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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview HD Supply Holdings, Inc. ("Holdings") indirectly owns all of the outstanding common stock of HD Supply, Inc. ("HDS"). Unless otherwise indicated, the disclosures below apply to both Holdings and HDS. See "Explanatory Note." Holdings, together with its direct and indirect subsidiaries, including HDS ("HD Supply"), is one of the largest industrial distributors in North America. We believe we have leading positions in the three distinct market sectors in which we specialize: Maintenance, Repair & Operations; Infrastructure & Power; and Specialty Construction. We serve these markets with an integrated go-to-market strategy. We operate through over 600 locations across 46 U.S. states and 9 Canadian provinces. We have approximately 15,000 associates delivering localized, customer-tailored products, services and expertise. We serve approximately 500,000 customers, which include contractors, government entities, maintenance professionals, home builders and industrial businesses. Our broad range of end-to-end product lines and services include over one million SKUs of quality, name-brand and proprietary-brand products as well as value-add services supporting the entire lifecycle of a project from infrastructure and construction to maintenance, repair and operations. Description of segments We operate our Company through four reportable segments: Facilities Maintenance, Waterworks, Power Solutions and White Cap. Facilities Maintenance. Facilities Maintenance distributes MRO products, provides value-add services and fabricates custom products. The markets that Facilities Maintenance serves include multifamily, hospitality, healthcare and institutional facilities. Products include electrical and lighting items, plumbing, HVAC products, appliances, janitorial supplies, hardware, kitchen and bath cabinets, window coverings, textiles and guest amenities, healthcare maintenance and water and wastewater treatment products. Waterworks. Waterworks distributes complete lines of water and wastewater transmission products, serving contractors and municipalities in the water and wastewater industries for residential and non-residential uses. Waterworks serves non-residential, residential, water systems, sewage systems and other markets. Products include pipes, fittings, valves, hydrants and meters for use in the construction, maintenance and repair of water and wastewater systems as well as fire-protection systems. Waterworks has complemented its core products through additional offerings, including smart meters (AMR/AMI), HDPE pipes and specific engineered treatment plant products and services. Power Solutions. Power Solutions distributes electrical transmission and distribution products, power plant MRO supplies and smart-grid products, and arranges materials management and procurement outsourcing for the power generation and distribution industries. Power Solutions serves utilities and electrical markets. Products include conductors such as wire and cable, transformers, overhead transmission and distribution hardware, switches, protective devices and underground distribution, connectors used in the construction or maintenance and repair of electricity transmission and substation distribution infrastructure, and electrical wire and cable, switchgear, supplies, lighting and conduit used in non-residential and residential construction. White Cap. White Cap distributes specialized hardware, tools and engineered materials to non-residential and residential contractors. Products include 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, erosion and sediment control equipment and other engineered materials used broadly across all types of non-residential and residential construction. In addition to the reportable segments, our consolidated financial results include "Corporate & Other." Corporate & Other is comprised of the following operating segments: Crown Bolt, Creative Touch Interiors ("CTI"), Repair & Remodel and HD Supply Canada. Crown Bolt is a retail distribution operator providing program and packaging solutions, sourcing, distribution, and in-store service, fasteners, builders' hardware, rope 31 -------------------------------------------------------------------------------- Table of Contents and chain and plumbing accessories, primarily serving The Home Depot, Inc. ("Home Depot") and other hardware stores. CTI offers turnkey supply and installation services for multiple interior finish options, including flooring, cabinets, countertops, and window coverings, along with comprehensive design center services for non-residential, residential and senior living projects. Repair & Remodel offers light remodeling and construction supplies, kitchen and bath cabinets, windows, plumbing materials, electrical equipment and other products, primarily to small remodeling contractors and trade professionals. HD Supply Canada is an industrial distributor that primarily focuses on servicing fasteners/industrial supplies and specialty lighting markets which operates across nine