of inventories, collect accounts receivable and pay expenses and otherwise manage our businesses would be adversely affected.

The implementation of our technology initiatives could disrupt our operations in the near term, and our technology initiatives might not provide the anticipated benefits or might fail.

We have made, and will continue to make, significant technology investments in each of our businesses and in our administrative functions. In large measure, our continued need to invest heavily in IT (approximately $42 million in fiscal 2009 and $39 million in fiscal 2008) is due to the need to upgrade and integrate legacy systems of the 33 acquisitions we have made since the beginning of fiscal 2005. Many of those entities used systems that were inadequate and required upgrades, particularly in the larger environment of our company. Our technology initiatives are designed to streamline our operations to allow our associates to continue to provide high quality service to our customers and to provide our customers a better experience, while improving the quality of our internal control environment. The cost and potential problems and interruptions associated with the implementation of our technology initiatives could disrupt or reduce the efficiency of our operations in the near term. In addition, our new or upgraded technology might not provide the anticipated benefits, it might take longer than expected to realize the anticipated benefits or the technology might fail altogether.

Our combined financial information as of and for periods prior to the Transactions is not representative of our future financial position, future results of operations or future cash flows nor does it reflect what our financial position, results of operations or cash flows would have been as a stand-alone company during the periods presented.

Our combined financial information as of and for periods prior to the Transactions included in this annual report on Form 10-K is not representative of our future financial position, future results of operations or future cash flows nor does it reflect what our financial position, results of operations or cash flows would have been as a stand-alone company during the periods presented. This is primarily because:

 

   

such combined financial information reflects allocation of expenses from Home Depot. Those allocations may be different from the comparable expenses we would have incurred as a stand-alone company;

 

   

our working capital requirements historically were satisfied as part of Home Depot’s corporate-wide cash management policies. In connection with the Transactions, we incurred a large amount of indebtedness and therefore assumed significant debt service costs. As a result, our cost of debt and capitalization is significantly different from that reflected in the historical combined financial information; and

 

   

as a result of the Transactions, we experienced increases in our costs, including the cost to establish an appropriate accounting and reporting system, debt service obligations, improving information technology, and other costs of being a stand-alone company.

 

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The interests of the Equity Sponsors may differ from the interests of holders of our 12% Senior Notes and our 13.5% Senior Subordinates Notes.

As a result of the Transactions, the Equity Sponsors and their affiliates own most of the outstanding capital stock of our parent company, HDS Investment Holding, Inc. (“Holding”). Holding entered into a stockholders agreement with its stockholders in connection with the closing of the Transactions which contains, among other things, provisions relating to Holding’s governance, transfer restrictions, tag-along rights, drag-along rights, preemptive rights and certain unanimous approval rights. This stockholders agreement provides that the Equity Sponsors are entitled to elect (or cause to be elected) nine out of ten of Holding’s directors, which includes three designees of each Equity Sponsor. One of the directors designated by the Equity Sponsor associated with CD&R shall serve as the chairman. See “Item 13. Certain Relationships and Related Party Transactions, and Director Independence–Stockholders agreement and stockholder arrangements.” The interests of the Equity Sponsors may differ from those of holders of our outstanding notes in material respects. For example, the Equity Sponsors may have an interest in pursuing acquisitions, divestitures, financings or other transactions that, in their judgment, could enhance their overall equity portfolios, even though such transactions might involve risks to holders of our outstanding notes. The Equity Sponsors are in the business of making investments in companies, and may from time to time in the future, acquire interests in businesses that directly or indirectly compete with certain portions of our business or are suppliers of our customers. The companies in which one or more of the Equity Sponsors invest may also pursue acquisition opportunities that may be complementary to our business and, as a result, those acquisition opportunities may not be available to us. Additionally, the Equity Sponsors may determine that the disposition of some or all of their interests in our company would be beneficial to the Equity Sponsors at a time when such disposition could be detrimental to the holders of our outstanding notes. If we encounter financial difficulties, or we are unable to pay our debts as they mature, the interests of our equity holders might conflict with those of the holders of our outstanding notes. In that situation, for example, the holders of our outstanding notes might want us to raise additional equity from our equity holders or other investors to reduce our leverage and pay our debts, while our equity holders might not want to increase their investment in us or have their ownership diluted and instead choose to take other actions, such as selling our assets. Moreover, the Equity Sponsors’ ownership of our company may have the effect of discouraging offers to acquire control of our company.

Our costs of doing business could increase as a result of changes in U.S. federal, state or local regulations.

Our operations are principally affected by various statutes, regulations and laws in the 44 U.S. states and nine Canadian provinces in which we operate. While we are not engaged in a “regulated” industry, we are subject to various laws applicable to businesses generally, including laws affecting land usage, zoning, the environment, health and safety, transportation, labor and employment practices (including pensions), competition, immigration and other matters. Additionally, building codes may affect the products our customers are allowed to use, and consequently, changes in building codes may affect the saleability of our products. Changes in U.S. federal, state or local regulations governing the sale of some of our products could increase our costs of doing business. In addition, changes to U.S. federal, state and local tax regulations could increase our costs of doing business. We cannot provide assurance that we will not incur material costs or liabilities in connection with regulatory requirements.

We deliver products to our customers through our own fleet of vehicles. The U.S. Department of Transportation, or the “DOT,” regulates our operations in domestic interstate commerce. We are subject to safety requirements governing interstate operations prescribed by the DOT. Vehicle dimensions and driver hours of service also remain subject to both federal and state regulation. More restrictive limitations on vehicle weight and size, trailer length and configuration, or driver hours of service would increase our costs, which, if we are unable to pass these cost increases on to our customers, would reduce our gross margins, increase our selling, general and administrative expenses and reduce our net income.

We cannot predict whether future developments in law and regulations concerning our businesses will affect our business financial condition and results of operations in a negative manner. Similarly, we cannot assess whether our businesses will be successful in meeting future demands of regulatory agencies in a manner which will not materially adversely affect our business, financial condition or results of operations.

 

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The nature of our business exposes us to construction defect and product liability claims as well as other legal proceedings.

We rely on manufacturers and other suppliers to provide us with the products we sell and distribute. As we do not have direct control over the quality of the products manufactured or supplied by such third party suppliers, we are exposed to risks relating to the quality of the products we distribute and install. It is possible that inventory from a manufacturer or supplier could be sold to our customers and later be alleged to have quality problems or to have caused personal injury, subjecting us to potential claims from customers or third parties. We have been subject to claims in the past, which have been resolved without material financial impact. We are involved in construction defect and product liability claims relating to our various construction trades and the products we distribute and manufacture and relating to products we have installed. In certain situations, we have undertaken to voluntarily remediate any defects, which can be a costly measure.

We also operate a large fleet of trucks and other vehicles and therefore face the risk of accidents. While we currently maintain insurance coverage to address these types of liabilities, we cannot assure you that we will be able to obtain such insurance on acceptable terms in the future, if at all, or that any such insurance will provide adequate coverage against potential claims. Further, while we seek indemnification against potential liability for products liability claims from relevant parties, including but not limited to manufacturers and distributors, we cannot guarantee that we will be able to recover under such indemnification agreements. Moreover, as we increase the number of private label products we distribute, our exposure to potential liability for products liability claims may increase. Product liability claims can be expensive to defend and can divert the attention of management and other personnel for significant time periods, regardless of the ultimate outcome. An unsuccessful product liability defense could be highly costly and accordingly result in a decline in revenues and profitability. In addition, uncertainties with respect to the Chinese legal system may adversely affect us in resolving claims arising from our exclusive brand products manufactured in China. Because many laws and regulations are relatively new and the Chinese legal system is still evolving, the interpretations of many laws, regulations and rules are not always uniform. Finally, even if we are successful in defending any claim relating to the products we distribute, claims of this nature could negatively impact customer confidence in our products and our company.

We are involved in a number of legal proceedings, and while we cannot predict the outcomes of such proceedings and other contingencies with certainty, some of these outcomes may adversely affect our operations or increase our costs.

We are involved in a number of legal proceedings, including government inquiries and investigations, as well as class action, products liability, consumer, employment, tort and other litigation. We cannot predict with certainty the outcomes of these legal proceedings and other contingencies, including environmental remediation and other proceedings commenced by government authorities. The outcome of some of these legal proceedings and other contingencies could require us to take or refrain from taking actions which could adversely affect our operations or could require us to pay substantial amounts of money. Additionally, defending against these lawsuits and proceedings may involve significant expense and diversion of management’s attention and resources from other matters. See “Item 3. Legal Proceedings.”

If we become subject to material liabilities under our self-insured programs, our financial results may be adversely affected.

We provide workers’ compensation, automobile and product/general liability coverage through a program that is partially self-insured. In addition, we provide medical coverage to our employees through a self-insured preferred provider organization. Though we believe that we have adequate insurance coverage in excess of self-insured retention levels, our results of operations and financial condition may be adversely affected if the number and severity of insurance claims increase.

Our success depends upon our ability to attract, train and retain highly qualified associates and key personnel.

To be successful, we must attract, train and retain a large and growing number of highly qualified associates while controlling related labor costs. Our ability to control labor costs is subject to numerous external factors, including prevailing wage rates and health and other insurance costs. We compete with other businesses for

 

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these associates and invest significant resources in training and motivating them. There is no assurance that we will be able to attract or retain highly qualified associates in the future, including, in particular, those employed by companies we acquire. A very small proportion of our employees are currently covered by collective bargaining or other similar labor agreements. Historically, the effects of collective bargaining and other similar labor agreements on us have not been significant. However, if a larger number of our employees were to unionize, including in the wake of any future legislation that makes it easier for employees to unionize, the effect on us may be negative. Any inability by us to negotiate acceptable new contracts under these collective bargaining arrangements could cause strikes or other work stoppages, and new contracts could result in increased operating costs. If any such strikes or other work stoppages occur, or if other employees become represented by a union, we could experience a disruption of our operations and higher labor costs. Labor relations matters affecting our suppliers of products and services could also adversely affect our business from time to time.

In addition, our business results depend largely upon our executives as well as our branch managers and sales personnel, including those of companies recently acquired, and their experience, knowledge of local market dynamics and specifications and long-standing customer relationships. We customarily sign employment letters providing for an agreement not to compete with key personnel of companies we acquire in order to maintain key customer relationships and manage the transition of the acquired business. Our inability to retain or hire qualified branch managers or sales personnel at economically reasonable compensation levels would restrict our ability to grow our business, limit our ability to continue to successfully operate our business and result in lower operating results and profitability.

Fluctuations in foreign currency exchange rates may significantly reduce our revenues and profitability.

As a wholesale distributor of manufactured products, our profitability is tied to the prices we pay to the manufacturers from which we purchase our products. Some of our suppliers price their products in currencies other than the U.S. dollar or incur costs of production in non-U.S. currencies. Accordingly, depreciation of the U.S. dollar against foreign currencies increases the prices we pay for these products. Even short-term currency fluctuations could adversely impact revenues and profitability if we are unable to pass higher supply costs on to our customers. Our delayed ability to pass on material price increases to our customers could adversely impact our financial condition, operating results and cash flows.

If we are unable to protect our intellectual property rights, or we infringe on the intellectual property rights of others, our ability to compete could be negatively impacted.

Our ability to compete effectively depends, in part, upon our ability to protect and preserve proprietary aspects of our intellectual property, including our trademarks and customer lists. The use of our intellectual property or similar intellectual property by others could adversely impact our ability to compete, cause us to lose net sales or otherwise harm our business. If it became necessary for us to resort to litigation to protect these rights, any proceedings could be burdensome and costly and we may not prevail.

Also, we cannot be certain that the products that we sell do not and will not infringe issued patents or other intellectual property rights of others. Further, we are subject to legal proceedings and claims in the ordinary course of our business, including claims of alleged infringement of the trademarks, patents and other intellectual property rights of third parties by us or our customers in connection with their use of the products that we distribute. Should we be found liable for infringement, we (or our suppliers) may be required to enter into licensing agreements (if available on acceptable terms or at all) or pay damages and cease making or selling certain products. Moreover, we may need to redesign or sell different products to avoid future infringement liability. Any of the foregoing could cause us to incur significant costs, prevent us from selling our products or negatively impact our ability to compete.

Our business may be subject to significant environmental, health and safety costs.

Our operations are subject to a broad range of federal, state, local and foreign environmental health and safety laws and regulations, including those governing discharges to air, soil and water, the handling and disposal of hazardous substances and the investigation and remediation of contamination resulting from releases of petroleum products and other hazardous substances. In the course of our operations, we store fuel in on-site

 

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storage tanks and we use and dispose of a limited amount of hazardous substances. We cannot assure you that compliance with existing or future environmental, health and safety laws, such as those relating to our remediation obligations, will not adversely affect future operating results.

We may be affected by global climate change or by legal, regulatory or market responses to such potential change.

Concern over climate change, including the impact of global warming, has led to significant federal, state, and international legislative and regulatory efforts to limit greenhouse gas (“GHG”) emissions. For example, in the past several years, the U.S. Congress has considered various bills that would regulate GHG emissions. While these bills have not yet received sufficient Congressional support for enactment, some form of federal climate change legislation is possible in the future. Even in the absence of such legislation, the Environmental Protection Agency, spurred by judicial interpretation of the Clean Air Act, may regulate GHG emissions, especially diesel engine emissions, and this could impose substantial costs on us. These costs include an increase in the cost of the fuel and other energy we purchase and capital costs associated with updating or replacing our internal fleet of trucks and other vehicles prematurely. In addition, new laws or future regulation could directly and indirectly affect our customers and suppliers (through an increase in the cost of production or their ability to produce satisfactory products) and our business (through the impact on our inventory availability, cost of sales, operations or demands for the products we sell). Until the timing, scope and extent of any future regulation becomes known, we cannot predict its effect on our cost structure or our operating results. Notwithstanding our dedication to being a responsible corporate citizen, it is reasonably possible that such legislation or regulation could impose material costs on us. Moreover, even without such legislation or regulation, increased awareness and any adverse publicity in the global marketplace about the GHGs emitted by companies involved in the transportation of goods could harm our reputation and reduce customer demand for our services.

Our failure to achieve and maintain effective disclosure controls and internal control over financial reporting could adversely affect our business, financial position and results of operations.

We are subject to the reporting requirements of the Securities Exchange Act of 1934 (the “Exchange Act”), as amended. We are required to evaluate the effectiveness of our disclosure controls and internal control over financial reporting on a periodic basis and publicly disclose the results of these evaluations and related matters, in accordance with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002. These reporting and other obligations place significant additional demands on our management and administrative and operational resources, including our accounting resources, which could adversely affect our operations among other things. To comply with these requirements, we have upgraded, and are continuing to upgrade our systems, including information technology, implemented additional financial and management controls, reporting systems and procedures and hired additional legal, internal audit, accounting and finance staff. We cannot be certain that we will be successful in implementing or maintaining adequate control over our financial reporting and financial processes. Furthermore, as we grow our business, our disclosure controls and internal controls will become more complex, and we will require significantly more resources to ensure that these controls remain effective. If we are unable to continue upgrading our financial and management controls, reporting systems, information technology and procedures in a timely and effective fashion, additional management and other resources of our company may need to be devoted to assist in compliance with the disclosure and financial reporting requirements and other rules that apply to reporting companies, which could adversely affect our business, financial position and results of operations.

 

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ITEM 2. PROPERTIES

As of January 31, 2010, HD Supply reported 770 branches in the United States and Canada, as is shown in the tables below. These locations utilized approximately 21 million square feet, of which approximately 11% was owned (including locations subject to a ground lease) and approximately 89% was leased. We generally prefer to lease our locations, as it provides the flexibility to expand or relocate our sites as needed to serve evolving markets.

 

UNITED STATES         STATE
TOTALS

Alabama

   AL    8   

Alaska

   AK    1   

Arizona

   AZ    48   

Arkansas

   AR    4   

California

   CA    95   

Colorado

   CO    19   

Delaware

   DE    3   

Florida

   FL    91   

Georgia

   GA    40   

Hawaii

   HI    3   

Idaho

   ID    3   

Illinois

   IL    17   

Indiana

   IN    13   

Iowa

   IA    5   

Kansas

   KS    5   

Kentucky

   KY    7   

Louisiana

   LA    11   

Maryland

   MD    12   

Massachusetts

   MA    2   

Michigan

   MI    4   

Minnesota

   MN    6   

Mississippi

   MS    9   

Missouri

   MO    13   

Montana

   MT    5   

Nebraska

   NE    4   

Nevada

   NV    11   

New Jersey

   NJ    6   

New Mexico

   NM    7   

North Carolina

   NC    49   

Ohio

   OH    22   

Oklahoma

   OK    6   

Oregon

   OR    6   

Pennsylvania

   PA    8   

South Carolina

   SC    21   

South Dakota

   SD    2   

Tennessee

   TN    12   

Texas

   TX    69   

Utah

   UT    9   

Virginia

   VA    21   

Washington

   WA    19   

West Virginia

   WV    4   

Wisconsin

   WI    4   

Wyoming

   WY    6   
          
SUBTOTAL (U.S. Only)    710   
          

 

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CANADA         PROV.
TOTALS

Alberta

   AB    6   

British Columbia

   BC    4   

Manitoba

   MB    2   

New Brunswick

   NB    1   

Nova Scotia

   NS    2   

Ontario

   ON    41   

Prince Edward Island

   PE    1   

Quebec

   QC    2   

Saskatchewan

   SK    1   
          
SUBTOTAL (Canada Only)    60   
          
        
TOTAL    770   
          

ITEM 3. LEGAL PROCEEDINGS

HD Supply is involved in litigation from time to time in the ordinary course of business. In management’s opinion, none of the proceedings are material in relation to the consolidated operations, cash flows, or financial position of HD Supply and the Company has adequate reserves to cover its estimated probable loss exposure.

 

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PART II

ITEM 6. SELECTED FINANCIAL DATA

The selected consolidated and combined financial data set forth below should be read in conjunction with “Management’s discussion and analysis of financial condition and results of operations” and the audited consolidated and combined financial statements and related notes appearing elsewhere in this annual report on Form 10-K. Our consolidated and combined financial information may not be indicative of our future performance and our combined financial information does not reflect what our financial position and results of operations would have been had we operated as a separate stand-alone entity during the Predecessor periods. See “Item 1A. Risk Factors - Our combined financial information as of and for periods prior to the Transactions is not representative of our future financial position, future results of operations or future cash flows nor does it reflect what our financial position, results of operations or cash flows would have been as a stand-alone company during the periods presented.” In addition, we note that due to the significant size and number of acquisitions we completed in the fiscal year ended January 28, 2007 and the period from January 29, 2007 to August 29, 2007, our historical data is not directly comparable on a period-over-period basis. See “Item 1. Business – Our history.”