provinces. Corporate & Other also includes costs related to our centralized support functions, which are comprised of finance, information technology, human resources, legal, supply chain and other support services, and removes inter-segment transactions. Acquisitions We enter into strategic acquisitions to expand into new markets, new platforms, and new geographies in an effort to better service existing customers and attract new ones. In accordance with the acquisition method of accounting under Accounting Standards Codification ("ASC") 805, Business Combinations, the results of the acquisitions we completed are reflected in our consolidated financial statements from the date of acquisition forward. On December 3, 2012, we purchased substantially all of the assets of Water Products of Oklahoma, Inc., Arkansas Water Products, LLC, and Municipal Water Works Supply, LP (collectively "Water Products"). These businesses distribute water, sewer, gas and related products, such as pipes, valves, fittings, hydrants, pumps and meters, and offer maintenance products and repair services primarily to municipalities and contractors. The businesses are operated as part of the Waterworks segment. On June 29, 2012, we purchased Peachtree Business Products LLC ("Peachtree"). Headquartered in Marietta, Georgia, Peachtree specializes in customizable business and property marketing supplies, serving residential and commercial property managers, medical facilities, schools and universities, churches and funeral homes. Peachtree is operated as part of the Facilities Maintenance segment. Discontinued operations On March 26, 2012, we sold all of the issued and outstanding equity interests in our Industrial Pipes, Valves and Fittings ("IPVF") business to Shale-Inland Holdings, LLC for approximately $477 million. Upon closing, we received cash proceeds of approximately $464 million, net of $5 million of transaction costs. As a result of the sale, we recorded a $9 million pre-tax gain in the first quarter of fiscal 2012. During the third quarter of fiscal 2012, we received cash proceeds of $13 million in accordance with the final working capital settlement, and, as a result, recorded an additional $3 million pre-tax gain. In accordance with Accounting Standards Codification ("ASC") 205-20, Discontinued Operations, the results of the IPVF operations and the gain on sale of the business are classified as discontinued operations. The presentation of discontinued operations includes revenues and expenses of the discontinued operations and gain on the sale of business, net of tax, as one line item on the Consolidated Statements of Operations and Comprehensive Income (Loss). For additional detail related to the results of operations of the discontinued operations, see "Note 2, Discontinued Operations," in the Notes to the Consolidated Financial Statements within Item 1 of this quarterly report on Form 10-Q. Key business metrics Net sales We earn our Net sales primarily from the sale of construction, infrastructure, maintenance and renovation and improvement related products and our provision of related services to approximately 500,000 customers, including contractors, government entities, maintenance professionals, home builders and industrial businesses. We recognize sales, 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 business units, particularly Waterworks 32 -------------------------------------------------------------------------------- Table of Contents and Power Solutions, fluctuate with the price of commodities as we seek to minimize the effects of changing commodities prices by passing such increases in the prices of certain commodity-based products to our customers. We ship products to customers predominantly by internal fleet and to a lesser extent by third-party carriers. Net sales 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. 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. Operating expenses Operating expenses are primarily comprised of selling, general and administrative costs, which include payroll expenses (salaries, wages, employee benefits, payroll taxes and bonuses), rent, insurance, utilities, repair and maintenance and professional fees. In addition, operating expenses include depreciation and amortization. Adjusted EBITDA and Adjusted net income (loss) We present Adjusted EBITDA because it is a primary measure used by management to evaluate operating performance. We believe the presentation of Adjusted EBITDA enhances investors' overall understanding of the financial performance of our business. Adjusted EBITDA is not a recognized term under accounting principles generally accepted in the United States of America ("GAAP") and does not purport to be an alternative to Net income (loss) as a measure of operating performance. We believe Adjusted EBITDA is helpful in highlighting operating trends, because it 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, we present Adjusted net income (loss) to measure our overall profitability as we believe it is an important measure of our performance. Adjusted net income (loss) is not a recognized term under