 

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Selected consolidated and combined financial information

 

     Successor               Predecessor  
     Fiscal year ended     Period from               Period from     Fiscal year ended  
(Dollars in millions)    January 31,
2010
    February 1,
2009
    August 30,
2007 to
February 3,
2008
                January 29,
2007 to
August 29,
2007
    January 28,
2007
    January 29,
2006
 

Statement of income data:

                  

Net sales

   $7,418      $9,768      $4,599            $7,121      $11,254      $4,276   

Cost of sales

   5,422      7,134      3,372            5,220      8,220      2,975   
                  

 

Gross profit

   1,996      2,634      1,227            1,901      3,034      1,301   

Operating expenses:

                  

Selling, general and administrative(1)

   1,680      2,063      1,001            1,424      2,094      943   

Depreciation and amortization

   386      403      168            115      184      68   

Restructuring

   28      34                             

Goodwill impairment

   224      1,053                             
                  

 

Total operating expenses

   $2,318      $3,553      $1,169            $1,539      $2,278      $1,011   
                  

Operating income (loss)

   (322   (919   58            362      756      290   

Interest expense

   602      644      289            221      321      55   

Interest (income)

        (2                          

Other (income) expense, net

   (208   11                             
                  

 

Income (loss) from continuing operations before provision for income taxes and discontinued operations

   (716   (1,572   (231         141      435      235   

Provision (benefit) for income taxes

   (211   (318   (83         58      169      92   
                  

Income (loss) from continuing operations

   (505   (1,254   (148         83      266      143   

Income (loss) from discontinued operations, net of tax

   (9   (1   (15         (27   7      7   
                  

Net income (loss)

   $(514   $(1,255   $(163         $56      $273      $150   
                  

 

Balance sheet data (end of period):

                  

Working capital (unaudited)(2)

   $1,925      $2,071      $2,009              $1,984      $783   

Cash and cash equivalents

   539      771      108              22      1   

Total assets

   7,845      9,088      10,593              11,365      5,132   

Total debt(3)

   5,775      6,056      5,800              6,408      2,852   

Total stockholders’ and owner’s equity

   688      1,175      2,433              2,970      1,340   

 

Other financial data:

                  

Cash interest expense(4)

   $363      $397      $191            $221      $321      $55   

EBITDA(5 )

   278      (519   230            481      947      361   

Adjusted EBITDA(5)

   355      601      233            514      964      370   

Capital expenditures

   58      77      75            176      243      91   

Ratio of earnings to fixed charges (unaudited)(6)

               1.5x      1.9x      2.7x   

 

Statement of cash flows data:

                  

Cash flows provided by (used in) operating activities (net)

   $69      $548      $364            $408      $248      $441   

Cash flows provided by (used in) investing activities (net)

   (41   37      (8,255         (140   (4,185   (2,447

Cash flows provided by (used in) financing activities (net)

   (263   86      7,977                (269   3,958      2,007   

 

(1) In fiscal 2006, we adopted the fair value based method of accounting for stock-based employee compensation as required by the Financial Accounting Standards Board’s guidance on share-based payments. The fair-value based method requires us to expense all stock-based employee compensation. Effective January 30, 2006, we have adopted this guidance using the modified prospective method. Accordingly, we have expensed all unvested options granted prior to fiscal 2003 in addition to continuing to recognize stock-based compensation expense for all share-based payments awarded since the adoption of the guidance in fiscal 2003, but prior period amounts have not been retrospectively adjusted.
(2) We define working capital as current assets (including cash) minus current liabilities, which include the current portion of long-term debt and accrued interest thereon.
(3) Total debt includes current and non-current installments of long-term debt and capital leases.

 

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(4) Cash interest expense represents total interest expense in continuing operations less (i) amortization of deferred financing costs, (ii) amortization of the asset related to the estimated fair value of the THD Guarantee, (iii) paid-in-kind (“PIK”) interest expense on our 13.5% Senior Subordinated Notes and (iv) amortization of amounts in accumulated other comprehensive income related to derivatives.

The following table provides a reconciliation of interest expense, the most directly comparable financial measure under generally accepted accounting principles in the United States of America (“U.S. GAAP”), to cash interest expense for the periods presented (amounts in millions):

 

     Successor              Predecessor
     Fiscal year ended      Period from              Period from    Fiscal year ended
      January 31,
2010
     February 1,
2009
     August 30,
2007 to
February 3,
2008
             January 29,
2007 to
August 29,
2007
   January 28,
2007
   January 29,
2006
               
Interest expense    $602       $644       $289           $221    $321    $55
Amortization of deferred financing costs    (33    (33    (14             
Amortization of THD Guarantee    (21    (21    (9             
PIK interest expense on our 13.5% Senior Subordinated Notes    (182    (192    (75             
Amortization of amounts in accumulated other comprehensive income related to derivatives    (3    (1                   
               
Cash interest expense    $363       $397       $191           $221    $321    $55
               

Cash interest expense is not a recognized term under U.S. GAAP and does not purport to be an alternative to interest expense. Management believes that cash interest expense is useful for analyzing the cash flow needs and debt service requirements of the Company.

 

(5) EBITDA, a measure used by management to evaluate operating performance, is defined as Net income (loss) less Income (loss) from discontinued operations, net of tax, plus (i) Interest expense and Interest income, net, (ii) Provision (benefit) for income taxes, and (iii) Depreciation and amortization. EBITDA is not a recognized term under U.S. GAAP and does not purport to be an alternative to net income as a measure of operating performance or to cash flows from operating activities as a measure of liquidity. Additionally, EBITDA is not intended to be a measure of free cash flow available for management’s discretionary use, as it does not consider certain cash requirements such as interest payments, tax payments and other debt service requirements. We believe EBITDA is helpful in highlighting trends because EBITDA 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. In addition, EBITDA provides more comparability between the historical results of HD Supply during the Predecessor periods and results that reflect the new capital structure in the Successor periods. We further believe that EBITDA is frequently used by securities analysts, investors and other interested parties in their evaluation of companies, many of which present an EBITDA measure when reporting their results. We compensate for the limitations of using non-GAAP financial measures by using them to supplement U.S. GAAP results to provide a more complete understanding of the factors and trends affecting the business than U.S. GAAP results alone. Because not all companies use identical calculations, our presentation of EBITDA may not be comparable to other similarly titled measures of other companies.

In addition, we present Adjusted EBITDA because it is based on “Consolidated EBITDA,” a measure which is used in calculating financial ratios in several material debt covenants in our Senior Secured Credit Facility and our ABL Credit Facility. 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 and our ABL Credit Facility requires us to maintain a fixed charge coverage ratio of 1:1 if we do not maintain $210 million of borrowing availability. Adjusted EBITDA is defined as EBITDA adjusted to exclude non-cash items and certain other adjustments to Consolidated Net Income permitted in calculating Consolidated EBITDA under our Senior Secured Credit Facility and our ABL Credit Facility. We believe that inclusion of supplementary adjustments to EBITDA applied in presenting Adjusted EBITDA is appropriate to provide additional information to investors about how the covenants in those agreements operate and about certain non-cash items, items that we do not expect to continue at the same level and other items. The Senior Secured Credit Facility and ABL Credit Facility permit us to make certain 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 annual report on Form 10-K. 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 “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources – External Financing.”

 

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EBITDA and Adjusted EBITDA have limitations as analytical tools and should not be considered in isolation or as substitutes for analyzing our results as reported under U.S. GAAP. Some of these limitations are:

 

   

EBITDA and Adjusted EBITDA do not reflect changes in, or cash requirements for, our working capital needs;

 

   

EBITDA and Adjusted EBITDA do not reflect our interest expense, or the requirements necessary to service interest or principal payments on our debt;

 

   

EBITDA and Adjusted EBITDA do not reflect our income tax expenses or the cash requirements to pay our taxes;

 

   

EBITDA and Adjusted EBITDA 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 EBITDA and Adjusted EBITDA do not reflect any cash requirements for such replacements.

The following table presents a reconciliation of net income (loss), the most directly comparable financial measure under U.S. GAAP, to EBITDA and Adjusted EBITDA for the periods presented (amounts in millions).

 

     Successor                Predecessor  
     Fiscal year ended      Period from                Period from    Fiscal year ended  
     January 31,
2010
     February 1,
2009
     August 30,
2007 to
February 3,
2008
          January 29,
2007 to
August 29,
2007
   January 28,
2007
     January 29,
2006
 
                    

Net income (loss)

   $   (514    $  (1,255    $   (163           $      56    $    273       $    150   

Less income (loss) from discontinued operations, net of tax

   9       1       15              27    (7    (7
                    

Income (loss) from continuing operations

   (505    (1,254    (148           83    266       143   
                    

Interest expense, net

   602       642       289              221    321       55   

Provision (benefit) from income taxes

   (211    (318    (83           58    169       92   

Depreciation and amortization

   392       411       172              119    191       71   
                    

EBITDA

   $    278       $     (519    $    230              $    481    $    947       $    361   
                    

 

Adjustments to EBITDA:

                        

Other (income) expense, net (i)

   (208    11                               

Goodwill impairment (ii)

   224       1,053                               

Restructuring charge (iii)

   38       36                               

Stock-based compensation (iv)

   18       14       1              33    17       9   

Management fee & related expenses paid to Equity Sponsors (v)

   5       6       2                         
                    

Adjusted EBITDA

   $    355       $      601       $    233              $    514    $    964       $    370   
                    

 

  (i) Represents the gain on extinguishment of debt, the gains/losses associated with the changes in fair value of interest rate swap contracts not accounted for under hedge accounting, and other non-operating income/expense.
  (ii) Represents the non-cash impairment charge of goodwill recognized during fiscal 2009 and fiscal 2008 in accordance with Accounting Standards Codification 350, Intangibles – Goodwill and Other.
  (iii) Represents the costs incurred for employee reductions and branch closures or consolidations. These costs include occupancy costs, severance, and other costs incurred to exit a location.
  (iv) The Predecessor periods include stock-based compensation costs for stock options, Employee Stock Purchase Plans and restricted stock. The Successor periods include stock-based compensation costs for stock options.
  (v) The Company entered into a management agreement whereby the Company pays the Equity Sponsors a $5 million annual aggregate management fee. In addition, the Company reimburses certain Equity Sponsor expenses.

Amounts were derived from our consolidated and combined financial statements.

 

(6) For the purposes of calculating the ratio of earnings to fixed charges, earnings consist of Income from continuing operations before provision (benefit) for income taxes plus fixed charges. Fixed charges include cash and non-cash interest expense, whether expensed or capitalized, amortization of debt issuance cost, amortization of the THD Guarantee and the portion of rental expense representative of the interest factor. The ratio of earnings to fixed charges was calculated as follows (amounts in millions):

 

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     Successor              Predecessor
     Fiscal year ended    Period from              Period from    Fiscal year ended
     January 31,
2010
   February 1,
2009
   August 30,
2007 to
February 3,
2008
        January 29,
2007 to
August 29,
2007
   January 28,
2007
   January 29,
2006
                

Income (loss) from continuing operations before provision (benefit) for income taxes

   $  (716)    $  (1,572)    $  (231)            $  141    $  435    $  235  

Add:

                        

Interest expense

   602    644    289             262    424    115  

Portion of rental expense under operating leases deemed to be the equivalent of interest

   60    65    28             41    59    20  
                

Adjusted earnings

   $   (54)    $    (863)    $     86             $  444    $  918    $  370  
                

Fixed charges:

                        

Interest expense

   $   602    $      644    $   289             $  262    $  424    $  115  

Portion of rental expense under operating leases deemed to be the equivalent of interest

   60    65    28             41    59    20  
                

Total fixed charges

   $   662    $      709    $   317             $  303    $  483    $  135  
                

Ratio of earnings to fixed charges(i)

                   1.5x    1.9x    2.7x  
                

 

  (i) For fiscal 2009, fiscal 2008, and the period from August 30, 2007 to February 3, 2008, our earnings were insufficient to cover fixed charges by $716 million, $1,572 million and $231 million, respectively.

 

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

We are one of the largest wholesale distributors based on sales serving the highly fragmented U.S. and Canadian Infrastructure & Energy, Maintenance, Repair & Improvement, and Specialty Construction market sectors. Through approximately 800 locations across the United States and Canada, we operate a diverse portfolio of distribution businesses that provide over 1 million SKUs to over 450,000 professional customers, including contractors, government entities, maintenance professionals, home builders and industrial businesses.

Description of market sectors

Through ten wholesale distribution businesses in the U.S. and a Canadian operation, we provide products and services to professional customers in the Infrastructure & Energy, Maintenance, Repair & Improvement and Specialty Construction market sectors, as presented below:

Infrastructure & Energy – To support established infrastructure and economic growth, our Infrastructure & Energy businesses serve customers in the Infrastructure & Energy market sector by meeting their demand for the critical supplies and services used to build and maintain water systems, oil refineries, and petrochemical plants, and for the generation, transmission, distribution and application of electrical power. This market sector is made up of the following businesses:

 

   

Waterworks – Distributes complete lines of water and wastewater transmission products, serving contractors and municipalities in all aspects of the water and wastewater industries.

 

   

Utilities – Distributes electrical transmission and distribution products, power plant maintenance, repair and operations (“MRO”) supplies and smart-grid technologies and provides materials management and procurement outsourcing arrangements to investor-owned utilities, municipal and provincial power authorities, rural electric cooperatives and utility contractors.

 

   

Industrial Pipe, Valves and Fittings (“IPVF”) – Distributes stainless steel and special alloy pipes, plates, sheets, flanges and fittings, as well as high performance valves, actuation services and high-density polyethylene pipes and fittings for oil and gas, petrochemical, power, food and beverage, pulp and paper, mining, and marine industries; IPVF also serves pharmaceutical customers, industrial and mechanical contractors, fabricators, wholesale distributors, exporters and original equipment manufacturers.

 

   

Electrical – Supplies electrical products such as wire and cable, switch gear supplies, lighting and conduit to residential and commercial contractors.

Maintenance, Repair & Improvement – Our Maintenance, Repair & Improvement businesses serve customers in the Maintenance, Repair & Improvement market sector by meeting their continual demand for supplies needed to fix and upgrade facilities across multiple industries. This market sector is made up of the following businesses:

 

   

Facilities Maintenance – Supplies MRO products and upgrade and renovation services largely to the multifamily, healthcare, hospitality, and institutional markets.

 

   

Crown Bolt – A retail distribution operator, providing program and packaging solutions, sourcing, distribution, and in-store service, primarily serving The Home Depot, Inc.

 

   

Repair & Remodel – Offers light remodeling and construction supplies primarily to small remodeling contractors and trade professionals.

Specialty Construction – Our Specialty Construction businesses serve customers in the Specialty Construction market sector by meeting their very distinct, customized supply needs in commercial, residential and industrial applications. This market sector is made up of the following businesses:

 

   

White Cap – Distributes specialized hardware, tools and building materials to professional contractors.

 

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HD SUPPLY, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Continued)

 

   

Plumbing – Distributes plumbing fixtures, faucets and finishes, HVAC equipment, pipes, valves, fittings and water heaters, as well as related services, to residential and commercial contractors.

 

   

Creative Touch Interiors (“CTI”) – Offers turnkey flooring installation services and countertop, cabinet and window covering installation services for the interior finish of residential and non-residential construction projects.

For a description of the relationship among our market sectors, our businesses and our financial reporting segments, see “Item 1. Business – Our sectors” within Part I of this annual report on Form 10-K.

Discontinued operations

On February 3, 2008, we closed on an agreement with ProBuild Holdings, selling all our interests in our Lumber and Building Materials operations. Cash proceeds of $105 million, less $2.5 million remaining in escrow and $2 million of professional service fees, were received on February 4, 2008. In April 2009, the Company received the remaining $2.5 million cash proceeds from escrow. Based on the net book value of net assets sold and the net proceeds, no gain or loss on the sale was recorded. As a condition of the agreement, HD Supply retained certain facilities that have been shut down. These facilities are recorded at fair value less costs to sell and are presented as Other current assets in the consolidated balance sheets. In addition, on-going lease liabilities and other occupancy costs, net of estimated sublease income, have been accrued and are presented as Other accrued expenses and Other long-term liabilities in the consolidated balance sheets.

In accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”), the results of the Lumber and Building Materials segment are classified as discontinued operations. The presentation of discontinued operations includes revenues and expenses, net of tax, of the Lumber and Building Materials operations as one line item on the consolidated and combined statements of operations. For additional detail related to the results of operations of the discontinued operations, see “Note 3 – Discontinued operations” in the notes to the consolidated and combined financial statements within Item 8 of Part II of this annual report on Form 10-K.

Key business metrics

Revenues

We earn our revenues primarily from the sale of over 1 million construction, infrastructure, maintenance and renovation and improvement related products and our provision of related services to over 450,000 professional customers, including contractors, government entities, maintenance professionals, home builders and industrial businesses. We recognize substantially all of our revenue, net of sales tax and allowances for returns and discounts, when persuasive evidence of an agreement exists, delivery has occurred or services have been rendered, price to the buyer is fixed and determinable and collectability is reasonably assured. Net sales in certain of our market sectors, particularly Infrastructure & Energy, fluctuate with the costs of required commodities.

We ship products to customers predominantly by internal fleet and to a lesser extent by third party carriers. Revenues are recognized from product sales when title to the products is passed to the customer, which generally occurs at the point of destination for products shipped by internal fleet and at the point of shipping for products shipped by third party carriers.

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. Shipping and handling costs associated with outbound freight are included in Selling, general and administrative expenses and totaled $97 million, $125 million, $62 million, and $87 million in fiscal 2009, in fiscal 2008, in the period from August 30, 2007 to February 3, 2008, and in the period from January 29, 2007 to August 29, 2007, respectively.

 

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HD SUPPLY, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Continued)

 

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 (including internal transfers), purchasing, receiving and warehousing are included in Selling, general and administrative expenses within operating expenses. Our gross profits may not be comparable to those of other companies, as other companies may include all of the costs related to their distribution network in cost of sales. We intend to improve gross profit through the continued implementation of analytical pricing optimization tools, which enable more sophisticated and disciplined product pricing at the individual customer level.

Operating expenses

Operating expenses are comprised of selling, general and administrative costs, including payroll expenses (salaries, wages, employee benefits, payroll taxes and bonuses), rent, insurance, utilities, repair and maintenance and professional fees, as well as depreciation and amortization, restructuring charges, and goodwill impairments.

Relationship with Home Depot

Historical relationship

On August 30, 2007, investment funds associated with Bain Capital Partners, LLC, The Carlyle Group and Clayton, Dubilier & Rice, Inc. formed HDS Investment Holding, Inc. (“Holding”) and entered into a stock purchase agreement with The Home Depot, Inc. (“Home Depot” or “THD”) pursuant to which Home Depot agreed to sell to Holding or to a wholly owned subsidiary of Holding certain intellectual property and all the outstanding common stock of HD Supply, Inc. and the Canadian subsidiary CND Holdings, Inc. On August 30, 2007, through a series of transactions, Holding’s direct wholly-owned subsidiary, HDS Holding Corporation, acquired direct control of HD Supply through the merger of its wholly owned subsidiary, HDS Acquisition Corp., with and into HD Supply (the “Company”). Through these transactions (the “Transactions”), Home Depot was paid cash of $8.2 billion and 12.5% of HDS Holding’s common stock worth $325 million for certain intellectual property and all of the outstanding common stock of HD Supply and CND Holdings, including all dividends and interest payable associated with those shares. During the first quarter of fiscal 2009, the Company received $22 million from Home Depot for the working capital adjustment and settlement of other items finalizing the purchase price of the Transactions.

Prior to the Transactions, Home Depot provided various support services to us, including human resources, tax, accounting, IT, legal, internal audit, operations and marketing. Cost for these services, which we refer to as the “THD management fee,” was charged to us based on specific identification of the services.

Home Depot also charged other costs directly to us such as payroll and related benefits, worker’s compensation and general liability self insurance costs, stock compensation, and general and administrative costs. These costs are recorded within Selling, general and administrative expenses.

Prior to the Transactions, we received advances from and made advances to Home Depot that represented loan and deposit agreements between various HD Supply entities and Home Depot. These agreements included debt funding as well as cash sweep arrangements. The interest rates when there were amounts due to Home Depot were the 90- day LIBOR rate plus a range from 100 to 250 points. When amounts were due from Home Depot the rates were the 90-day LIBOR rate less 12.5 basis points. Original maturity terms were ten years and maturity dates ranged from 2010 to 2016. These agreements included auto-renewal clauses that extended the maturity dates annually subsequent to the initial maturity date absent notice by Home Depot. In conjunction with the Transactions, the loan and deposit agreements, along with any outstanding balances, were contributed by THD to HD Supply.

On-going relationship

We derive revenue from the sale of products to Home Depot. Prior to and subsequent to the Transactions, revenue from these sales is recorded at an amount that approximates market but may not necessarily represent a

 

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HD SUPPLY, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Continued)

 

price an unrelated third party would pay. In addition to sales, we purchase products from Home Depot. Prior to the Transactions, all purchases were at cost and were recorded in our cost of sales when the inventory was sold. Subsequent to the Transactions, all purchases are at amounts that management believes an unrelated third party would pay.

Strategic agreement

On the date of the Transactions, THD entered into a strategic purchase agreement with Crown Bolt. This agreement provides a guaranteed revenue stream to Crown Bolt through January 31, 2015 by specifying minimum annual purchase requirements from THD.

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 favorable weather and longer daylight conditions during these periods. Seasonal variations in operating results may also be significantly impacted by inclement weather conditions, such as cold or wet weather, which can delay construction projects.

Basis of Presentation

The accompanying consolidated and combined financial statements are presented for two periods: Predecessor and Successor, which relate to the period preceding the Transactions and the period succeeding the Transactions, respectively. The Predecessor financial statements represent the combined operations of HD Supply, Inc. and CND Holdings, Inc. (which has been dissolved as of February 2, 2009). The Successor financial statements represent the consolidated operations of HD Supply, Inc. and its subsidiaries. The Company refers to the operations of HD Supply for both the Predecessor and Successor periods. Prior to the Transactions, HD Supply was a wholly-owned subsidiary of Home Depot.

The Transactions were accounted for as a purchase in accordance with U.S. GAAP, which resulted in a new basis of accounting. Pursuant to that guidance, the 12.5% continuing ownership of Home Depot is reflected at fair value, together with the remainder of the purchase price for the Transactions related to new ownership, and such fair value is allocated to the tangible and intangible assets and liabilities based on estimates of fair value in accordance with U.S. GAAP. The Predecessor and Successor financial statements are not comparable as a result of applying a new basis of accounting.

The preparation of the Predecessor financial statements includes the use of “push down” accounting procedures wherein certain assets, liabilities and expenses historically recorded or incurred at the THD level, which related to or were incurred on behalf of HD Supply and have been identified and allocated or pushed down as appropriate to reflect the stand-alone financial results of HD Supply for the periods presented. Allocations were made primarily based on specific identification. Management believes the methodology applied in the allocation of these costs is reasonable. Interest expense included in these financial statements reflects the terms of the intercompany debt agreements between THD and HD Supply. These terms may not be indicative of terms reached on a third-party basis. These Predecessor financial statements may not necessarily be indicative of the cost structure or results of operations that would have existed if HD Supply operated as a stand-alone, independent business.

Fiscal Year

HD Supply’s fiscal year is a 52- or 53-week period ending on the Sunday nearest to January 31. Fiscal years ended January 31, 2010 (“fiscal 2009”) and February 1, 2009 (“fiscal 2008”) both include 52 weeks. The Successor period from August 30, 2007 to February 3, 2008 (“Successor 2007”) includes 22 weeks and 4 days. The Predecessor period from January 29, 2007 to August 29, 2007 (“Predecessor 2007”) includes 30 weeks and 3 days. Presented herein are unaudited pro forma results of operations for the period from January 29, 2007 to February 3, 2008 (“pro forma 2007”), assuming the Transactions had been completed as of January 29, 2007. Pro forma 2007 includes 53 weeks. The fiscal year ending January 30, 2011 (“fiscal 2010”) includes 52 weeks.

 

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Index to Financial Statements

HD SUPPLY, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Continued)

 

Consolidated results of operations

Consolidated results of operations – fiscal 2009 and fiscal 2008

 

Dollars in millions, Successor periods              Percentage
increase
(decrease)
   % of Net sales    Basis point
increase
(decrease)
     Fiscal
    2009    
   Fiscal
    2008    
      Fiscal
    2009    
   Fiscal
2008
  

Net sales

     $  7,418         $   9,768       (24.1)%       100.0%     100.0%     –     

    Gross profit

   1,996       2,634       (24.2)%       26.9         27.0         (10)    

Operating expenses:

                 

    Selling, general & administrative

   1,680       2,063       (18.6)%       22.6         21.1         150     

    Depreciation & amortization

   386       403       (4.2)%       5.2         4.1         110     

    Restructuring

   28       34       (17.6)%       0.4         0.4         –     

    Goodwill impairment(a)

   224       1,053       (78.7)%       3.0         10.8         (780)    
                     

        Total operating expenses

   2,318       3,553       (34.8)%       31.2         36.4         (520)    

    Operating income (loss)

   (322)      (919)      (65.0)%       (4.3)        (9.4)        (510)    

Interest expense

   602       644       (6.5)%       8.1         6.6         150     

Interest (income)

   –       (2)      *         –         –         –     

Other (income) expense, net

   (208)      11       *         (2.8)        0.1         (290)    
                     

    Income (loss) from continuing operations before provision (benefit) for income taxes

   (716)      (1,572)      (54.5)%       (9.6)        (16.1)        (650)    

Provision (benefit) for income taxes

   (211)      (318)      (33.6)%       (2.8)        (3.3)        (50)    
                     

    Income (loss) from continuing operations

     $  (505)        $  (1,254)      (59.7)%       (6.8)        (12.8)        (600)    
                     

 

* not meaningful

(a) – See “Item 8. Financial Statements and Supplementary Data – Notes to Consolidated and Combined Financial Statements – Note 6, Goodwill and Intangible Assets.”

Highlights

Financial performance in fiscal 2009 declined compared to fiscal 2008, primarily as a result of continued decline in the residential, commercial, and municipal construction markets, decline in the oil and gas markets, and unfavorable fluctuations in prices of commodities, such as steel, PVC, copper, and nickel. After a decline of 12.4% in 2009, driven largely by a 27.1% decline in new residential spending, total U.S. construction spending is expected to grow at a 6.2% compound annual growth rate from 2009 through 2013. This forecasted growth is attributed to a recovery in residential construction, beginning with a 5.4% increase in 2010 spending, and, after a projected 10.5% decline in 2010, robust growth in 2011 and beyond for non-residential construction.

Fiscal 2009 was negatively impacted by a non-cash goodwill impairment charge of $224 million. In addition, the Company recorded charges of $28 million for branch closure and consolidation charges and $10 million for liquidation of excess inventory, primarily at our Specialty Construction and Infrastructure & Energy market sectors as part of our previously announced restructuring plan initiated in the third quarter of fiscal 2009. Fiscal 2009 was also negatively impacted by inventory valuation charges of $20 million, recorded in the fourth quarter as a result of continued weakness in the construction and oil and gas markets. The inventory liquidation and valuation charges are included in Cost of sales in the Company’s consolidated statement of operations. We expect to incur an additional $16 million in charges during fiscal 2010 for the fiscal 2009 restructuring plan. This plan should be complete by the end of the first half of fiscal 2010. As a result of changes in market conditions and the need to remain competitive for talent in our labor force, the Company adjusted the targets for its long-term incentive compensation plans, resulting in a charge of $7 million during the fourth quarter of fiscal 2009. We continued to benefit from our ongoing corporate cost reduction efforts and branch closure and consolidation activities. Despite the general economic weakness impacting our business, we have been able to maintain strong liquidity, with almost $900 million in liquidity as of January 31, 2010.

Net sales

Net sales decreased $2,350 million, or 24.1%, during fiscal 2009 as compared to fiscal 2008.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Continued)

 

The decrease in Net sales in fiscal 2009 was driven by our Infrastructure & Energy and Specialty Construction market sectors, in addition to a slight decrease at our Maintenance, Repair & Improvement market sector. Volume declines as a result of the weakening residential, commercial, and municipal construction markets and unfavorable commodity prices were the primary causes of the decreases in Net sales. Partially offsetting these declines were positive impacts from efforts to gain new market share.

Gross profit

Gross profit decreased $638 million, or 24.2%, during fiscal 2009 as compared to fiscal 2008.

The decrease was primarily at our Infrastructure & Energy and Specialty Construction market sectors with declines of $336 million and $277 million, respectively. In addition to volume declines, gross profit was negatively impacted by charges of $10 million for liquidation of excess inventory and $20 million of inventory valuation charges, recorded as a result of continued weakness in the construction and oil and gas markets. Our Maintenance, Repair & Improvement market sector’s gross profit was down slightly year over year, with a decline of $7 million, or 0.8%.

Gross profit as a percentage of Net sales (“gross margin”) decreased 10 basis points to 26.9% in fiscal 2009 from 27.0% in fiscal 2008, due to unfavorable commodity prices, competitive pricing, product inflation and the inventory liquidation and valuation charges, substantially offset by a shift in our business mix toward our higher margin Maintenance, Repair & Improvement market sector.

Operating expenses

Operating expenses decreased $1,235 million, or 34.8%, during fiscal 2009 as compared to fiscal 2008. Operating expenses were negatively impacted by goodwill impairment charges of $224 million and $1,053 million in fiscal 2009 and fiscal 2008, respectively. Excluding the goodwill impairment charges in both periods, operating expense decreased $406 million, or 16.2%, during fiscal 2009 as compared to fiscal 2008. Branch closures, personnel reductions and other cost initiatives resulted in a decrease in selling, general, and administrative expenses. In addition, depreciation and amortization expense decreased slightly in fiscal 2009 as compared to fiscal 2008 as certain intangible assets became fully amortized during fiscal 2009.

Operating expenses as a percentage of Net sales decreased to 31.2% in fiscal 2009 from 36.4% in fiscal 2008, primarily due to the goodwill impairment in fiscal 2008. Excluding the goodwill impairments in both periods, operating expenses as a percentage of Net sales increased 260 basis points during fiscal 2009 as compared to fiscal 2008. Our success in reducing operating expenses is partially offset by our continued investment in maintaining our infrastructure to support the key markets in which we serve in anticipation of a market recovery. The declines in unit sales and commodity prices at our Infrastructure & Energy and Maintenance, Repair & Improvement market sectors adversely affected absorption of overhead costs and contributed to the increase in operating expenses as a percentage of Net sales. This increase was partially offset by a slight decline in operating expenses, excluding goodwill impairment charges, as a percentage of Net sales at our Specialty Construction market sector.

Operating income (loss)

Operating loss of $322 million decreased $597 million during fiscal 2009 as compared to fiscal 2008, primarily due to the goodwill impairment charge in fiscal 2008. Excluding the goodwill impairment charges in both periods, operating loss increased $232 million during fiscal 2009 as compared to fiscal 2008. Operating loss excluding goodwill impairment charges increased primarily as a result of the volume declines due to the weakening of the residential, commercial, and municipal construction markets. Operating loss as a percentage of Net sales improved 510 basis points in fiscal 2009 as compared to fiscal 2008, primarily due to the larger goodwill impairment charge in fiscal 2008. Excluding the impact of the goodwill impairment charges in both periods, operating loss as a percentage of Net sales increased 270 basis points in fiscal 2009 as compared to fiscal 2008. The increase was driven by our Infrastructure & Energy and Specialty Construction market sectors, partially offset by a decrease at our Maintenance, Repair, & Improvement market sector.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Continued)

 

Interest expense

Interest expense associated with interest-bearing debt was lower in fiscal 2009 as compared to fiscal 2008. The decline in interest expense was primarily due to lower interest rates, and to a lesser extent, lower average debt balances. The lower average debt balances in fiscal 2009 as compared to fiscal 2008 were primarily due to the first quarter 2009 repurchase of $252 million in principal of the 13.5% Senior Subordinated Notes and repayments of the Senior ABL Credit Facility, partially offset by incremental borrowings associated with our third quarter fiscal 2008 draw on the Revolving Credit Facility in response to the volatility in the capital markets and, to a lesser extent, the interest capitalization on the 13.5% Senior Subordinated Notes.

Other (income) expense, net

During first quarter 2009, we repurchased $252 million principal amount, plus accrued interest of $15 million, of the 13.5% Senior Subordinated Notes due 2015 for $62 million. As a result, we recognized a $200 million pre-tax gain for the extinguishment of this portion of the 13.5% Senior Subordinated Notes, net of the write-off of unamortized deferred debt issuance costs. In addition, we recognized an $11 million gain in fiscal 2009 related to the valuation of our interest rate swaps.

Provision (benefit) for income taxes

The benefit for income taxes from continuing operations decreased to $211 million in fiscal 2009 from $318 million in fiscal 2008. The effective rate for continuing operations for fiscal 2009 and fiscal 2008 was a benefit of 29.5% and 20.2%, respectively. The higher effective rate for fiscal 2009 was primarily related to the larger goodwill impairment in fiscal 2008, a portion of which is non-deductible.

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. It is reasonably possible that a material adjustment of the valuation allowance could occur within one year.

Consolidated, combined, and pro forma results of operations – fiscal 2008 and fiscal 2007

The unaudited pro forma condensed consolidated results of operations for fiscal 2007 are presented giving effect to the Transactions as if they had occurred on January 29, 2007. The unaudited pro forma condensed consolidated results of operations for fiscal 2007 are based on our historical audited consolidated and combined financial statements included elsewhere in this annual report on Form 10-K, adjusted to give pro forma effect to the Transactions, which are deemed to occur concurrently and which are summarized below:

 

  Changes in depreciation and amortization expenses resulting from the fair value adjustments to net tangible and amortizable intangible assets;

 

  Increase in interest expense resulting from additional indebtedness incurred in connection with the Transactions, and amortization of debt issuance costs and intangible assets related to the THD Guarantee; and

 

  The effect on provision for income taxes of the pro forma adjustments.

The unaudited pro forma condensed consolidated results of operations for fiscal 2007 are presented because management believes it provides a meaningful comparison of operating results enabling twelve months of fiscal 2007 to be compared with fiscal 2008, adjusting for the impact of the Transactions. The unaudited pro forma condensed consolidated financial statements are for informational purposes only and do not purport to represent what our actual results of operations would have been if the Transactions had been completed as of January 29, 2007 or that may be achieved in the future. The unaudited pro forma condensed consolidated financial information and the accompanying notes should be read in conjunction with our historical audited consolidated and combined financial statements and related notes appearing elsewhere in this annual report on Form 10-K and other financial information contained in “Risk Factors” in this annual report on Form 10-K.

 

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HD SUPPLY, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Continued)

 

Dollars in millions    Successor    Successor    Predecessor                 Percentage Increase (Decrease)
     Fiscal 2008    Successor
2007
   Predecessor
2007
   Pro Forma
Adjustments
       Pro Forma
2007
  Fiscal 2008
vs.
Successor
2007
  Successor
2007 vs.
Predecessor
2007
  Fiscal 2008
vs. Pro
Forma 2007
                                        

Net sales

     $ 9,768        $ 4,599        $ 7,121        $  –          $ 11,720     112.4     (35.4)   (16.7)  

Gross profit

     2,634        1,227        1,901        –          3,128     114.7     (35.5)   (15.8)  

Operating expenses:

                      

Selling, general & administrative

     2,063        1,001        1,424        –          2,425     106.1     (29.7)   (14.9)  

Depreciation & amortization

     403        168        115        109     a      392     139.9     46.1    2.8   

Restructuring

     34        –        –        –          –     *     –     *    

Goodwill impairment

     1,053        –        –        –          –     *     –     *    
                                          

Total operating expenses

     3,553        1,169        1,539        109          2,817     *     (24.0)   26.1   

Operating income (loss)

     (919)       58        362        (109)         311     *     (84.0)   *    

Interest expense

     644        289        221        178     b      688     122.8     30.8    (6.4)  

Interest (income)

     (2)       –        –        –          –     *     *     *    

Other (income) expense, net

     11        –        –        –          –     *     *     *    
                                          

Income (loss) from continuing operations before provision (benefit) for income taxes

     (1,572)       (231)       141        (287)         (377)    *     *     *    

Provision (benefit) for income taxes

     (318)       (83)       58        (106)    c      (131)    *     *     (142.7)  
                                          

Income (loss) from continuing operations

     $ (1,254)       $ (148)       $ 83        $ (181)         $ (246)    *     *     *   
                                          

 

 *   not meaningful

 

(a) The Transactions were accounted for as a purchase in accordance with U.S. GAAP. Under these principles, the acquisition consideration was allocated to our tangible assets and liabilities based on their fair values. The excess purchase price over the fair value of the net assets acquired was recorded as goodwill. The pro forma adjustment shown below is based upon our final valuation of tangible and intangible net assets as if the Transaction occurred on January 29, 2007 (amounts in millions).

 

New depreciation expense (i)

         $ 71     

New amortization expense (i i)

     153     
         

Total pro forma depreciation and amortization expense

     224     

Less: Historical depreciation and amortization expense

     115     
         

Adjustment to depreciation and amortization expense

         $ 109     
         

 

  (i) Fair value of fixed assets acquired, and included in continuing operations, was $647 million with a weighted average useful life of 5.3 years.

(ii)

 

(Dollars in millions)

     Fair value        Useful life  
(in years)
   New amortization
 expense (7 months) 
    

Customer relationships

     $ 1,546      7            $ 129           

Strategic purchase agreement

     166      7      14           

Trade names

     150      20        4           

Leasehold interests

     18      4      3           

Covenant not to compete

     12      2      3           
                   
     $ 1,892                 $ 153           
                   

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Continued)

 

(b) Reflects the pro forma adjustment to interest expense as if our capital structure from the Transactions was in place as of January 29, 2007 (amounts in millions):

 

Interest on new borrowings (i)

         $ 367     

Amortization of deferred financing costs and THD Guarantee (ii)

     32     
         

Total pro forma interest expense

     399     

Less: Historical interest expense

     221     
         

Adjustment to interest expense

         $ 178     
         

 

  (i) Pro-forma interest expense for Predecessor 2007 assumes: (1) an estimated average outstanding balance of $1,350 million on our ABL Credit Facility using an assumed interest rate equal to the seven-month average of the 1-month LIBOR during the Predecessor 2007 period (5.32%) plus 1.5%, (2) $1,000 million on our Term Loan using an assumed interest rate equal to the seven-month average of the 1-month LIBOR during the Predecessor 2007 period (5.32%) plus 1.25%, (3) $2,500 million on our 12% Senior Notes and (4) $1,300 million on our 13.5% Senior Subordinated Notes.

 

  (ii) Represents amortization expense on approximately $210 million of deferred financing costs in connection with the Transactions using a weighted average maturity of 6.3 years and amortization of the $106 million THD Guarantee over 5 years.

 

(c) Computed as the statutory tax rate of 39.1% and an adjustment for non-deductible paid-in-kind (“PIK”) interest expense.

 

     % of Net Sales     
     Successor    Successor    Predecessor              Basis Point Increase (Decrease)
     Fiscal 2008    Successor
2007
   Predecessor
2007
   Pro Forma
Adjustments
   Pro Forma
2007
   Fiscal 2008
vs.
Successor
2007
   Successor
2007 vs.
Predecessor
2007
   Fiscal 2008
vs. Pro
Forma 2007
                             

Net sales

   100.0%      100.0%      100.0%      –      100.0%      –      –      –  

Gross profit

   27.0      26.7      26.7      –      26.7      30      –      30  

Operating expenses:

                       

Selling, general & administrative

   21.1      21.8      20.0      –      20.7      (70)     180      40  

Depreciation & amortization

   4.1      3.6      1.6      1.5      3.3      50      200      80  

Restructuring

   0.4      –      –      –      –      40      –      40  

Goodwill impairment

   10.8      –      –      –      –      1,080      –      1,080  
                                 

Total operating expenses

   36.4      25.4      21.6      1.5      24.0      1,100      380      1,240  

Operating income (loss)

   (9.4)     1.3      5.1      (1.5)     2.7      (1,070)     (380)     (1,210) 

Interest expense

   6.6      6.3      3.1      2.5      5.9      30      320      70  

Interest (income)

   0.0      –      –      –      –      *      –      *  

Other (income) expense, net

   0.1      –      –      –      –      10      –      10  
                                 

Income (loss) from continuing operations before provision (benefit) for income taxes

   (16.1)     (5.0)     2.0      (4.0)     (3.2)     (1,110)     (700)     (1,290) 

Provision (benefit) for income taxes

   (3.3)     (1.8)     0.8      (1.5)     (1.1)     (150)     (260)     (220) 
                                 

Income (loss) from continuing operations

   (12.8)     (3.2)     1.2      (2.5)     (2.1)     (960)     (440)     (1,070) 
                                 

 

 *   not meaningful

 

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HD SUPPLY, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Continued)

 

Fiscal 2008 compared to Successor 2007

Highlights

Financial performance in fiscal 2008 declined compared to Successor 2007, primarily as a result of continued decline in the residential and commercial construction markets, but was positively influenced by changes in business mix, sales initiatives, reduction in force initiatives, pricing initiatives and other cost reductions. Fiscal 2008 was negatively impacted by a non-cash goodwill impairment charge of $1,053 million, a restructuring charge of $36 million and a charge related to the provision for uncollectible trade receivables of $33 million.