GAAP and does not purport to be an alternative to Net income (loss) as a measure of operating performance. Adjusted net income (loss) is defined as Net income (loss) less Income (loss) from discontinued operations, net of tax, further adjusted for certain non-cash, non-recurring or unusual items, net of tax. We further believe that Adjusted EBITDA and Adjusted net income (loss) are frequently used by securities analysts, investors and other interested parties in their evaluation of companies, many of which present an Adjusted EBITDA or Adjusted net income (loss) measure when reporting their results. We compensate for the limitations of using non-GAAP financial measures by using them to supplement GAAP results to provide a more complete understanding of the factors and trends affecting the business than GAAP results alone. Because not all companies use identical calculations, our presentation of Adjusted EBITDA and Adjusted net income (loss) may not be comparable to other similarly titled measures of other companies. Adjusted EBITDA is based on "Consolidated EBITDA," a measure which is defined in HDS's Senior Term Facility and Senior ABL Facility and used in calculating financial ratios in several material debt covenants. 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 33 -------------------------------------------------------------------------------- Table of Contents calculated based on Consolidated EBITDA and our Senior ABL Facility requires us to maintain a minimum fixed charge coverage ratio of 1:1 if our specified excess availability (including an amount by which our borrowing base exceeds the outstanding amounts) under the Senior ABL Facility falls below the greater of $150 million and 10% of the aggregate commitments. Adjusted EBITDA 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, (iii) Depreciation and amortization and further adjusted to exclude non-cash items and certain other adjustments to Consolidated Net Income permitted in calculating Consolidated EBITDA under our Senior Term Facility and our Senior ABL Facility. We believe that presenting Adjusted EBITDA is appropriate to provide additional information to investors about how the covenants in those agreements operate and about certain non-cash and other items. The Senior Term Facility and Senior ABL Facility permit us to make certain additional 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 Form 10-Q. 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 our Registration Statement on Form S-1, as amended (File No. 333-187872), under "Description of Certain Indebtedness." Adjusted EBITDA and Adjusted net income (loss) have limitations as analytical tools and should not be considered in isolation or as a substitute for analyzing our results as reported under GAAP. Some of these limitations are: † Adjusted EBITDA and Adjusted net income (loss) do not reflect changes in, or cash requirements for, our working capital needs; † Adjusted EBITDA does not reflect our interest expense, or the requirements necessary to service interest or principal payments on our debt; † Adjusted EBITDA does not reflect our income tax expenses or the cash requirements to pay our taxes; † Adjusted EBITDA and Adjusted net income (loss) 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 Adjusted EBITDA does 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 GAAP, to Adjusted EBITDA for the periods presented: Three Months Ended Six Months Ended August 4, July 29, August 4, July 29, 2013 2012 2013 2012 Net income (loss) $ (72 ) $ (56 ) $ (203 ) $ (416 ) Less income (loss) from discontinued operations, net of tax - - - 16 Income (loss) from continuing operations (72 ) (56 ) (203 ) (432 ) Interest expense, net 144 158 291 324 Provision (benefit) for income taxes 12 1 55 34 Depreciation and amortization (i) 62 84 122 167 Loss on extinguishment & modification of debt (ii) 46 - 87 220 Stock-based compensation (iii) 5 5 8 10 Management fee & related expenses paid to Equity Sponsors (iv) 1 2 2 3 Costs related to initial public offering (v) 20 - 20 - Other - (2 ) - (1 ) Adjusted EBITDA $ 218 $ 192 $ 382 $ 325 -------------------------------------------------------------------------------- (i) Depreciation and amortization includes amounts recorded within Cost of sales in the Consolidated Statements of Operations. 34 -------------------------------------------------------------------------------- Table of Contents (ii) Represents the loss on extinguishment of debt including the premium paid to repurchase or call the debt as well as the write-off of unamortized deferred financing costs and other assets or liabilities associated with such debt. Also includes the costs of debt modification. (iii) Represents the stock-based compensation costs. (iv) The Company entered into consulting agreements with the Equity Sponsors whereby the Company paid the Equity Sponsors a $5 million annual aggregate management fee and related expenses. These consulting agreements were terminated in conjunction with the Company's initial public offering in the second quarter of fiscal 2013. (v) Represents the costs expensed in connection