During fiscal 2008, we tested goodwill for recoverability at all ten reporting units assigned goodwill during the annual goodwill impairment testing in the third quarter, and we tested goodwill a second time at seven reporting units during the fourth quarter as a result of significant declines in economic conditions impacting these businesses. The testing resulted in a non-cash goodwill impairment charge for fiscal 2008 of $1,053 million related to six of the ten reporting units. The primary cause of impairment of the goodwill was a reduction in expected future cash flows for these businesses as a result of the decline in the residential and commercial construction markets and the general decline in economic conditions.

As a result of acquisition integration, the decline in the residential and commercial construction markets, and the general decline in economic conditions, management evaluated the operations and performance of individual branches and identified branches for closure or consolidation and a reduction in workforce. This analysis identified a total of 32 branches to be closed and a reduction in workforce of 1,300 employees. As a result, in fiscal 2008, we recorded a restructuring charge of $36 million, of which $2 million, related to inventory liquidation, is recorded in Cost of sales. We incurred an additional $5 million in restructuring costs during fiscal 2009 as part of this restructuring plan.

As a result of the deteriorating economic conditions and a review of the Company’s trade receivable aging and collection patterns, the Company recorded a charge of $33 million, included in selling, general and administrative expense, as a provision for uncollectible trade receivable accounts during the fourth quarter of fiscal 2008.

Net sales

Net sales increased to $9,768 million during fiscal 2008 from $4,599 million during Successor 2007, an increase of $5,169 million.

The increase in Net sales is primarily due to twelve months of operations included in fiscal 2008 compared to five months of operations included in Successor 2007. Partially offsetting the increase in fiscal 2008 Net sales was the impact of the weakening residential construction market, resulting in a significant decline in Net sales at our Infrastructure & Energy and Specialty Construction market sectors. Resulting branch closures also contributed to declines in Net sales. Partially offsetting these declines was organic sales growth at our Maintenance, Repair, & Improvement market sector.

Gross profit

Gross profit increased to $2,634 million during fiscal 2008 from $1,227 million during Successor 2007, an increase of $1,407 million.

The increase in gross profit was driven by twelve months of operations included in fiscal 2008 compared to five months of operations included in Successor 2007. Gross margin increased 30 basis points to 27.0% in fiscal 2008 as compared to Successor 2007, as a result of a shift in our business mix toward our higher margin Maintenance, Repair, & Improvement market sector as well as improvements in gross margin at this same market sector. This was substantially offset by an erosion of gross margins at our Specialty Construction market sector due to competitive pricing and fluctuations in commodity prices.

Operating expenses

Operating expenses increased $2,384 million during fiscal 2008 compared to Successor 2007, primarily due to twelve months of operations included in fiscal 2008 compared to five months of operations included in Successor 2007 as well as the goodwill impairment charge of $1,053 million recorded in fiscal 2008. Operating expenses as a

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Continued)

 

percentage of Net sales increased 1,100 basis points in fiscal 2008 compared to Successor 2007, of which 1,080 basis points were attributable to the goodwill impairment charge. Excluding the goodwill impairment charge, operating expense as a percentage of Net sales increased 20 basis points. An additional 70 basis point increase was due to the restructuring charge of $34 million and a provision for uncollectible trade receivables charge of $33 million in fiscal 2008. Branch closures, personnel reductions and other cost initiatives resulted in a decrease in selling, general and administrative expenses as a percentage of Net sales.

Operating income (loss)

Operating income declined $977 million during fiscal 2008 compared to Successor 2007, primarily as a result of the goodwill impairment charge recorded in fiscal 2008. Excluding the goodwill impairment charge, operating income increased $76 million, primarily due to twelve months of operations included in fiscal 2008 compared to five months of operations included in Successor 2007, substantially offset by the impact of the continued weakening of the residential and commercial construction market and deteriorating general economic conditions. Operating income as a percentage of Net sales decreased 1,070 basis points in fiscal 2008, of which 1,080 basis points are attributable to the goodwill impairment charge recorded in fiscal 2008. Excluding the goodwill impairment charge, operating income as a percentage of Net sales in fiscal 2008 was comparable to Successor 2007, increasing 10 basis points. Branch closures, personnel reductions and other cost initiatives resulted in an increase in operating income as a percentage of Net sales in fiscal 2008. This increase was substantially offset by the impacts of the $36 million restructuring charge (including $2 million in Cost of sales) and $33 million provision for uncollectible trade receivables charge in fiscal 2008.

Interest expense

Interest expense increased $355 million in fiscal 2008 as compared to Successor 2007, primarily due to twelve months of interest included in fiscal 2008 compared to five months of interest included in Successor 2007. The effective rate for interest expense on indebtedness decreased during fiscal 2008 as compared to an annualized rate for Successor 2007 due to a decline in market interest rates, partially offset by a slight increase in the average balance outstanding during fiscal 2008.

Provision (benefit) for income taxes

The benefit for income taxes increased to $318 million in fiscal 2008 from $83 million in Successor 2007. As a percentage of pre-tax income, the benefit declined to 20.2% from 35.9%, primarily as a result of non-deductibility of a portion of the goodwill impairment recorded in fiscal 2008.

Successor 2007 compared to Predecessor 2007

Highlights

Financial performance in Successor 2007 declined slightly compared to Predecessor 2007, primarily as a result of continued decline in the residential construction market and, to a lesser extent, the impact of seasonality. Additionally, Successor 2007 reflects increased depreciation and amortization costs associated with the application of purchase accounting for the Transactions and the additional interest cost from the debt issued to finance the Transactions.

Net sales

Net sales decreased to $4,599 million during Successor 2007 from $7,121 million during Predecessor 2007, a decrease of $2,522 million.

The decrease in Net sales is primarily due to the inclusion of five months of operations in Successor 2007 as compared to seven months of operations included in Predecessor 2007. In addition, the Predecessor 2007 period includes the majority of the spring and summer months which typically experience higher construction spending due to better weather and longer daylight hours. The impact of the weakening residential construction market throughout fiscal 2007 resulted in declines in Net sales at our Infrastructure & Energy and Specialty Construction market sectors.

 

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Index to Financial Statements

HD SUPPLY, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Continued)

 

Gross profit

Gross profit decreased to $1,227 million during Successor 2007 from $1,901 million during Predecessor 2007, a decrease of $674 million, or 35.5%.

The decline in gross profit was primarily due to the inclusion of five months of operations in Successor 2007 as compared to seven months of operations included in Predecessor 2007. Gross margin remained flat at 26.7% in Successor 2007 and Predecessor 2007. A slight increase in gross margins at our Specialty Construction sector was offset by slight declines at our other market sectors.

Operating expenses

Operating expenses decreased $370 million during Successor 2007 compared to Predecessor 2007, primarily due to the inclusion of five months of operations in Successor 2007 as compared to seven months of operations included in Predecessor 2007. Operating expenses as a percentage of Net sales increased 380 basis points in Successor 2007 as compared to Predecessor 2007, primarily due to the decline in unit sales adversely affecting the absorption of overhead costs and the increased depreciation and amortization expense as a result of the Transactions.

Operating income (loss)

Operating income declined $304 million during Successor 2007 compared to Predecessor 2007, primarily due to the inclusion of five months of operations in Successor 2007 as compared to seven months of operations included in Predecessor 2007. Operating income as a percentage of Net sales declined 380 basis points in Successor 2007 as compared to Predecessor 2007 due entirely to the increase in operating expenses as a percentage of Net sales.

Interest expense

Interest expense of $289 million for Successor 2007 reflects the indebtedness entered into to finance the Transactions. Interest expense of $221 million for Predecessor 2007 reflects the loan agreements between HD Supply and our former parent, Home Depot.

Provision (benefit) for income taxes

The Successor 2007 benefit for income taxes was $83 million compared with a provision of $58 million in Predecessor 2007. As a percentage of pre-tax income, the benefit of 35.9% in Successor 2007 compares with a provision of 41.1% in Predecessor 2007. The decline in the effective tax rate is reflective of an increase in non-deductible expenses related to interest expense.

Fiscal 2008 compared to pro forma 2007

Highlights

Financial performance in fiscal 2008 declined compared to pro forma 2007, primarily as a result of continued decline in the residential and commercial construction markets, but was positively influenced by changes in business mix, sales initiatives, reduction in force initiatives, pricing initiatives and other cost reductions. Fiscal 2008 was negatively impacted by a non-cash goodwill impairment charge of $1,053 million, a restructuring charge of $36 million, and a charge related to the provision for uncollectible trade receivables of $33 million.

During fiscal 2008, we tested goodwill for recoverability at all ten reporting units assigned goodwill during the annual goodwill impairment testing in the third quarter, and we tested goodwill a second time at seven reporting units during the fourth quarter as a result of significant declines in economic conditions impacting these businesses. The testing resulted in a non-cash goodwill impairment charge for fiscal 2008 of $1,053 million related to six of the ten reporting units. The primary cause of impairment of the goodwill was a reduction in expected future cash flows for these businesses as a result of the decline in the residential and commercial construction markets and the general decline in economic conditions.

As a result of acquisition integration, the decline in the residential and commercial construction markets, and the general decline in economic conditions, management evaluated the operations and performance of individual

 

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Index to Financial Statements

HD SUPPLY, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Continued)

 

branches and identified branches for closure or consolidation and a reduction in workforce. This analysis identified a total of 32 branches to be closed and a reduction in workforce of 1,300 employees. As a result, in fiscal 2008, we recorded a restructuring charge of $36 million, of which $2 million, related to inventory liquidation, is recorded in Cost of sales. We expect to incur an additional $9 million in restructuring costs during fiscal 2009 as part of this restructuring plan.

As a result of the deteriorating economic conditions and a review of the Company’s trade receivable aging and collection patterns, the Company recorded a charge of $33 million, included in selling, general and administrative expense, as a provision for uncollectible trade receivable accounts during the fourth quarter of fiscal 2008.

Net sales

Net sales decreased to $9,768 million during fiscal 2008 from $11,720 million during pro forma 2007, a decrease of $1,952 million, or 16.7%.

The impact of the weakening residential construction market resulted in a significant decline in Net sales at our Infrastructure & Energy and Specialty Construction market sectors. Resulting branch closures also contributed to the decline in Net sales. In addition, Net sales in fiscal 2008 reflect fiscal 2008’s 52-week period versus pro forma 2007’s 53-week period. Partially offsetting these declines was organic sales growth at our Maintenance, Repair, & Improvement market sector.

Gross profit

Gross profit decreased to $2,634 million during fiscal 2008 from $3,128 million during pro forma 2007, a decrease of $494 million, or 15.8%.

The decline in gross profit was driven by declines at our Specialty Construction and Infrastructure & Energy market sectors of $310 million and $201 million, respectively. These declines were partially offset by an increase of $25 million at our Maintenance, Repair & Improvement market sector. Gross profit as a percentage of Net sales increased 30 basis points to 27.0% in fiscal 2008 from 26.7% in pro forma 2007, as a result of a shift in our business mix toward our higher margin Maintenance, Repair, & Improvement market sector. This was substantially offset by an erosion of margins at our Specialty Construction market sector due to competitive pricing and, to a lesser extent, our Infrastructure & Energy market sector due to fluctuations in commodity prices.

Operating expenses

Operating expenses increased $736 million during fiscal 2008 compared to pro forma 2007, primarily due to the goodwill impairment charge of $1,053 million recorded in fiscal 2008. Excluding the goodwill impairment charge, operating expenses decreased $317 million during fiscal 2008 compared to pro forma 2007. Branch closures, personnel reductions and other cost initiatives resulted in a decrease in selling, general, and administrative expenses. These decreases in expenses were partially offset in fiscal 2008 by a restructuring charge of $34 million and a provision for uncollectible trade receivables charge of $33 million. Operating expenses as a percentage of Net sales increased 1,240 basis points in fiscal 2008 compared to pro forma 2007, of which 1,080 basis points were attributable to the goodwill impairment charge. Excluding the goodwill impairment charge, operating expense as a percentage of Net sales increased 160 basis points. Declines in unit sales adversely affected absorption of overhead costs and contributed to the increase in operating expenses as a percentage of Net sales.

Operating income (loss)

Operating income declined $1,230 million during fiscal 2008 compared to pro forma 2007, primarily as a result of the goodwill impairment charge. Excluding the goodwill impairment charge, operating income declined $177 million, primarily as a result of the continued weakening of the residential and commercial construction market and deteriorating general economic conditions. Operating income as a percentage of Net sales decreased 1,210 basis points in fiscal 2008, of which 1,080 basis points are attributable to the goodwill impairment charge recorded in fiscal 2008. Excluding the goodwill impairment charge, operating income as a percentage of Net sales decreased 130 basis points in fiscal 2008 as compared to pro forma 2007 primarily due to the $36 million restructuring charge (including $2 million in Cost of sales), $33 million provision for uncollectible trade

 

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Index to Financial Statements

HD SUPPLY, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Continued)

 

receivables charge, and an increase of $11 million in depreciation and amortization for recent additions to fixed assets.

Interest expense

Interest expense decreased $44 million in fiscal 2008 as compared to pro forma 2007, primarily due to a decline in market interest rates and, to a lesser extent, lower average balances outstanding during fiscal 2008.

Provision (benefit) for income taxes

The benefit for income taxes increased to $318 million in fiscal 2008 from $131 million in pro forma 2007. As a percentage of pre-tax income, the benefit declined to 20.2% in fiscal 2008 from 34.5% in pro forma 2007, primarily as a result of non-deductibility of a portion of the goodwill impairment recorded in fiscal 2008.

Results of operations by market sector

Infrastructure & Energy

Fiscal 2009 and fiscal 2008

 

Dollars in millions, Successor periods      Fiscal 2009        Fiscal 2008      Increase
  (Decrease)  
    

Net sales

     $ 3,694.6        $ 5,011.4      (26.3)%     

Operating income (loss)

     (160.6)      (564.5)     (71.6)%     

% of Net sales

     (4.3)%        (11.3)%      (700) bps     

Net sales

Net sales decreased $1,317 million, or 26.3%, during fiscal 2009 as compared to fiscal 2008.

The decline in Net sales in fiscal 2009 compared to fiscal 2008 was driven by Waterworks, which had a decline in Net sales of $707 million. Utilities, Electrical, and IPVF also had declines in Net sales in fiscal 2009 of $218 million, $214 million, and $174 million, respectively, as compared to fiscal 2008. Volume declines as a result of the continued economic weakness in the residential housing, municipal, and commercial construction markets were the primary drivers for the declines in Net sales at Waterworks, Utilities and Electrical, having an estimated impact of over $1 billion. Net sales declines at IPVF, and to a lesser extent Electrical, were driven by the fluctuation of commodity prices, primarily nickel at IPVF and copper and steel at Electrical.

Operating income (loss)

Operating loss decreased $404 million to a loss of $161 million during fiscal 2009 as compared to fiscal 2008. The primary driver of the decline was a goodwill impairment charge of $801 million during fiscal 2008, offset partially by a goodwill impairment charge of $194 million in fiscal 2009. Operating income excluding the goodwill impairment charges in both periods was $34 million and $237 million for fiscal 2009 and fiscal 2008, respectively, a decrease of $203 million, or 85.9%, during fiscal 2009 as compared to fiscal 2008.

The operating income decrease in fiscal 2009, excluding the goodwill impairment charges in both periods, compared to fiscal 2008 was driven by decreases of $87 million and $90 million at Waterworks and IPVF, respectively. Utilities and Electrical also experienced declines in operating income, excluding the goodwill impairment charges in both periods, of $12 million and $14 million, respectively. The decline in operating income for fiscal 2009, excluding the goodwill impairment charges in both periods, at Waterworks, Utilities, and Electrical was primarily driven by volume declines related to the weakening of the residential, municipal, and commercial construction markets. In addition, during the fourth quarter of fiscal 2009, inventory valuation charges of $20 million were recognized at Utilities and IPVF as a result of the continued weakening of the construction and oil and gas markets. Partially offsetting these negative impacts was a decline in selling, general, and administrative costs, primarily due to personnel reductions and branch closures, and other cost reduction efforts. The decline in operating income at IPVF, excluding the goodwill impairment charges in both periods, was driven by margin compression as a result of commodity price declines, the inventory valuation charge referred to above, and was also partially impacted by volume declines.

 

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Index to Financial Statements

HD SUPPLY, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Continued)

 

Operating loss as a percentage of Net sales in fiscal 2009 improved as compared to fiscal 2008 primarily due to the goodwill impairment charge in fiscal 2008, partially offset by the goodwill impairment charge in fiscal 2009. Excluding the goodwill impairment charges in both periods, operating income as a percentage of Net sales declined 380 basis points in fiscal 2009 as compared to fiscal 2008. This decline was driven by gross margin declines at IPVF and the reduction in sales outpacing the reduction in fixed costs, primarily at Waterworks and Electrical.

Fiscal 2008 and fiscal 2007

 

Dollars in millions    Successor    Successor    Predecessor                  Increase (Decrease)
     Fiscal 2008    Successor
2007
   Predecessor
2007
   Pro Forma
Adjustments
       Pro Forma
2007
  

Fiscal 2008

vs.

Successor
2007

   Successor
2007 vs.
Predecessor
2007
   Fiscal 2008
vs. Pro
Forma 2007
                                         

Net sales

     $ 5,011.4        $ 2,314.3        $ 3,606.1        $ –          $ 5,920.4      116.5%        (35.8)%       (15.4)%  

Operating income (loss)

     (564.5)       141.0        292.9        (44.0)    a      389.9      *          (51.9)%       *     

% of Net sales

     (11.3)%       6.1%       8.1%       (1.2)%         6.6%       (1,740) bps        (200) bps      (1,790) bps 

 

 *   not meaningful

 

(a) The Transactions were accounted for as a purchase in accordance with U.S. GAAP. Under these principles, the acquisition consideration was allocated to our tangible assets and liabilities based on their fair values. The excess purchase price over the fair value of the net assets acquired was recorded as goodwill. The pro forma adjustment shown below is based upon our final valuation of tangible and intangible net assets as if the Transaction occurred on January 29, 2007 (amounts in millions).

 

New depreciation expense (i)

         $   15.5     

New amortization expense (i i)

     72.7     
         

Total pro forma depreciation and amortization expense

     88.2     

Less: Historical depreciation and amortization expense

     44.2     
         

Adjustment to depreciation and amortization expense

         $ 44.0     
         

 

  (i) Fair value of fixed assets acquired, and included in continuing operations, was $82 million with a weighted average useful life of 3.1 years.

(ii)

 

(Dollars in millions)

     Fair value        Useful life  
(in years)
   New amortization
  expense (7 months)  
    

Customer relationships

         $ 861       7    $  71     

Leasehold interests

     (2)      4          –     

Covenant not to compete

     7       2          2     
                 
         $ 866         $  73     
                 

Fiscal 2008 compared to Successor 2007

Net sales

Net sales increased to $5,011.4 million during fiscal 2008 from $2,314.3 million during Successor 2007, an increase of $2,697 million. The increase in Net sales is primarily due to twelve months of operations included in fiscal 2008 compared to five months of operations included in Successor 2007.

Partially offsetting the increase in fiscal 2008 were volume declines as a result of the economic downturn, primarily in the residential housing market. Electrical was further impacted by branch closures that occurred in late Successor 2007 and the fluctuation of commodity prices, primarily copper and steel; though this impact was substantially offset by strong commercial business in Texas. IPVF also experienced a negative impact on Net sales related to commodity prices as a decrease in nickel prices resulted in lower average selling prices of key products. However, volume increases at IPVF within the key end markets of downstream oil and gas, as well as petrochemical and chemical markets, outweighed the impact of falling nickel prices during fiscal 2008.

 

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Index to Financial Statements

HD SUPPLY, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Continued)

 

Operating income (loss)

Operating income decreased $705 million during fiscal 2008 compared to Successor 2007, primarily as a result of a goodwill impairment charge in fiscal 2008 of $801 million, partially offset by the inclusion of twelve months of operations in fiscal 2008 compared to five months of operations included in Successor 2007. Excluding the goodwill impairment charge, operating income increased $96 million in fiscal 2008. Operating income as a percentage of Net sales decreased 1,740 basis points in fiscal 2008 as compared to Successor 2007, of which 1,600 basis points were attributable to the goodwill impairment charge.