with the initial public offering, including approximately $18 million paid to the Equity Sponsors for termination of the consulting agreements. The following table presents a reconciliation of Net income (loss), the most directly comparable financial measure under GAAP, to Adjusted net income (loss) for the periods presented: Three Months Ended Six Months Ended August 4, July 29, August 4, July 29, 2013 2012 2013 2012 Net income (loss) $ (72 ) $ (56 ) $ (203 ) $ (416 ) Less income (loss) from discontinued operations, net of tax - - - 16 Income (loss) from continuing operations (72 ) (56 ) (203 ) (432 ) Plus: Provision (benefit) for income taxes 12 1 55 34 Less: Cash income taxes (3 ) (2 ) (5 ) (2 ) Plus: Amortization of acquisition-related intangible assets (other than software) 33 60 67 120 Plus: Loss on extinguishment & modification of debt (i) 46 - 87 220 Plus: Costs related to the initial public offering (ii) 20 - 20 - Adjusted net income (loss) $ 36 $ 3 $ 21 $ (60 ) -------------------------------------------------------------------------------- (i) Represents the loss on extinguishment of debt including the premium paid to repurchase or call the debt as well as the write-off of unamortized deferred financing costs and other assets or liabilities associated with such debt. Also includes the costs of debt modifications. (ii) Represents the costs expensed in connection with the initial public offering, including approximately $18 million paid to the Equity Sponsors for termination of the consulting agreements. 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. Fiscal Year Our fiscal year is a 52- or 53-week period ending on the Sunday nearest to January 31. Fiscal year ending February 2, 2014 ("fiscal 2013") includes 52 weeks and fiscal year ending February 3, 2013 ("fiscal 2012") included 53 weeks. The three months ended August 4, 2013 ("second quarter 2013") and July 29, 2012 ("second quarter 2012") both included 13 weeks. The six months ended August 4, 2013 and July 29, 2012 both included 26 weeks. 35 -------------------------------------------------------------------------------- Table of Contents Consolidated results of operations Three Months Ended Percentage Six Months Ended Percentage August 4, July 29, Increase August 4, July 29, Increase 2013 2012 (Decrease) 2013 2012 (Decrease) Net Sales $ 2,257 $ 2,059 9.6 % $ 4,325 $ 3,895 11.0 % Gross Profit 661 594 11.3 1,259 1,117 12.7 Operating expenses: Selling, general and administrative 450 408 10.3 889 805 10.4 Depreciation and amortization 61 83 (26.5 ) 120 166 (27.7 ) Total operating expenses 511 491 4.1 1,009 971 3.9 Operating Income 150 103 45.6 250 146 71.2 Interest expense 144 158 (8.9 ) 291 324 (10.2 ) Loss on extinguishment & modification of debt 46 - * 87 220 * Other (income) expense, net 20 - * 20 - * Income (Loss) from Continuing Operations Before Income Taxes (60 ) (55 ) (9.1 ) (148 ) (398 ) 62.8 Provision (benefit) for income taxes 12 1 * 55 34 61.8 Income (Loss) from Continuing Operations (72 ) (56 ) (28.6 ) (203 ) (432 ) 53.0 Income (loss) from discontinued operations, net of tax - - * - 16 * Net Income (Loss) $ (72 ) $ (56 ) (28.6 ) $ (203 ) $ (416 ) 51.2 Non-GAAP financial data: Adjusted EBITDA $ 218 $ 192 13.5 % $ 382 $ 325 17.5 % Adjusted net income (loss) $ 36 $ 3 * $ 21 $ (60 ) * % of Net Sales % of Net Sales Three Months Ended Basis Point Six Months Ended Basis Point August 4, July 29, Increase August 4, July 29, Increase 2013 2012 (Decrease) 2013 2012 (Decrease) Net Sales 100.0 % 100.0 % - 100.0 % 100.0 % - Gross Profit 29.3 28.8 50 29.1 28.7 40 Operating expenses: Selling, general and administrative 19.9 19.8 10 20.6 20.7 (10 ) Depreciation and amortization 2.8 4.0 (120 ) 2.7 4.3 (160 ) Total operating expenses 22.7 23.8 (110 ) 23.3 25.0 (170 ) Operating Income 6.6 5.0 160 5.8 3.7 210 Interest expense 6.4 7.7 (130 ) 6.7 8.3 (160 ) Loss on extinguishment & modification of debt 2.0 - 200 2.0 5.6 (360 ) Other (income) expense, net 0.9 - 90 0.5 - 50 Income (Loss) from Continuing Operations Before Income Taxes (2.7 ) (2.7 ) - (3.4 ) (10.2 ) 680 Provision (benefit) for income taxes 0.5 - 50 1.3 0.9 40 Income (Loss) from Continuing Operations (3.2 ) (2.7 ) (50 ) (4.7 ) (11.1 ) 640 Income (loss) from discontinued operations, net of tax - - - - 0.4 (40 ) Net Income (Loss) (3.2 ) (2.7 ) (50 ) (4.7 ) (10.7 ) 600 Non-GAAP financial data: Adjusted EBITDA 9.7 9.3 40 8.8 8.3 50 Adjusted net income (loss) 1.6 0.1 150 0.5 (1.5 ) 200 -------------------------------------------------------------------------------- * Not meaningful 36 -------------------------------------------------------------------------------- Table of Contents Highlights Net sales in second quarter 2013 increased $198 million, or 9.6%, compared to second quarter 2012. Each of our four reportable segments realized increases in Net sales. Operating income in second quarter 2013 increased $47 million, or 45.6%, as compared to second quarter 2012. Our growth initiatives and investments in the business resulted in an increase to Adjusted EBITDA of $26 million, or 13.5%, in second quarter 2013 as compared to second quarter 