The operating income decrease in fiscal 2008 compared to Successor 2007 was driven by decreases of $663.6 million, $27.3 million, $7.6 million, and $7.1 million, at Waterworks, Utilities, IPVF, and Electrical, respectively. Excluding the goodwill impairment charge, operating income increased by $17.2 million, $17.1 million, and $68.7 million at Waterworks, Utilities, and IPVF, respectively, partially offset by a decrease of $7.1 million at Electrical.

During fiscal 2008, Waterworks, Utilities, and Electrical were impacted by volume declines related to the weakening of the residential and commercial construction markets. In addition, operating income for the market sector was negatively impacted by a restructuring charge of $8 million recorded in late fiscal 2008 for branch closures and consolidations and personnel reductions, and a $12 million charge recorded in late fiscal 2008 for a provision for uncollectible trade receivable accounts, primarily at Waterworks and IPVF, as a result of declining general economic conditions and a review of the aging trade receivable accounts and collection patterns.

Excluding the goodwill impairment charge, operating income as a percentage of Net sales declined 140 basis points in fiscal 2008 compared to Successor 2007. Gross margins at Waterworks and IPVF declined slightly during fiscal 2008 as compared to Successor 2007, while Utilities and Electrical experienced slight improvements, resulting in no change for the market sector period over period. However, the reduction in monthly sales outpaced the reduction in fixed costs as a result of cost initiatives for Waterworks, Utilities, and Electrical, resulting in a decrease in operating income as a percentage of Net sales. The decline in operating income as a percentage of Net sales at IPVF was primarily driven by a decline in gross margins as a result of lower average selling prices due to the decline in the price of nickel and, to a lesser extent, an increase in operating costs as a percentage of Net sales.

Successor 2007 compared to Predecessor 2007

Net sales

Net sales decreased to $2,314.3 million during Successor 2007 from $3,606.1 million during Predecessor 2007, a decrease of $1,292 million.

The decrease in Net sales is primarily due to five months of operations included in Successor 2007 compared to seven months of operations included in Predecessor 2007. In addition, the Predecessor 2007 period includes the majority of the spring and summer months which typically experience higher construction activity due to better weather and longer daylight hours. Waterworks experienced significant volume declines in Successor 2007 as compared to Predecessor 2007 as a result of the economic downturn, primarily in the residential housing market.

Operating income (loss)

Operating income decreased $152 million during Successor 2007 compared to Predecessor 2007, primarily due to the inclusion of five months of operations in Successor 2007 compared to seven months of operations included in Predecessor 2007. Operating income as a percentage of Net sales decreased 200 basis points in Successor 2007 as compared to Predecessor 2007.

The operating income decrease in Successor 2007 compared to Predecessor 2007 was driven by decreases of $82.5 million, $20.1 million, $38.9 million, and $10.4 million at Waterworks, Utilities, IPVF, and Electrical, respectively. Operating income as a percentage of Net sales declined across the entire sector, driven by an increase in depreciation and amortization as a result of the Transactions and a reduction in gross margins at IPVF due to the impact of fluctuating commodity prices.

 

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Index to Financial Statements

HD SUPPLY, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Continued)

 

Fiscal 2008 compared to pro forma 2007

Net sales

Net sales decreased to $5,011.4 million during fiscal 2008 from $5,920.4 million during pro forma 2007, a decrease of $909 million. The decline in Net sales in fiscal 2008 compared to pro forma 2007 was driven by Waterworks, Utilities, and Electrical, which had declines in Net sales of $631 million, $163 million, and $169 million, respectively. Volume declines as a result of the economic downturn, primarily in the residential housing market, were the primary drivers for the declines in Net sales for these operations, having an estimated impact of approximately $930 million. Electrical was further impacted by branch closures that occurred in late fiscal 2007 and the fluctuation of commodity prices, primarily copper and steel; though this impact was substantially offset by strong commercial business in Texas. IPVF also experienced a negative impact on Net sales related to commodity prices as a decrease in nickel prices resulted in lower average selling prices of key products. However, volume increases at IPVF within the key end markets of downstream oil and gas, as well as petrochemical and chemical markets, outweighed the impact of falling nickel prices resulting in an increase in Net sales of $54 million during fiscal 2008 as compared to pro forma 2007.

Operating income (loss)

Operating income decreased $954 million during fiscal 2008 compared to pro forma 2007, primarily as a result of a goodwill impairment charge in fiscal 2008 of $801 million. Excluding the goodwill impairment charge, operating income decreased $153 million in fiscal 2008. Operating income as a percentage of Net sales decreased 1,790 basis points in fiscal 2008 as compared to the pro forma 2007, of which 1,600 basis points were attributable to the goodwill impairment charge.

The operating income decrease in fiscal 2008 compared to pro forma 2007 was driven by decreases of $775.9 million, $64.7 million, $23.4 million, and $90.4 million at Waterworks, Utilities, Electrical, and IPVF, respectively. Excluding the goodwill impairment charge, operating income declines were $95.1 million, $20.3 million, $23.4 million, and $14.1 million at Waterworks, Utilities, Electrical, and IPVF, respectively. Excluding the goodwill impairment charge, the decline in operating income at Waterworks, Utilities, and Electrical was primarily driven by volume declines related to the weakening of the residential and commercial construction markets. In addition, operating income for the market sector was negatively impacted by a restructuring charge of $8 million recorded in late fiscal 2008 for branch closures and consolidations and personnel reductions, and a $12 million charge recorded in late fiscal 2008 for a provision for uncollectible trade receivable accounts, primarily at Waterworks and IPVF, as a result of declining general economic conditions and a review of the aging trade receivable accounts and collection patterns. Partially offsetting these negative impacts, was a decline in selling, general, and administrative costs at Waterworks and Electrical, primarily due to personnel reductions and branch closures, and other cost reduction efforts.

Excluding the goodwill impairment charge, operating income as a percentage of Net sales declined 190 basis points in fiscal 2008 compared to pro forma 2007. Gross margins at Waterworks, Utilities, and Electrical were relatively flat year over year; however, the reduction in sales outpaced the reduction in fixed costs of these businesses, resulting in a decrease in operating income as a percentage of Net sales. The decline in operating income as a percentage of Net sales at IPVF was primarily driven by a decline in gross margins as a result of lower average selling prices due to the decline in the price of nickel.

Maintenance, Repair & Improvement

Fiscal 2009 and fiscal 2008

 

Dollars in millions, Successor periods      Fiscal 2009        Fiscal 2008      Increase
  (Decrease)  
    

Net sales

     $ 2,023.4        $ 2,070.2      (2.3)%     

Operating income

     155.6        162.4      (4.2)%     

% of Net sales

     7.7%        7.8%      (10) bps     

 

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Index to Financial Statements

HD SUPPLY, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Continued)

 

Net sales

Net sales decreased $47 million, or 2.3%, during fiscal 2009 as compared to fiscal 2008.

The decline in Net sales was driven by Facilities Maintenance and Repair & Remodel, which both had declines in Net sales of $25 million. These declines were partially offset at Crown Bolt, which had an increase in Net sales of $4 million in fiscal 2009 as compared to fiscal 2008. The general economic deterioration and the weakening of the residential construction market were the primary causes of the declines in Net sales in fiscal 2009. Partially offsetting the volume declines was an increase in Net sales driven by sales initiatives at both Crown Bolt and Facilities Maintenance.

Operating income

Operating income decreased $7 million, or 4.2%, during fiscal 2009 as compared to fiscal 2008. The primary driver of the decline was a goodwill impairment charge of $30 million at Repair & Remodel during fiscal 2009. Excluding the goodwill impairment charge, operating income increased $23 million during fiscal 2009 as compared to fiscal 2008.

The operating income increase in fiscal 2009, excluding the goodwill impairment charge, as compared to fiscal 2008 was driven by increases of $23 million and $5 million at Facilities Maintenance and Crown Bolt, respectively, partially offset by a decrease of $5 million at Repair & Remodel.

The operating income increases at Facilities Maintenance and Crown Bolt for fiscal 2009 were driven by decreases in selling, general and administrative expenses primarily as a result of lower personnel and freight costs. In addition, operating income at Facilities Maintenance was positively impacted in fiscal 2009 by a reduction in depreciation and amortization expense and an increase in gross profit as a result of strategic pricing partially offset by product inflation. The operating income decrease at Repair & Remodel, excluding the goodwill impairment charge, was driven by volume declines, as a result of the weakening residential construction market partially offset by a decline in selling, general, and administrative expense due to cost reduction efforts.

Operating income as a percentage of Net sales decreased 10 basis points in fiscal 2009 as compared to fiscal 2008, driven by the goodwill impairment charge at Repair & Remodel. Excluding the goodwill impairment charge, operating income as a percentage of Net sales increased 140 basis points in fiscal 2009 as compared to fiscal 2008, driven by declines in selling, general and administrative expenses across the sector and improvements in gross margin at Facilities Maintenance.

During November 2009, Facilities Maintenance replaced a highly customized and overburdened software system with SAP. The November launch encompassed order entry, customer relationship management, sales, receiving, returns, billing, inventory payables, business intelligence, and purchasing management processes which are now highly integrated and streamlined. The new SAP platform operates on stronger and more secure IT infrastructure to enable continued growth and expansion as well as a better customer experience. Facilities Maintenance’s capital expenditures for the system were $40 million, incurred during fiscal 2009, fiscal 2008, and fiscal 2007. The SAP platform will be amortized over 6 years, resulting in an incremental annualized amortization expense of approximately $7 million. Fiscal 2009 includes an incremental $1 million of amortization expense related to the new SAP platform.

Fiscal 2008 and fiscal 2007

 

Dollars in millions    Successor    Successor    Predecessor                  Increase (Decrease)
     Fiscal 2008    Successor
2007
   Predecessor
2007
   Pro Forma
Adjustments
       Pro Forma
2007
  

  Fiscal 2008  
vs.

Successor
2007

   Successor
2007 vs.
Predecessor
2007
  

Fiscal 2008

vs. Pro
  Forma 2007  

                                         

Net sales

     $ 2,070.2        $ 850.2        $ 1,237.2        $ –          $ 2,087.4      143.5%     (31.3)%     (0.8)%  

Operating income (loss)

     162.4        44.7        157.8        (59.1)    a      143.4      *      (71.7)%     13.2%   

% of Net sales

     7.8%       5.3%       12.8%       (4.8)%         6.9%     250 bps     (750) bps     90 bps  

 

 *   not meaningful

 

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Index to Financial Statements

HD SUPPLY, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Continued)

 

(a) The Transactions were accounted for as a purchase in accordance with U.S. GAAP. Under these principles, the acquisition consideration was allocated to our tangible assets and liabilities based on their fair values. The excess purchase price over the fair value of the net assets acquired was recorded as goodwill. The pro forma adjustment shown below is based upon our final valuation of tangible and intangible net assets as if the Transaction occurred on January 29, 2007 (amounts in millions).

 

New depreciation expense (i)

         $ 20.7     

New amortization expense (i i)

     61.8     
         

Total pro forma depreciation and amortization expense

     82.5     

Less: Historical depreciation and amortization expense

     23.4     
         

Adjustment to depreciation and amortization expense

         $ 59.1     
         

 

  (i) Fair value of fixed assets acquired, and included in continuing operations, was $178 million with a weighted average useful life of 5.0 years.

(ii)

 

  (Dollars in millions)

     Fair value        Useful life  
(in years)
   New amortization
  expense (7 months)  
    

  Customer relationships

         $  549      7                  $  45             

  Strategic purchase agreement

   166      7          14             

  Trade names

   18      20          1             

  Leasehold interests

   10      4          1             

  Covenant not to compete

   2      2          1             
               
         $  745                 $  62             
               

Fiscal 2008 compared to successor 2007

Net sales

Net sales increased to $2,070.2 million during fiscal 2008 from $850.2 million during Successor 2007, an increase of $1,220 million.

The increase in Net sales is primarily due to twelve months of operations included in fiscal 2008 compared to five months of operations included in Successor 2007. In addition, Net sales at Facilities Maintenance increased due to an increase in renovation sales, pricing initiatives and overall organic growth in the business. Partially offsetting these increases was the negative impact of the weakening residential construction market at Repair & Remodel.

Operating income

Operating income increased $117.7 million during fiscal 2008 compared to Successor 2007, primarily due to twelve months of operations included in fiscal 2008 compared to five months of operations included in Successor 2007. The operating income increase in fiscal 2008 compared to Successor 2007 was driven by increases of $104.4 million, $10.2 million and $3.1 million at Facilities Maintenance, Crown Bolt, and Repair & Remodel, respectively.

Operating income as a percentage of Net sales increased 250 basis points in fiscal 2008 as compared to Successor 2007. This increase was primarily driven by gross margin improvements across the entire market sector. Improvements in gross margins at both Facilities Maintenance and Crown Bolt were primarily due to pricing initiatives and the impact of a new product launch by Crown Bolt in late 2007, which temporarily reduced margins during Successor 2007. Gross margins at Repair & Remodel improved during fiscal 2008 as a result of closing less profitable branches in fiscal 2007.

Successor 2007 compared to Predecessor 2007

Net sales

Net sales decreased to $850.2 million during Successor 2007 as compared to $1,237.2 million during Predecessor 2007, a decrease of $387 million.

The decrease in Net sales is primarily due to the inclusion of five months of operations in Successor 2007 as compared to seven months of operations included in Predecessor 2007. In addition, the Predecessor 2007 period

 

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HD SUPPLY, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Continued)

 

includes the majority of the spring and summer months which typically experience higher construction activity due to better weather and longer daylight hours. Repair & Remodel was also negatively impacted by the weakening of the residential construction market, which led to four branch closures.

Operating income

Operating income decreased $113.1 million during Successor 2007 compared to Predecessor 2007, primarily due to the inclusion of five months of operations in Successor 2007 as compared to seven months of operations included in Predecessor 2007. The operating income decrease in Successor 2007 compared to Predecessor 2007 was driven by decreases of $62.1 million, $35.3 million and $15.6 million at Facilities Maintenance, Crown Bolt, and Repair & Remodel, respectively.

Operating income as a percentage of Net sales decreased 750 basis points in Successor 2007 as compared to the Predecessor 2007, driven by an increase in depreciation and amortization primarily due to the Transactions. In addition, Crown Bolt’s gross margins and operating income as a percentage of Net sales in Successor 2007 were negatively impacted by the initial costs related to a new product launch in late 2007. Repair & Remodel’s gross margins in Successor 2007 were negatively impacted by the weakening residential construction market. Partially offsetting these negative impacts was a decrease in selling, general and administrative costs as a percentage of Net sales at Facilities Maintenance.

Fiscal 2008 compared to pro forma 2007

Net sales

Net sales decreased to $2,070.2 million during fiscal 2008 from $2,087.4 million during pro forma 2007, a decrease of $17 million.

The decline in Net sales in fiscal 2008 compared to pro forma 2007 was driven by Repair & Remodel, which had a decline in Net sales of $67 million. This decline was significantly offset at Facilities Maintenance and Crown Bolt, which had increases in Net sales of $32 million and $17 million, respectively, in fiscal 2008 compared to pro forma 2007. The weakening of the residential construction market was the primary driver of the decline in Net sales at Repair & Remodel, which led to four branch closures. Substantially offsetting these declines was sales growth at Facilities Maintenance, driven by an increase in renovation sales, pricing initiatives and overall organic growth in the business, the impact of sales initiatives at Repair & Remodel, and sales growth at Crown Bolt as a result of pricing initiatives and the addition of a new product line offering in late fiscal 2007.

Operating income

Operating income increased $19 million during fiscal 2008 compared to pro forma 2007. Operating income as a percentage of Net sales increased 90 basis points in fiscal 2008 as compared to pro forma 2007. The operating income increase in fiscal 2008 compared to pro forma 2007 was driven by increases of $30.2 million and $0.3 million at Facilities Maintenance and Crown Bolt, respectively, partially offset by a decrease of $11.5 million at Repair & Remodel.

The operating income increases at Facilities Maintenance and Crown Bolt were driven by improvements in gross margins due to pricing initiatives. Substantially offsetting this improvement at Crown Bolt was a $7 million increase in depreciation and amortization expense due to capital expenditures on store fixtures with relatively short useful lives. The operating income decrease at Repair & Remodel was driven by volume declines and related branch closures, as a result of the weakening residential construction market. Partially offsetting these negative impacts to operating income was a decline in selling, general, and administrative expense at Repair & Remodel due to cost reduction efforts.

The increase in operating income as a percentage of Net sales was driven by gross margin improvements at Facilities Maintenance and Crown Bolt due to pricing initiatives. However, the improvement at Crown Bolt was substantially offset by an increase in depreciation and amortization expense. Gross margins at Repair & Remodel also improved during fiscal 2008 as a result of closing less profitable branches in fiscal 2007. However, the

 

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HD SUPPLY, INC.

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS

(Continued)

 

reduction in sales outpaced the reduction in fixed costs of the business, resulting in a decrease in operating income as a percentage of Net sales.

Specialty Construction

Fiscal 2009 and fiscal 2008

 

Dollars in millions, Successor periods      Fiscal 2009        Fiscal 2008      Increase
    (Decrease)    

Net sales

   $ 1,530.6       $2,460.4       (37.8)%   

Operating income (loss)

   (196.2)      (365.1)      (46.3)%   

% of Net sales

   (12.8)%       (14.8)%       (200) bps  

Net sales

Net sales decreased $930 million, or 37.8%, during fiscal 2009 as compared to fiscal 2008.

White Cap, CTI, and Plumbing experienced declines in Net sales of $498 million, $152 million, and $280 million, respectively, in fiscal 2009 as compared to fiscal 2008. The weakening of the residential and commercial construction markets continued to have a negative impact on the Specialty Construction sector, having an estimated volume impact of approximately $700 million in fiscal 2009 as compared to fiscal 2008. In addition, branch closures at Plumbing in the second half of fiscal 2008 and during fiscal 2009 had an estimated negative impact on Net sales of $43 million in fiscal 2009 as compared to fiscal 2008. During fiscal 2009, CTI experienced a negative impact on Net sales due to fewer upgrade purchases by customers in new home construction and White Cap and Plumbing reported declines in Net sales due to unfavorable commodity prices, such as rebar and copper.

Operating income (loss)

Operating loss decreased $169 million during fiscal 2009 as compared to fiscal 2008, primarily as a result of a $252 million goodwill impairment charges in fiscal 2008. Excluding the goodwill impairment charge, operating loss increased $83 million during fiscal 2009 as compared to fiscal 2008.

The increase in operating loss in fiscal 2009 as compared to fiscal 2008, excluding the goodwill impairment charges, was driven by increases of $85 million and $31 million at White Cap and Plumbing, respectively, partially offset by a decrease in operating loss of $32 million at CTI.

The increases in operating loss during fiscal 2009, excluding the goodwill impairment charges, were primarily driven by volume declines related to the weakening of the residential and commercial construction markets and, to a lesser extent, competitive pricing pressures and fluctuating commodity prices. Operating income (loss) in fiscal 2009 and fiscal 2008 were negatively impacted by restructuring charges for additional branch closures and consolidations and personnel reductions. Charges of $29 million and $18 million were recorded in fiscal 2009 and fiscal 2008, respectively. Of these charges, $9 million and $2 million for fiscal 2009 and fiscal 2008, respectively, was related to inventory liquidation charges, which are included in Cost of sales in the Company’s consolidated statement of operations. Under the fiscal 2009 plan initiated in the third quarter of fiscal 2009, the Specialty Construction sector expects to close approximately 15 branches and reduce workforce personnel by approximately 340 employees. As of January 31, 2010, we have completed the closure of 8 branches and approximately 180 headcount reductions. We expect to incur an additional $15 million under this plan in fiscal 2010. During fiscal 2009, operating loss was positively impacted by a decline in selling, general and administrative costs primarily due to personnel reductions and other cost reduction efforts.

Operating loss as a percentage of Net sales decreased 200 basis points in fiscal 2009 as compared to fiscal 2008. Excluding the goodwill impairment charge in fiscal 2008, operating loss as a percentage of Net sales increased 820 basis points in fiscal 2009 as compared to fiscal 2008. During fiscal 2009, volume declines, fluctuating commodity prices, and pricing pressures resulted in a decline in gross margins that outpaced the reduction in fixed costs of the business, resulting in an increase in operating loss as a percentage of Net sales.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Continued)

 

Fiscal 2008 and fiscal 2007

 

Dollars in millions   Successor   Successor   Predecessor           Increase (Decrease)
    Fiscal 2008   Successor
2007
  Predecessor
2007
  Pro Forma
Adjustments
  Pro Forma
2007
  Fiscal 2008
vs.
Successor
2007
  Successor
2007 vs.
Predecessor
2007
  Fiscal 2008
vs. Pro
Forma 2007

Net sales

    $ 2,460.4        $ 1,323.5        $ 2,120.5       $ –          $ 3,444.0     85.9%     (37.6)%     (28.6)%  

Operating income (loss)

    (365.1)       (12.8)       23.3       (2.7)  a     7.8     *       *        *     

% of Net sales

    (14.8)%       (1.0)%       1.1%       (0.1)%         0.2%     (1,380) bps    (210) bps    (1,500) bps 

 

 *   not meaningful

 

(a) The Transactions were accounted for as a purchase in accordance with U.S. GAAP. Under these principles, the acquisition consideration was allocated to our tangible assets and liabilities based on their fair values. The excess purchase price over the fair value of the net assets acquired was recorded as goodwill. The pro forma adjustment shown below is based upon our final valuation of tangible and intangible net assets as if the Transaction occurred on January 29, 2007 (amounts in millions).

 

New depreciation expense (i)

    $   20.2    

New amortization expense (i i)

    15.6    
       

Total pro forma depreciation and amortization expense

    35.8    

Less: Historical depreciation and amortization expense

    33.1    
       

Adjustment to depreciation and amortization expense

    $ 2.7    
       

 

  (i) Fair value of fixed assets acquired, and included in continuing operations, was $247 million with a weighted average useful life of 7.1 years.

(ii)

 

(Dollars in millions)

    Fair value       Useful life  
(in years)
  New amortization
  expense (7 months)  
   

Customer relationships

          $   136     7               $    11          

Trade names

    21     20       1          

Leasehold interests

    21     4       3          

Covenant not to compete

    2     2       1          
             
          $   180               $    16          
             

Fiscal 2008 compared to successor 2007

Net sales

Net sales increased to $2,460.4 million during fiscal 2008 from $1,323.5 million during Successor 2007, an increase of $1,137 million.

The increase in Net sales is primarily due to twelve months of operations included in fiscal 2008 compared to five months of operations included in Successor 2007. Partially offsetting this increase was the negative impact of the weakening of the residential and commercial construction markets. In addition, Plumbing closed approximately 60 branches during fiscal 2008 and CTI experienced a negative impact due to competitive pressure on pricing.

Operating income (loss)

Operating income decreased $352 million during fiscal 2008 compared to Successor 2007, primarily as a result of a goodwill impairment charge of $252 million, partially offset by the inclusion of twelve months of operations in fiscal 2008 compared to five months of operations in Successor 2007. Excluding the goodwill impairment charge, operating income decreased $100 million in fiscal 2008. Operating income as a percentage of Net sales decreased 1,380 basis points during fiscal 2008 compared to Successor 2007, of which 1,020 basis points were attributable to the goodwill impairment charge.

The decrease in operating income in fiscal 2008 compared to Successor 2007 was driven by decreases of $159.4 million, $130.0 million, and $62.8 million at CTI, Plumbing, and White Cap, respectively. Excluding the goodwill

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Continued)

 

impairment charges, the operating income decreases were $91.9 million and $19.3 million at CTI and Plumbing, respectively, partially offset by an increase of $11.3 million at White Cap.

Excluding the goodwill impairment charge, the decline in operating income was primarily driven by volume declines related to the weakening of the residential and commercial construction markets. In addition, CTI’s operating income was negatively impacted by competitive pressure on pricing. During fiscal 2008, operating income was positively impacted by a decline in selling, general and administrative costs primarily due to branch closures and personnel reductions, and other cost reduction efforts. These declines were partially offset by a fourth quarter charge of $20 million for a provision for uncollectible trade receivables as a result of declining general economic conditions and a review of the aging trade receivable accounts and collection patterns. In addition, operating income for the market sector was negatively impacted by a restructuring charge of $18 million recorded in late fiscal 2008 for additional branch closures and consolidations and personnel reductions.

Excluding the goodwill impairment charge, operating income as a percentage of Net sales declined 360 basis points in fiscal 2008 compared to Successor 2007. The decline was primarily driven by CTI, and, to a lesser extent, Plumbing. The volume declines and pricing pressures at CTI resulted in a significant decline in gross margins that outweighed the impact of cost reductions, including the improvements resulting from personnel reductions. Gross margins at Plumbing were flat in fiscal 2008 as compared to Successor 2007; however, the reduction in monthly sales outpaced the reduction in fixed costs of the business, resulting in a decrease in operating income as a percentage of Net sales. Offsetting these declines was an improvement in operating income as a percentage of Net sales at White Cap driven by a decline in selling, general, and administrative costs as a percentage of Net sales.

Successor 2007 compared to predecessor 2007

Net sales

Net sales decreased to $1,323.5 million during Successor 2007 from $2,120.5 million during Predecessor 2007, a decrease of $797 million.

The decrease in Net sales is primarily due to five months of operations included in Successor 2007 compared to seven months of operations included in Predecessor 2007. In addition, the Predecessor 2007 period includes the majority of the spring and summer months which typically experience higher construction activity due to better weather and longer daylight hours. White Cap and Plumbing experienced volume declines in Successor 2007 as compared to Predecessor 2007 as a result of the weakening residential and commercial construction markets.

Operating income (loss)

Operating income decreased $36 million during Successor 2007 compared to Predecessor 2007, primarily due to the inclusion of five months of operations in Successor 2007 compared to seven months of operations included in Predecessor 2007. Operating income as a percentage of Net sales decreased 210 basis points in Successor 2007 as compared to Predecessor 2007.

The operating income decrease in Successor 2007 compared to Predecessor 2007 was driven by decreases of $24.0 million and $19.2 million at White Cap and Plumbing, respectively, partially offset by an increase of $7.0 million at CTI. The decline in operating income as a percentage of Net sales was driven by volume declines at White Cap and Plumbing, which adversely affected the absorption of overhead costs. Partially offsetting this decline was an increase in operating income as a percentage of Net sales at CTI, driven by a reduction in selling, general, and administrative costs as a percentage of Net sales.

Fiscal 2008 compared to pro forma 2007

Net sales

Net sales decreased to $2,460.4 million during fiscal 2008 from $3,444.0 million during pro forma 2007, a decrease of $984 million.

 

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HD SUPPLY, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Continued)

 

White Cap, CTI, and Plumbing experienced declines in Net sales of $202 million, $333 million, and $448 million, respectively, in fiscal 2008 compared to pro forma 2007. The weakening of the residential and commercial construction markets was the primary driver in the decline in Net sales, having an estimated impact of approximately $800 million. In addition, Plumbing closed approximately 60 branches during fiscal 2008, having an estimated negative impact on Net sales of $210 million, and CTI experienced a negative impact due to competitive pressure on pricing. Partially offsetting these declines were pricing and sales initiatives and favorable commodity prices at White Cap and Plumbing.

Operating income (loss)

Operating income decreased $373 million during fiscal 2008 compared to pro forma 2007, primarily as a result of a goodwill impairment charge of $252 million. Excluding the goodwill impairment charge, operating income decreased $121 million in fiscal 2008. Operating income as a percentage of Net sales decreased 1,500 basis points during fiscal 2008 compared to pro forma 2007, of which 1,020 basis points were attributable to the goodwill impairment charge.

The decrease in operating income in fiscal 2008 compared to pro forma 2007 was driven by decreases of $151.4 million, $145.1 million, and $76.4 million at CTI, Plumbing, and White Cap, respectively. Excluding the goodwill impairment charges, the operating income decreases were $83.9 million, $34.4 million, and $2.3 million at CTI, Plumbing, and White Cap, respectively.

Excluding the goodwill impairment charge, the decline in operating income was primarily driven by volume declines related to the weakening of the residential and commercial construction markets and, to a lesser extent, the closure of branches at Plumbing. In addition, CTI’s operating income was negatively impacted by competitive pressure on pricing, substantially offset by improvements in pricing at White Cap. During fiscal 2008, operating income was positively impacted by a decline in selling, general and administrative costs primarily due to branch closures and personnel reductions, for a combined positive impact of approximately $160 million, and other cost reduction efforts. These declines were partially offset by a fourth quarter charge of $20 million for a provision for uncollectible trade receivables as a result of declining general economic conditions and a review of the aging trade receivable accounts and collection patterns. In addition, operating income for the market sector was negatively impacted by a restructuring charge of $18 million recorded in late fiscal 2008 for additional branch closures and consolidations and personnel reductions.

Excluding the goodwill impairment charge, operating income as a percentage of Net sales declined 480 basis points in fiscal 2008 compared to pro forma 2007. The decline was primarily driven by CTI, and, to a lesser extent, Plumbing. The volume declines and pricing pressures at CTI resulted in a significant decline in gross margins that outweighed the impact of cost reductions, including the improvements resulting from a 45% decrease in personnel. Gross margins at Plumbing were relatively flat year over year; however, the reduction in sales outpaced the reduction in fixed costs of the business, resulting in a decrease in operating income as a percentage of Net sales.

Liquidity, capital resources and financial condition

Sources and uses of cash

We had $539 million in cash and cash equivalents and $359 million of available borrowings at January 31, 2010, for a combined liquidity of approximately $900 million. During fiscal 2009, cash inflow was primarily provided by cash receipts from operations including the cash receipt of an IRS refund of $134 million and receipt of the final working capital adjustment related to the Transactions of $22 million. These inflows were offset by cash used to meet the needs of the business including, but not limited to, payment of operating expenses, funding capital expenditures, and the payment of interest on debt.

Given the recent volatility in the capital markets, the Company has invested approximately $322 million in U.S. Treasury securities to fund operations in the event that any of the financial institutions that have committed to fund the Company's Revolving Credit Facility or ABL Credit Facility are unable or unwilling to meet their commitments. 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.

 

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NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS

(Continued)

 

We believe that these sources of funds will be sufficient to meet the operating needs of our business for at least the next twelve months.

As a result of recent tax legislation regarding net operating loss carry-back periods, we were able to file for a cash refund of approximately $220 million from the IRS for income tax previously paid. This filing occurred on April 6, 2010.

Information about the Company’s cash flows, by category, is presented in the consolidated and combined Statements of Cash Flows.

Net cash provided by (used for):

 

        Successor           Successor           Successor           Predecessor        
Amounts in millions   Fiscal
2009
  Fiscal
2008
  Successor
2007
  Predecessor
2007
 

Operating activities

  $    69        $    548       $364        $    408       

Investing activities

  (41)       37       (8,255)       (140)      

Financing activities

  (263)       86       7,977        (269)      
                 

Working capital

Working capital decreased to $1,925 million as of the end of fiscal 2009 from $2,071 million as of the end of fiscal 2008. The decrease in working capital during fiscal 2009 was driven by a decrease in accounts receivable, inventory, and cash and cash equivalents, substantially offset by a decrease in accounts payable. We continue to focus on asset management initiatives that are intended to improve our working capital efficiency in the future.

Working capital increased to $2,071 million as of the end of fiscal 2008 from $2,009 million as of the end of Successor 2007. The increase in working capital during fiscal 2008 was driven by an increase in cash and cash equivalents and a decrease in accounts payable, substantially offset by a decrease in accounts receivable and inventory. We continue to focus on asset management initiatives that are intended to improve our working capital efficiency in the future.

Operating activities

Cash flow from operating activities in fiscal 2009 was $69 million compared with $548 million in fiscal 2008. The decline in cash flow during fiscal 2009 as compared to fiscal 2008 was primarily the result of the timing of payments for the purchase of inventory and a reduction in operating income due primarily to the continued deterioration in the residential and commercial construction markets during fiscal 2009, partially offset by a reduction in receivables and inventory and the cash receipt of an IRS refund.

Cash flow from operating activities in fiscal 2008 was $548 million compared with $364 million in Successor 2007 and $408 million in Predecessor 2007. Cash provided by operating activities in fiscal 2008 and Successor 2007 reflect the Net Loss less non-cash charges for depreciation, amortization, goodwill impairment, and interest expense. Also contributing to cash provided by operating activities in fiscal 2008 and Successor 2007 was a more efficient use of working capital as a result of our efforts to operate our business with less inventory on hand and to more aggressively collect receivables. The increase in cash flow in fiscal 2008 compared with Successor 2007 and Predecessor 2007 is due to fiscal 2008 containing twelve months of operations compared with Successor 2007 containing five months and Predecessor 2007 containing seven months. The decline in monthly cash flow from operating activities in fiscal 2008 and Successor 2007 as compared to Predecessor 2007 is primarily related to the cash flow support of THD during Predecessor 2007 reflected as Non-cash charges from THD in the Combined Statement of Cash Flows.

Investing activities

During fiscal 2009, cash used in investing activities was $41 million, primarily driven by $58 million of capital expenditures and the $16 million acquisition of ORCO, partially offset by the receipt of $22 million for the final working capital adjustment related to the Transactions.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Continued)

 

During fiscal 2008, cash provided by investing activities was $37 million, primarily driven by the receipt of $99 million of net proceeds from the sale of our Lumber & Building Materials business, partially offset by capital expenditures of $77 million.

During Successor 2007, cash used in investing activities was $8,255 million, driven by the $8,183 million for the Transactions and $75 million of capital expenditures. During Predecessor 2007, cash used in investing activities was $140 million driven by capital expenditures of $176 million. Capital expenditures during Successor 2007 and Predecessor 2007 were higher than fiscal 2009 and fiscal 2008 as a result of integration of acquisitions in those earlier periods and investment in infrastructure due to the separation from THD.

Financing activities

During fiscal 2009, cash used in financing activities was $263 million, as a result of debt repayments, including the repurchase of $252 million principal amount of the 13.5% Senior Subordinated Notes for $62 million.

During fiscal 2008, cash provided by financing activities totaled $86 million, driven by $75 million of net borrowings on our long-term debt and $10 million of equity contributions.

During Successor 2007, cash provided by financing activities was $7,977 million driven by the issuance of $6,041 million in debt and $2,275 million of equity contributions to finance the Transactions. Partially offsetting these positive cash flows was $244 million of net payments made on revolving debt and $95 million of debt issuance costs. During Predecessor 2007, cash used in financing activities was $269 million driven by net payments to THD.

External financing

Since the Transactions, we are highly leveraged. As of January 31, 2010, we have an aggregate principal amount of $5.8 billion of outstanding debt and $359 million of available borrowings under our ABL Credit Facility (after giving effect to the borrowing base limitations). In order to fund the Transactions, we entered into several debt agreements as described below.

Senior Secured Credit Facility

On August 30, 2007, the Company entered into a senior secured credit facility (the “Senior Secured Credit Facility”) comprised of a $1 billion term loan (the “Term Loan”) and a $300 million revolving credit facility (the “Revolving Credit Facility”). The Term Loan has required quarterly principal payments of $2.5 million beginning December 31, 2007 with the balance due August 30, 2012. Additionally, beginning in fiscal 2009, the Company is required to pay down the Term Loan in an amount equal to 50% of Excess Cash Flow from the preceding fiscal year, as defined in the Term Loan agreement; such percentage is reduced to 0% depending on the attainment of certain leverage ratio targets. Under the Excess Cash Flow provisions of the Senior Secured Credit Facility, we are not required to make any repayments of the Term Loan during fiscal 2010 and were not required make any repayments of the Term Loan during fiscal 2009. At January 31, 2010 and February 1, 2009, the Term Loan principal outstanding was $978 million and $987 million, respectively.

The Term Loan is guaranteed by Home Depot and bears interest at Prime plus 0.25% or LIBOR plus 1.25% at the Company’s election. At January 31, 2010 and February 1, 2009, the Term Loan interest rate was 1.48% and 1.72%, respectively. Interest on the Term Loan is due at the end of each calendar quarter with respect to Prime rate draws or at the maturity of each LIBOR draw (unless said draw is for a six-, nine-, or twelve-month period, then interest shall be paid quarterly). The guarantee by Home Depot was valued at $106 million and is being amortized to interest expense over the five-year life of the Term Loan on a straight-line basis which approximates the effective interest method. During fiscal 2009, fiscal 2008, and the period from August 30, 2007 to February 3, 2008, the Company recorded amortization of the guarantee of $21 million, $21 million and $9 million, respectively. The Senior Secured Credit Facility is further collateralized by all of the capital stock of HD Supply, Inc. and its subsidiary guarantors and by 65% of the capital stock of its foreign subsidiaries as well as by other tangible and intangible assets owned by the Company subject to the priority of liens described in the guarantee and collateral agreement dated as of August 30, 2007. The Senior Secured Credit Facility contains various restrictive covenants including limitations on additional indebtedness and dividend payments and stipulations

 

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(Continued)

 

regarding the use of proceeds from asset dispositions. The Company is in compliance with all such covenants. The Senior Secured Credit Facility is subject to an acceleration clause under an Event of Default, as defined in the Senior Secured Credit Facility agreement. Management believes the likelihood of such acceleration to be remote.

The Revolving Credit Facility is due August 30, 2013 and bears interest at Prime plus 3.0% or LIBOR plus 4.0% at the Company’s election. The Revolving Credit Facility also has a 0.5% unused commitment fee and a Letter of Credit fee of 4.0% per annum. The Company had an outstanding balance of $300 million as of both January 31, 2010 and February 1, 2009, at an interest rate of 4.23% and 4.39%, respectively. As of January 31, 2010 and February 1, 2009, there were no outstanding Letters of Credit under the Revolving Credit Facility. Interest on the Revolving Credit Facility is due at the end of each calendar quarter with respect to Prime rate draws or at the maturity of each LIBOR draw (unless said draw is for a six-, nine-, or twelve-month period, then interest shall be paid quarterly). The Senior Secured Credit Facility can be repaid at any time without penalty or premium.

Asset Based Lending Credit Agreement

On August 30, 2007, the Company entered into a $2.1 billion Asset Based Lending Credit Agreement (the “ABL Credit Facility”) subject to borrowing base limitations. The ABL Credit Facility matures on August 30, 2012 and bears interest at Prime plus 0.5% or LIBOR plus 1.5% per annum at the Company’s election. At January 31, 2010 and February 1, 2009, the ABL Credit Facility interest rate was 2.062% and 2.039%, respectively. The ABL Credit Facility also contains an unused commitment fee of 0.25%. As of January 31, 2010 and February 1, 2009, the ABL Credit Facility had an outstanding balance of $596 million and $786 million, respectively. As of January 31, 2010, the Company has available borrowings under the ABL Credit Facility of $359 million, after giving effect to the borrowing base limitations. The Company can use up to $400 million of its available borrowing under the ABL Credit Facility for Letters of Credit which are charged a fee of 1.5% per annum. As of January 31, 2010 and February 1, 2009, there were $65 million and $60 million, respectively, of Letters of Credit outstanding under the ABL Credit Facility. The ABL Credit Facility can be repaid at any time without penalty or premium. The ABL Credit Facility contains various restrictive covenants including a limitation on the amount of dividends to be paid. In addition, if our availability under the ABL Credit Facility falls below $210 million (a “Liquidity Event”), we will be required to maintain a Fixed Charge Coverage Ratio of at least 1.0:1.0. The Company is in compliance with all such covenants. The ABL Credit Facility is collateralized by all of the capital stock of HD Supply, Inc. and its subsidiary guarantors and by 65% of the capital stock of its foreign subsidiaries as well as by other tangible and intangible assets owned by the Company subject to the priority of liens described in the guarantee and collateral agreement dated as of August 30, 2007. The ABL Credit Facility is subject to an acceleration clause in a Liquidity Event or an Event of Default, as defined in the ABL Credit Facility agreement. Under such acceleration, the administrative agent can direct payments from the Company’s depository accounts to directly pay down the outstanding balance under the ABL Credit Facility. Management believes the likelihood of such acceleration to be remote.

Lehman Brothers

On September 15, 2008, the parent company of Lehman Brothers, Lehman Brothers Holdings Inc., filed a petition under Chapter 11 of the U.S. Bankruptcy Code with the United States Bankruptcy Court for the Southern District of New York. Lehman Brothers is committed to fund $100 million of the Company’s $300 million available Revolving Credit Facility and up to $95 million of the Company’s $2.1 billion ABL Credit Facility. During September 2008, the Company drew down the entire $300 million Revolving Credit Facility and invested the proceeds in U.S. Treasury securities. Lehman Brothers funded their $100 million commitment of the Revolving Credit Facility but has failed to fund a portion of their ABL Credit Facility commitment. As of January 31, 2010, outstanding borrowings under the ABL Credit Facility from Lehman Brothers are approximately $10 million. In addition, the Administrative Agent of the ABL Credit Facility holds $15 million in escrow funds, which are available to honor Lehman’s pro rata portion of any ABL Credit Facility draw. The combined available unfunded commitment from Lehman Brothers as of January 31, 2010 (prior to the ABL Credit Facility borrowing base limitations) was approximately $70 million.

 

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Senior Notes

On August 30, 2007, the Company issued $2.5 billion of Senior Notes bearing interest at a rate of 12.0% (the “12.0% Senior Notes”). Interest payments are due each March and September 1st through maturity. The 12.0% Senior Notes mature on September 1, 2014 and can be redeemed by the Company as follows:

 

         Redemption Period        Redemption Price    
 

    Sept. 1, 2011 – August 31, 2012

     106% plus accrued interest    

    Sept. 1, 2012 – August 31, 2013

     103% plus accrued interest    

    Sept. 1, 2013 – Thereafter

     100% plus accrued interest    

The Company may also redeem all or a portion of the 12.0% Senior Notes under certain conditions and for the price as described in the agreement prior to September 1, 2011. The 12.0% Senior Notes contain various restrictive covenants including limitations on additional indebtedness and dividend payments and stipulations regarding the use of proceeds from asset dispositions. The Company is in compliance with all such covenants.

Senior Subordinated Notes

On August 30, 2007, the Company issued $1.3 billion of Senior Subordinated PIK Notes bearing interest at a rate of 13.5% (the “13.5% Senior Subordinated Notes”). Interest payments are due each March and September 1st through maturity except that the first eight payment periods through September 2011 shall be paid in kind (“PIK”) and therefore increase the balance of the outstanding indebtedness rather than be paid in cash. During fiscal 2009, the Company repurchased $252 million principal amount, plus accrued interest of $15 million, of the 13.5% Senior Subordinated Notes. As a result of PIK interest capitalizations and the extinguishment of a portion of the principal, as of January 31, 2010, the outstanding principal balance of the 13.5% Senior Subordinated Notes was $1.4 billion. The 13.5% Senior Subordinated Notes mature on September 1, 2015 and can be redeemed by the Company as follows:

 

         Redemption Period        Redemption Price    
 

    Sept. 1, 2011 – August 31, 2012

     106.75% plus accrued interest    

    Sept. 1, 2012 – August 31, 2013

     103.375% plus accrued interest    

    Sept. 1, 2013 – Thereafter

     100% plus accrued interest    

The Company may also redeem all or a portion of the 13.5% Senior Subordinated Notes under certain conditions and for the price as described in the agreement prior to September 1, 2011. The 13.5% Senior Subordinated Notes contain various restrictive covenants including limitations on additional indebtedness and dividend payments and stipulations regarding the use of proceeds from asset dispositions. The Company is in compliance with all such covenants.

The Company and its affiliates may from time to time repurchase or otherwise retire the Company’s debt and take other steps to reduce the Company’s debt or otherwise improve the Company’s balance sheet. These actions may include open market repurchases, negotiated repurchases and other retirements of outstanding debt. The amount of debt that may be repurchased or otherwise retired, if any, will depend on market conditions, trading levels of the Company’s debt from time to time, the Company’s cash position and other considerations.

Credit Agreement Amendments and The Home Depot, Inc. Consent

On March 19, 2010, the Company entered into Amendment No. 3 (the “Cash Flow Amendment”) to its $1.3 billion Senior Secured Credit Facility, dated as of August 30, 2007, by and among the Company, Merrill Lynch Capital Corporation, as administrative agent and collateral agent, and the other lenders and financial institutions from time to time party thereto. The Cash Flow Amendment extended the maturity date from August 30, 2012 to April 1, 2014 of approximately $873 million in principal amount of outstanding Term Loans under the Senior Secured Credit Facility. THD, which guarantees payment of the Term Loans under the Senior Secured Credit Facility, consented to the Cash Flow Amendment. Concurrently, THD and the Company entered into an agreement pursuant to which THD consented to any later amendment to the Senior Secured Credit Facility, as amended, (similar in form and substance to the Cash Flow Amendment) that would extend the maturity of the

 

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remaining approximately $104 million of outstanding Term Loans to a date that is not later than the maturity date in effect from time to time under the Cash Flow Amendment. In addition, the Company entered into a letter agreement with THD, pursuant to which the Company agreed that, while the THD guarantee is outstanding, the Company would not voluntarily repurchase 12.0% Senior Notes or any 13.5% Senior Subordinated Notes, directly or indirectly, without THD’s prior written consent, subject to certain exceptions, including debt repurchases with equity or permitted refinancings. The Company also agreed to prepay $30 million in aggregate principal amount of non-extending Term Loans under the Senior Secured Credit Facility. The maturity date of the extended outstanding Term Loans may be further extended to a date not later than June 1, 2014, without further consent by the lenders, if THD provides a notice electing to extend its guarantee of the Term Loans to such later date. However, THD is under no obligation to provide such notice or make such election to further extend its guarantee, and the Company cannot provide any assurance that THD will provide such notice or make such election or on what terms it might do so. The remaining outstanding nonextended Term Loans will mature on the original maturity date of such loans, i.e. August 30, 2012. All Terms Loans outstanding under the Senior Secured Credit Facility, as amended, amortize in nominal quarterly installments equal to 0.25% of the original aggregate principal amount of the Term Loans. The Cash Flow Amendment also increased the borrowing margins applicable to the extended portion of the Term Loans by 150 basis points.

On March 19, 2010, the Company also entered into the Limited Consent and Amendment No. 3 (the “ABL Amendment”) to its $2.1 billion Asset Based Lending Credit Agreement (“ABL Credit Facility”), dated as of August 30, 2007, by and among the Company, certain subsidiaries of the Company, GE Business Financial Services Inc. (formerly known as Merrill Lynch Business Financial Services Inc.), as administrative agent and collateral agent, GE Canada Finance Holding Company, as Canadian administrative agent and Canadian collateral agent, and the several lenders and financial institutions from time to time parties thereto. Pursuant to the ABL Amendment, the Company (i) converted approximately $214 million of commitments under the ABL Credit Facility into a term loan (the “ABL Term Loan”), (ii) extended the maturity date of approximately $1,537 million of the commitments under the ABL Revolving Credit Facility from August 30, 2012 to the later of April 1, 2014 and the maturity date of the extended term loans under the Cash Flow Amendment, and (iii) reduced the total commitments under the ABL Credit Facility by approximately $45 million. The ABL Term Loan does not amortize and the entire principal amount thereof is due and payable on the later of April 1, 2014 and the maturity date of the extended Term Loans under the Senior Secured Credit Facility, as amended. The remaining approximately $304 million of commitments under the ABL Credit Facility matures on the original maturity date of such commitments, i.e. August 30, 2012. In addition, the ABL Amendment provided for a borrowing rate of Prime plus 225 basis points or LIBOR plus 325 basis points applicable to the ABL Term Loan and increased the borrowing margins applicable to the extended portion of the ABL Revolving Credit Facility by 175 basis points and the commitment fee applicable to such portion by 50 basis points.

The table below summarizes amounts outstanding as of March 28, 2010 under our Senior Secured Credit Facility and ABL Credit Facility, and the maturity dates of such indebtedness, giving effect to the Cash Flow Amendment and ABL Amendment (amounts in millions).

 

        August 30,    
2012
      August 30,    
2013
      April 1,    
2014

Senior Secured Credit Facility

     

Term Loan

  $74   $    –   $874

Revolving Credit Facility

      –     300        –

ABL Credit Facility

     

ABL Term Loan

      –         –     214

ABL Revolving Credit Facility

    60         –     315

Rating agency actions

During the third quarter of fiscal 2009, Standard & Poor's Ratings Services reaffirmed our B rating, but lowered its outlook on the Company to negative and Moody’s Investors Service lowered the Company’s rating to CAA1, with a stable outlook, from B3. Both agencies cited the Company’s exposure to the ongoing weakness in U.S. construction as well as high leverage levels as the primary pressures on the ratings.

 

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Registration statement

On July 27, 2009, HD Supply, Inc. filed a registration statement on Form S-4/A with the U.S. Securities and Exchange Commission in accordance with the registration rights agreements relating to the 12.0% Senior Notes and 13.5% Senior Subordinated Notes. On July 28, 2009, the registration statement was declared effective by the SEC and the offer to exchange outstanding 12.0% Senior Notes with registered 12.0% Senior Notes and outstanding 13.5% Senior Subordinated Notes with registered 13.5% Senior Subordinated Notes was executed. The exchange offer closed on August 25, 2009 with all of the notes held by eligible participants in the exchange offer tendered.

Interest rate swaps

We maintain interest rate swap agreements to exchange fixed and variable rate interest payment obligations without the exchange of the underlying principal amounts. Our swaps commit us to pay fixed interest and receive variable interest, effectively converting $400 million of floating-rate debt to fixed rate debt. During fiscal 2009, we paid a weighted average fixed rate of 3.8% and received a weighted average floating rate of 0.3% on the combined notional value of $400 million. During fiscal 2008, we paid a weighted average fixed rate of 3.8% and received a weighted average floating rate of 2.4% on the combined notional value of $400 million. In January 2010, swaps with a combined $200 million notional value matured. The remaining swaps, having a combined $200 million notional value, mature in January 2011. As of January 31, 2010, the swaps have a weighted average fixed pay rate of 3.9% and a weighted average floating receive rate of 0.2% on the combined notional value of $200 million.

Commodity and interest rate risk

Commodity risk

We are aware of the potentially unfavorable effects inflationary pressures may create through higher asset replacement costs and related depreciation, higher interest rates and higher material costs. In addition, our operating performance is affected by price fluctuations in steel, nickel, copper, aluminum, PVC and other commodities. We seek to minimize the effects of inflation and changing prices through economies of purchasing and inventory management resulting in cost reductions and productivity improvements as well as price increases to maintain reasonable gross margins.

As discussed above, our results of operations were favorably or negatively impacted by fluctuating commodity prices based on our ability or inability to pass increases in the prices of certain commodity-based products to our customers. Such commodity price fluctuations have from time to time produced volatility in our financial performance and could continue to do so in the future.

Interest rate risk related to debt

We are subject to interest rate risk associated with our Senior Secured Credit Facility and our ABL Credit Facility.

As of January 31, 2010, the Senior Secured Credit Facility was comprised of the following:

 

   

A $1.0 billion Term Loan due August 30, 2012, with an outstanding balance of $978 million. The Term Loan is guaranteed by THD and bears interest at Prime plus 0.25% or LIBOR plus 1.25% at the Company’s election. At January 31, 2010 the Term Loan interest rate was 1.48%.

 

   

A $300 million Revolving Credit Facility due August 30, 2013 that bears interest at Prime plus 3.0% or LIBOR plus 4.0% at the Company’s election. The Revolving Credit Facility also has a 0.5% unused commitment fee and a Letter of Credit fee of 4.0% per annum. As of January 31, 2010, the Company had an outstanding balance of $300 million, at an interest rate of 4.23%, and no outstanding Letters of Credit under the Revolving Credit Facility.

As of January 31, 2010, the ABL Credit Facility was comprised of the following:

 

   

A $2.1 billion ABL Revolving Credit Facility due August 30, 2012 that bears interest at Prime plus 0.5% or LIBOR plus 1.5% per annum at the Company’s election. At January 31, 2010 the ABL Revolving

 

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Credit Facility interest rate was 2.062%. As of January 31, 2010, the ABL Revolving Credit Facility had an outstanding balance of $596 million. As of January 31, 2010, the Company could use up to $400 million of its available borrowing under the ABL Credit Facility for Letters of Credit which are charged a fee of 1.5% per annum. As of January 31, 2010, there were $65 million of Letters of Credit outstanding under the ABL Credit Facility.

While changes in interest rates impact the fair value of the fixed rate debt, there is no impact to earnings and cash flow. Alternatively, while changes in interest rates do not affect the fair value of our variable-interest rate debt, they do affect future earnings and cash flows. A 1% increase in interest rates on our variable-rate debt would increase our annual forecasted interest expense by approximately $17 million, net of the impact of our interest rate swaps (based on our borrowings on our credit facilities as of January 31, 2010).

Interest rate risk related to derivatives

We are also subject to interest rate risk on our interest rate swap agreements to exchange fixed and variable rate interest payment obligations without the exchange of the underlying principal amounts. The Company pays fixed interest and receives variable interest, effectively converting $200 million of floating-rate debt to fixed rate debt. As of January 31, 2010, the swaps have a weighted average fixed pay rate of 3.9% and a weighted average floating receive rate of 0.2%. The weighted average floating receive rate cannot fall below zero; therefore our interest rate risk for the remainder of fiscal 2010 is limited to the $200 million notional value at 0.2%, or less than $1 million.

Off-balance sheet arrangements

In accordance with generally accepted accounting principles, operating leases for a portion of our real estate and other assets are not reflected in our Consolidated Balance Sheets.

Contractual obligations

The following table discloses aggregate information about our contractual obligations as of January 31, 2010 and the periods in which payments are due (amounts in millions):

 

         Payments due by period
       Total  

Fiscal

2010

   Fiscal
2011-2012
   Fiscal
2013-2014
   Fiscal years
after 2014
      

Long-term debt (1)

           $   6,193           $ 10       $   1,563       $   2,800       $   1,820   

Interest on long-term debt(2)

     2,620     344         922         1,108         246   

Operating leases

     652     170         244         126         112   

Unconditional purchase obligations ( 3)

     279     279         –         –         –   

Interest rate swaps ( 4)

     7     7         –         –         –   
      

  Total contractual cash obligations ( 5)

           $ 9,751           $   810       $ 2,729       $ 4,034       $   2,178   
      

 

(1) The long-term debt amount above includes $418 million in the “Fiscal years after 2014” column for interest that will be paid in kind through 2012, increasing the balance of the indebtedness outstanding rather than be paid in cash. As disclosed above in “Liquidity, capital resources and financial condition – External financing – Credit Agreement Amendments and The Home Depot, Inc. Consent,” we amended our Senior Secured Credit Facility and our ABL Credit Facility subsequent to the end of fiscal 2009. Giving effect to these amendments would increase the long-term debt included in the “Fiscal 2010” column by $30 million, reduce the long-term debt included in the “Fiscal 2011-2012” column by $1,472 million, and increase the long-term debt included in the “Fiscal 2013-2014” column by $1,442 million.

 

(2) As disclosed above in “Liquidity, capital resources and financial condition – External financing – Credit Agreement Amendments and The Home Depot, Inc. Consent,” we amended our Senior Secured Credit Facility and our ABL Credit Facility subsequent to the end of fiscal 2009. Giving effect to these amendments referenced above would increase the interest expense on long-term debt in the “Fiscal 2010” column, the “Fiscal 2011-2012” column, and the “Fiscal 2013-2014” column by $30 million, $69 million, and $74 million, respectively.

 

(3) Unconditional purchase obligations include various commitments with vendors to purchase inventory.

 

(4) The amounts due for the interest rate swaps are based on market valuations at January 31, 2010. Actual payments, if any, may differ at settlement date.

 

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(5) The contractual obligations table does not include capital lease obligations due to their immateriality. In addition, the table excludes $190 million of unrecognized tax benefits due to uncertainty regarding the timing of future cash payments, if any, related to the liabilities recorded in accordance with the U.S. GAAP guidance for uncertain tax positions (previously known as FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109”).

Recent accounting pronouncements

FASB codification – In June 2009, the FASB issued Statement of Financial Accounting Standard (“SFAS”) No. 168, “The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles, a replacement of FASB Statement No. 162” (“SFAS 168”). SFAS 168 establishes the FASB Accounting Standards Codification™ (“Codification” or “ASC”) as the single source of authoritative U.S. GAAP recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the SEC under authority of federal securities laws are also sources of authoritative U.S. GAAP for SEC registrants. The Codification supersedes all existing non-SEC accounting and reporting standards. All other nongrandfathered, non-SEC accounting literature not included in the Codification will become nonauthoritative. U.S. GAAP is not intended to be changed as a result of the FASB's Codification project, but it does change the way the guidance is organized and presented.

The Codification is effective for interim and annual periods ending after September 15, 2009. HD Supply adopted the Codification in the third quarter of fiscal 2009. As a result, references to accounting standards within these financial statements have been updated to reflect the Accounting Standards Codification references. The adoption did not impact the Company’s financial position or results of operations.

Multiple-deliverable revenue arrangements – In October 2009, the FASB issued Accounting Standards Update No. 2009-13, “Multiple-Deliverable Revenue Arrangements — a consensus of the FASB Emerging Issues Task Force” (“ASU 2009-13”). This ASU addresses how to separate deliverables under multiple-deliverable arrangements and how to measure and allocate arrangement consideration to one or more units of accounting. In addition, ASU 2009-13 expands the disclosures related to a company’s multiple-deliverable revenue arrangements. The ASU is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. The impact on the Company of adopting ASU 2009-13 will depend on the nature, terms and size of multiple-deliverable revenue arrangements entered into or materially modified after the effective date. The Company does not expect the adoption of ASU 2009-13 to have a material impact on the Company’s financial position or results of operations.

Fair value measurements – In February 2008, the FASB deferred the effective date of certain fair value measurement accounting principles (codified within ASC 820, Fair Value Measurements and Disclosures) for all nonfinancial assets and liabilities, except those that are recognized or disclosed in the financial statements at fair value at least annually, to fiscal years beginning after November 15, 2008. The accounting principles deferred address the measurement of fair value by companies when they are required to use a fair value measure for recognition or disclosure purposes under U.S. GAAP and, accordingly, do not require any new fair value measurements. Effective February 2, 2009, HD Supply adopted these fair value measurement accounting principles for all nonfinancial assets and liabilities that are measured at fair value on a non-recurring basis, such as goodwill and identifiable intangible assets. The adoption did not impact the Company’s financial position or results of operations.

In April 2009, the FASB issued a new accounting standard that requires disclosure of fair value for any financial instruments not currently reflected at fair value on the balance sheet for all interim periods (codified within ASC 825, Financial Instruments). This standard is effective for interim and annual periods ending after June 15, 2009. HD Supply adopted the new standard in the second quarter of fiscal 2009. See Notes to the Consolidated and Combined Financial Statements for disclosures required by this new pronouncement.

In April 2009, the FASB issued a new accounting standard that provides guidance in determining fair values when there is no active market or where the price inputs being used represent distressed sales (codified within ASC 820, Fair Value Measurements and Disclosures). Specifically, it reaffirms the need to use judgment to ascertain if a formerly active market has become inactive and in determining fair values when markets have become inactive. The new standard is effective for interim and annual periods ending after June 15, 2009. HD

 

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Supply adopted the new standard in the second quarter of fiscal 2009. The adoption did not have an impact on the consolidated financial statements and results of operations.

Business combinations – In December 2007, the FASB issued a new accounting standard for business combinations (codified within ASC 805, Business Combinations) which requires that the acquisition method of accounting be used in all business combinations and for an acquirer to be identified for each business combination. The standard defines the acquirer as the entity that obtains control of one or more businesses in the business combination and establishes the acquisition date as the date that the acquirer achieves control. It requires an acquirer to recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date. The Company adopted the provisions of this new standard on February 2, 2009. The new standard is effective for business combinations for which the acquisition date is on or after the adoption date. The impact on the Company of adopting the new standard will depend on the nature, terms and size of the business combinations completed after the adoption date.

Noncontrolling interests – In December 2007, the FASB issued a new accounting standard which establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary (codified within ASC 810, Consolidation). It clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. The Company adopted the provisions of this new standard on February 2, 2009. The Company currently does not have a noncontrolling interest in a subsidiary; therefore, the adoption did not have an impact on the Company’s consolidated financial statements and results of operations.

Derivative instruments – In March 2008, the FASB issued a new accounting standard which expands disclosure requirements for derivatives (codified within ASC 815, Derivatives and Hedging) to provide an enhanced understanding of (1) how and why an entity uses derivative instruments, (2) how derivative instruments and related hedged items are accounted for, and (3) how derivative instruments affect an entity’s financial position, financial performance, and cash flows. The Company adopted the provisions this new standard on February 2, 2009. See Notes to the Consolidated and Combined Financial Statements for disclosures required by this new pronouncement.

Intangible assets – In April 2008, the FASB issued a new accounting standard which amends the factors that should be considered in developing renewal or extension assumptions used in determining the useful life of a recognized intangible asset (codified within ASC 275, Risks and Uncertainties, and ASC 350, Intangibles – Goodwill and Other). The Company adopted the provisions of this new standard on February 2, 2009. The adoption did not impact the Company’s consolidated financial statements and results of operations.

Subsequent events – In May 2009 and clarified in February 2010, the FASB issued a new accounting standard which establishes general standards of accounting for and disclosure of events or transactions occurring after the balance sheet date (codified within ASC 855, Subsequent Events). The Company adopted this new accounting standard as of June 30, 2009, which was the required effective date. The adoption did not impact the Company’s consolidated financial statements, results of operations, or disclosures.

Critical accounting policies

Our critical accounting policies include:

Revenue recognition

We recognize revenue when persuasive evidence of an agreement exists, delivery has occurred or services have been rendered, price to the buyer is fixed and determinable and collectability is reasonably assured. We ship products to customers predominantly by internal fleet and to a lesser extent by third party carriers. Revenues, net of sales tax and allowances for returns and discounts, are recognized from product sales when title to the products is passed to the customer, which generally occurs at the point of destination for products shipped by internal fleet and at the point of shipping for products shipped by third party carriers.

 

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Allowance for doubtful accounts

We evaluate the collectability of accounts receivable based on numerous factors, including past transaction history with customers, their credit worthiness and an assessment of our lien and bond rights. Initially, we estimate an allowance for doubtful accounts as a percentage of aged receivables. This estimate is periodically adjusted when we become aware of a specific customer’s inability to meet its financial obligations (e.g., bankruptcy filing) or as a result of changes in our historical collection patterns. While we have a large customer base that is geographically dispersed, a slowdown in the markets in which we operate may result in higher than expected uncollectible accounts, and therefore, the need to revise estimates for bad debts. To the extent historical credit experience is not indicative of future performance or other assumptions used by management do not prevail, the allowance for doubtful accounts could differ significantly, resulting in either higher or lower future provisions for doubtful accounts.

Inventories

Inventories are carried at the lower of cost or market. The cost of substantially all of our inventories is determined by the moving or weighted average cost method. We evaluate our inventory value at the end of each quarter to ensure that it is carried at the lower of cost or market. This evaluation includes an analysis of historical physical inventory results, a review of potential excess and obsolete inventories based on inventory aging and anticipated future demand. Periodically, each branch’s perpetual inventory records are adjusted to reflect any declines in net realizable value below inventory carrying cost. To the extent historical physical inventory results are not indicative of future results and if future events impact, either favorably or unfavorably, the saleability of our products or our relationship with certain key vendors, our inventory reserves could differ significantly, resulting in either higher or lower future inventory provisions.

Consideration received from vendors

At the beginning of each calendar year, we enter into agreements with many of our vendors providing for inventory purchase rebates (“vendor rebates”) upon achievement of specified volume purchasing levels. We accrue the receipt of vendor rebates as part of our cost of sales for products sold based on progress towards earning the vendor rebates, taking into consideration cumulative purchases of inventory to date and projected purchases through the end of the year. An estimate of unearned vendor rebates is included in the carrying value of inventory at each period end for vendor rebates to be received on products not yet sold. While we believe we will continue to receive consideration from vendors in fiscal 2010 and thereafter, there can be no assurance that vendors will continue to provide comparable amounts of vendor rebates in the future.

Impairment of long-lived assets

Long-lived assets, including property and equipment, are reviewed for possible impairment whenever events or circumstances indicate that the carrying amount of an asset may not be recoverable. To analyze recoverability, we project undiscounted future cash flows over the remaining life of the asset. If these projected cash flows are less than the carrying amount, an impairment loss is recognized based on the fair value of the asset less any costs of disposition. Our judgment regarding the existence of impairment indicators are based on market and operational performance. Future events could cause us to conclude that impairment indicators exist and that assets are impaired. Evaluating the impairment also requires us to estimate future operating results and cash flows that require judgment by management. If different estimates were used, the amount and timing of asset impairments could be affected.

Goodwill

Goodwill represents the excess of the purchase price paid over the fair value of the net assets acquired in connection with business acquisitions. Accounting Standards Codification (“ASC”) 350, Intangibles – Goodwill and Other, requires entities to periodically assess the carrying value of goodwill by reviewing the fair value of the net assets underlying all acquisition-related goodwill on a reporting unit basis, as defined by ASC 350. We assess the recoverability of goodwill in the third quarter of each fiscal year. We also use judgment in assessing whether we need to test goodwill more frequently for impairment than annually given factors such as unexpected adverse

 

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(Continued)

 

economic conditions, competition, product changes and other external events. If the carrying amount of a reporting unit that contains goodwill exceeds fair value, a possible impairment would be indicated.

We determine the fair value of a reporting unit using a discounted cash flow (“DCF”) analysis and a market comparable method, with each method being equally weighted in the calculation. This is a departure from our fiscal 2008 goodwill impairment test. In fiscal 2008, the Company relied entirely on the DCF analysis due to the extreme volatility in the financial markets during the second half of 2008. The market comparable method was calculated during that period as a validation that the fair value derived from the DCF analysis was comparable to its market peers.

Determining fair value requires the exercise of significant judgment, including judgment about appropriate discount rates, perpetual growth rates, the amount and timing of expected future cash flows, as well as relevant comparable company earnings multiples for the market comparable approach. The cash flows employed in the DCF analyses are based on the Company’s most recent five-year budget and, for years beyond the budget, the Company’s estimates, which are based on estimated exit multiples ranging from five to seven times the final budgeted year earnings before interest, taxes, depreciation and amortization. The discount rates used in the DCF analyses are intended to reflect the risks inherent in the future cash flows of the respective reporting units and range from 12.5% to 15.0%. For the market comparable approach, the Company evaluated comparable company public trading values, using multiples that ranged from five to nine times earnings before interest, taxes, depreciation and amortization. During fiscal 2009 and fiscal 2008, as a result of our goodwill impairment testing, we recorded goodwill impairment charges of $224 million and $1,053 million, respectively.

The Company’s discounted cash flow model is based on HD Supply’s expectation of future market conditions for each of the reporting units, as well as discount rates that would be used by market participants in an arms-length transaction. Future events could cause the Company to conclude that market conditions have declined or discount rates have increased to the extent that the Company’s goodwill could be further impaired. It is not possible at this time to determine if any such future impairment charge would result.

In order to evaluate the sensitivity of the fair value calculations on the goodwill impairment test, the Company applied a hypothetical 100 basis point increase in the risk adjusted discount rate of each reporting unit. Such an increase would have resulted in an additional impairment charge of $41 million during fiscal 2009. The Company also measured the impact of applying a hypothetical 1x decline to the exit multiples used for the years beyond the Company’s five-year budget. Such a decrease would have resulted in an additional impairment charge of $123 million during fiscal 2009 at the following reporting units: Waterworks, Utilities, White Cap, and Repair & Remodel.

Income Taxes

Income taxes are determined under the liability method as required by ASC 740, Income Taxes. Income tax expense or benefit is based on pre-tax financial accounting income. Deferred tax assets and liabilities are recognized for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. This measurement is reduced, if necessary, by a valuation allowance based on the amount of tax benefits that, based on available evidence, are not more likely than not to be realized. An increase in the amount of future deferred tax assets or lower than expected future earnings could require us to establish a valuation allowance on our deferred taxes.

In addition, we have foreign and domestic net operating losses (“NOLs”) that expire at various dates beginning in 2012. At this time, we believe that, based on a number of factors, it is more likely than not that these losses will be utilized before they expire, and thus no valuation allowance has been established except on certain specific state NOLs. Lower than expected future earnings or certain ownership changes could impair or eliminate the value of the NOLs recorded.

Effective January 29, 2007, we adopted the provisions of FASB Interpretation No. 48 (“FIN 48,” now codified within ASC 740), which clarifies the accounting for uncertainty in income taxes. FIN 48 prescribes guidance related to the financial statement recognition and measurement of tax positions taken or expected to be taken in a

 

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HD SUPPLY, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Continued)

 

tax return. The interpretation prescribes the minimum recognition threshold that a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosure. Initial recognition, derecognition and measurement is based on management’s judgment given the facts, circumstances and information available at the reporting date. If these judgments are not accurate then future income tax expense or benefit could be different.

Self-insurance

We have a high deductible insurance program for most losses related to general liability, product liability, environmental liability, automobile liability, workers’ compensation, and are self-insured for medical claims and certain legal claims. The expected ultimate cost for claims incurred as of the balance sheet date is not discounted and is recognized as a liability. Self-insurance losses for claims filed and claims incurred but not reported are accrued based upon estimates of the aggregate liability for uninsured claims using loss development factors and actuarial assumptions followed in the insurance industry and historical loss development experience.

To the extent the projected future development of the losses resulting from workers’ compensation, automobile, general and product liability claims incurred as of January 31, 2010 differs from the actual development of such losses in future periods, our insurance reserves could differ significantly, resulting in either higher or lower future insurance expense.

Management estimates

Management believes the assumptions and other considerations used to estimate amounts reflected in our combined financial statements are appropriate. However, if actual experience differs from the assumptions and other considerations used in estimating amounts reflected in our combined financial statements, the resulting changes could have a material adverse effect on our combined results of operations, and in certain situations, could have a material adverse effect on our financial condition.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The information required by this Item is included under “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Index to financial statements

 

     Page

Reports of Independent Registered Public Accounting Firms

   71

Consolidated statements of operations for (i) the fiscal year ended January 31, 2010, (ii)  the fiscal year ended February 1, 2009 and (iii) the period from August 30, 2007 to February 3, 2008 (Successor Periods)

   73

Combined statement of operations for the period from January 29, 2007 to August  29, 2007 (Predecessor Period)

   73

Consolidated balance sheets as of January 31, 2010 and February 1, 2009 (Successor Periods)

   74

Consolidated statements of stockholders’ equity and comprehensive income for (i)  the fiscal year ended January 31, 2010, (ii) the fiscal year ended February 1, 2009 and (iii) the period from August 30, 2007 to February 3, 2008 (Successor Periods)

   75

Combined statement of owner’s equity and comprehensive income for the period from January  29, 2007 to August 29, 2007 (Predecessor Period)

   75

Consolidated statements of cash flows for (i) the fiscal year ended January 31, 2010, (ii)  the fiscal year ended February 1, 2009 and (iii) the period from August 30, 2007 to February 3, 2008 (Successor Periods)

   76

Combined statement of cash flows for the period from January 29, 2007 to August  29, 2007 (Predecessor Period)

   76

Notes to consolidated and combined financial statements

   77

 

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Report of Independent Registered Public Accounting Firm

To The Board of Directors and Shareholders of HD Supply, Inc.:

In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss) and cash flows present fairly, in all material respects, the financial position of HD Supply, Inc. and its subsidiaries (“the Company”) at January 31, 2010 and February 1, 2009, and the results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule for the years ended January 31, 2010 and February 1, 2009 listed in the index appearing under Item 15(c) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

We also have audited the adjustments to the financial statement disclosures of the period from August 30, 2007 to February 3, 2008 (Successor Company) and the period from January 29, 2007 to August 29, 2007 (Predecessor Company), which were applied to retrospectively reflect the change in the composition of reportable segments as discussed in Note 17. In our opinion, such adjustments are appropriate and have been properly applied. We were not engaged to audit, review, or apply any procedures to the financial statements of the period from August 30, 2007 to February 3, 2008 (Successor Company) and the period from January 29, 2007 to August 29, 2007 (Predecessor Company) other than with respect to the adjustments and, accordingly, we do not express an opinion or any other form of assurance on those financial statements taken as a whole.

/s/ PricewaterhouseCoopers LLP

Atlanta, Georgia

April 13, 2010

 

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Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

HD Supply, Inc.:

We have audited, before the effect of the adjustment to retrospectively apply the change in accounting related to the Creative Touch Interiors segment described in Note 17, the consolidated statements of operations of HD Supply Inc. and subsidiaries (Successor Company) and the related consolidated statements of stockholders’ equity and comprehensive income (loss), and cash flows for the period August 30, 2007 to February 3, 2008, and the combined statements of operations of HD Supply, Inc. and HD Supply Canada Inc. wholly owned subsidiaries of The Home Depot, Inc. (Predecessor Company) and the related combined statements of owner’s equity and cash flows for the period January 29, 2007 to August 29, 2007. The financial statements before the effects of the adjustment discussed in Note 17 are not presented herein. The consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements, before the effect of the adjustment to retrospectively apply the change in accounting related to the Creative Touch Interiors segment described in Note 17, present fairly, in all material respects, the results of operations of HD Supply, Inc. and subsidiaries and the related cash flows for the period August 30, 2007 to February 3, 2008 and the results of operations of HD Supply, Inc. and HD Supply Canada Inc. wholly owned subsidiaries of The Home Depot, Inc. and the related cash flows for the period January 29, 2007 to August 29, 2007 in conformity with U.S. generally accepted accounting principles.

We were not engaged to audit, review, or apply any procedures to the adjustment to retrospectively apply the change in accounting described in Note 17 and, accordingly, we do not express an opinion or any other form of assurance about whether such adjustment was appropriate and has been properly applied. That adjustment was audited by a successor auditor.

/s/ KPMG LLP

May 9, 2008

Orlando, FL

Certified Public Accountants

 

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HD SUPPLY, INC.

CONSOLIDATED AND COMBINED STATEMENTS OF OPERATIONS

Amounts in millions

 

     Successor         Predecessor
        Fiscal Year   
Ended
January 31,
2010
      Fiscal Year   
Ended
February 1,
2009
      Period from   
August 30,
2007 to
February 3,
2008
          Period from 
January 29,
2007 to
August 29,
2007
 

Net Sales

   $     7,418             $     9,768         $    4,599              $  7,121      

Cost of sales

   5,422         7,134         3,372              5,220      
                        

    Gross Profit

   1,996         2,634         1,227              1,901      

Operating expenses:

                

    Selling, general and administrative

   1,680         2,063         1,001              1,424      

    Depreciation and amortization

   386         403         168              115      

    Restructuring

   28         34         –              –      

    Goodwill impairment

   224         1,053         –              –      
                        

        Total operating expenses

   2,318         3,553         1,169              1,539      
                        
 

    Operating Income (Loss)

   (322)        (919)        58              362      
 

Interest expense

   602         644         289              221      

Interest (income)

   –         (2)        –              –      

Other (income) expense, net

   (208)        11         –              –      
                        

    Income (Loss) from Continuing Operations Before Provision (Benefit) for Income Taxes

   (716)        (1,572)        (231)             141      

Provision (benefit) for income taxes

   (211)        (318)        (83)             58      
                        

    Income (Loss) from Continuing Operations

   (505)        (1,254)        (148)             83      

Loss from discontinued operations, net of tax

   (9)        (1)        (15)             (27)     
                        

    Net Income (Loss)

   $    (514)            $  (1,255)        $     (163)             $       56      
                        

The accompanying notes are an integral part of these financial statements.

 

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HD SUPPLY, INC.

CONSOLIDATED BALANCE SHEETS

Amounts in millions, except share data

 

     Successor
       January 31,  
2010
     February 1,  
2009

ASSETS

     

Current assets:

     

    Cash and cash equivalents

   $       539       $       771   

    Receivables, less allowance for doubtful accounts of $56 and $95

   846       1,123   

    Inventories

   1,018       1,218   

    Deferred tax asset

   169       154   

    Other current assets

   230       147   
         

        Total current assets

   2,802       3,413   
         

Property and equipment, net

   453       545   

Goodwill

   3,149       3,368   

Intangible assets, net

   1,253       1,511   

Other assets

   188       251   
         

        Total assets

   $7,845       $  9,088   
         

LIABILITIES AND STOCKHOLDERS’ EQUITY

     

Current liabilities:

     

    Accounts payable

   $484       $       870   

    Accrued compensation and benefits

   84       119   

    Current installments of long-term debt

   10       10   

    Other accrued expenses

   299       343   
         

        Total current liabilities

   877       1,342   
         

Long-term debt, excluding current installments

   5,765       6,046   

Deferred tax liabilities

   203       194   

Other long-term liabilities

   312       331   
         

        Total liabilities

   7,157       7,913   
         

Stockholders’ equity:

     

    Common stock, par value $0.01; authorized 1,000 shares; issued 1,000 shares at January 31, 2010 and February 1, 2009

   –       –   

    Paid-in capital

   2,643       2,625   

    Accumulated deficit

   (1,944)      (1,418)  

    Accumulated other comprehensive loss

   (11)      (32)  
         

        Total stockholders’ equity

   688       1,175   
         

        Total liabilities and stockholders’ equity

   $    7,845       $  9,088   
         

The accompanying notes are an integral part of these financial statements.

 

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HD SUPPLY, INC.

CONSOLIDATED AND COMBINED STATEMENTS OF STOCKHOLDERS’ AND

OWNER’S EQUITY AND COMPREHENSIVE INCOME (LOSS)

Amounts in millions

 

  PREDECESSOR    Period from
January 29, 2007 to
August 29, 2007

  Owner’s equity balance at beginning of period

   $    2,970        

  Net income

   56        

  Other comprehensive income (loss):

  

    Foreign currency translation adjustment

   15        
    

  Total comprehensive income (loss)

   71        
    

  Net investment by THD

   877        
    

  Owner’s equity balance at end of period

   $    3,918        
    

 

  SUCCESSOR

 

   Common
Stock
  

Paid-in

Capital

   Accumulated
Deficit
   Accumulated Other
Comprehensive
Income (Loss)
   Total  
Equity  

  Balance at August 30, 2007

   $      –        $          –    $          –       $        –       $          –   
    

  Equity contribution

      2,600          2,600   

  Net loss

         (163)         (163)  

  Other comprehensive income (loss):

              

    Unrealized losses on derivatives, net of tax of $4

            (6)      (6)  

    Foreign currency translation adjustment

            1       1   
                

  Total comprehensive income (loss)

               (168)  

  Stock-based compensation

      1          1   
    

  Balance at February 3, 2008

   $      –        $  2,601    $   (163)      $      (5)      $  2,433   
    

  Equity contribution

      10          10   

  Net loss

         (1,255)         (1,255)  

  Other comprehensive income (loss):

              

    Unrealized gains on derivatives, net of tax of $(2)

            3       3   

    Foreign currency translation adjustment, net of tax of $2

            (30)      (30)  
                

  Total comprehensive income (loss)

               (1,282)  

  Stock-based compensation

      14          14   
    

  Balance at February 1, 2009

   $      –        $  2,625    $  (1,418)      $    (32)      $  1,175   
    

  Net loss

         (514)         (514)  

  Other comprehensive income (loss):

              

    Unrealized gains on derivatives, net of tax of $(1)

            2       2   

    Foreign currency translation adjustment, net of tax of $1

            19       19   
                

  Total comprehensive income (loss)

               (493)  

  Stock-based compensation

      18          18   

  Change in fiscal year end of subsidiary

         (13)         (13)  

  Other

         1          1   
    

  Balance at January 31, 2010

   $      –        $  2,643    $  (1,944)      $    (11)      $     688   
    

The accompanying notes are an integral part of these financial statements.

 

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HD SUPPLY, INC.

CONSOLIDATED AND COMBINED STATEMENTS OF CASH FLOWS

Amounts in millions

 

     Successor          Predecessor
     Fiscal Year
Ended
January 31,
2010
   Fiscal Year
Ended
February 1,
2009
   Period from
August 30, 2007
to February 3,
2008
         Period from
January 29, 2007
to August 29,
2007

CASH FLOWS FROM OPERATING ACTIVITIES:

                

Net income (loss)

         $   (514)               $   (1,255)              &nb