2012. During second quarter 2013, we completed an initial public offering of approximately 61 million shares of our common stock, resulting in net proceeds of approximately $1.0 billion, net of underwriters' discounts and commissions and paid and unpaid offering expenses of approximately $17 million. We used the net proceeds from the offering to redeem all $950 million of HDS's outstanding 10.50% Senior Subordinated Notes due 2021 (the "January 2013 Senior Subordinated Notes") and pay related transaction fees and other expenses. The remaining net proceeds were used for general corporate purposes. As a result of the debt repayment, HDS incurred a loss on extinguishment of debt of approximately $44 million. In addition, we amended HDS's Senior ABL Facility, as defined below, to, among other changes, lower the borrowing margin by 25 basis points and extend the maturity date of the Senior ABL Facility to June 28, 2018 (or the maturity date under the HDS's Term Loan Facility, as defined below, if earlier). In connection with the amendment, HDS recognized an approximately $3 million loss on extinguishment of debt for the write-off of pro-rata unamortized deferred debt costs for the portion of the amendment considered an extinguishment. As of August 4, 2013, our liquidity was $946 million. (See "Liquidity and Capital Resources - External Financing" for further information.) Net sales Net sales in second quarter 2013 increased $198 million, or 9.6%, compared to second quarter 2012 and $430 million, or 11.0%, in the first six months of fiscal 2013 as compared to the same period in fiscal 2012. Each of our reportable segments experienced an increase in Net sales in second quarter 2013 and in the first six months of fiscal 2013 as compared to the same periods in fiscal 2012. The Net sales increases were primarily due to growth initiatives at each of our businesses and, to a lesser extent, increases in market volume and recent acquisitions. Organic sales growth was 7.8% for second quarter 2013 and 9.1% in the first six months of fiscal 2013 as compared to the same periods in fiscal 2012. Our fiscal 2012 acquisitions provided $37 million and $78 million of non-organic sales growth in second quarter 2013 and in the first six months of fiscal 2013, respectively. Gross profit Gross profit increased $67 million, or 11.3%, during second quarter 2013 as compared to second quarter 2012 and $142 million, or 12.7%, in the first six months of fiscal 2013 as compared to the same period in fiscal 2012. The increase in Gross profit, driven by our Facilities Maintenance, Waterworks, and White Cap businesses, was primarily due to sales growth from initiatives, market volume and product mix. Second quarter 2013 and the first six months of fiscal 2013 included a reduction to Gross profit of $6 million and $12 million, respectively, due to the negotiated price reduction under the amended strategic purchase agreement between Crown Bolt and The Home Depot, Inc. ("Home Depot"). While the amendment extended the agreement five years through January 31, 2020, retaining Crown Bolt as the exclusive supplier of certain products to Home Depot, it eliminated the minimum purchase requirement and additionally reduced future pricing. Gross profit as a percentage of Net sales ("gross margin") increased approximately 50 basis points to 29.3% in second quarter 2013 as compared to 28.8% in second quarter 2012. In the first six months of fiscal 2013, gross margin of 29.1% increased approximately 40 basis points as compared to the same period in fiscal 2012. The improvement in gross margin in both periods was driven by our Facilities Maintenance, Waterworks and White Cap businesses. 37 -------------------------------------------------------------------------------- Table of Contents Operating expenses Operating expenses increased $20 million, or 4.1%, during second quarter 2013 as compared to second quarter 2012 and $38 million, or 3.9%, in the first six months of fiscal 2013 as compared to the same period in fiscal 2012. Selling, general and administrative expenses increased $42 million, or 10.3%, in second quarter 2013 as compared to second quarter 2012 and $84 million, or 10.4%, in the first six months of fiscal 2013 as compared to the same period in fiscal 2012. The increase in both periods is primarily as a result of increases in variable expenses due to higher sales volume and investments in growth initiatives. Depreciation and amortization expense decreased $22 million, or 26.5%, in second quarter 2013 as compared to second quarter 2012 and $46 million, or 27.7%, in the first six months of fiscal 2013 as compared to the same period in fiscal 2012. The decrease in both periods is primarily as a result of certain acquisition-related intangible assets, recorded in 2007 when HD Supply separated from Home Depot, becoming fully amortized during fiscal 2012. Operating expenses as a percentage of Net sales decreased approximately 110 basis points to 22.7% in second quarter 2013 as compared to second quarter 2012 and approximately 170 basis points to 23.3% in the first six months of fiscal 2013 as compared to the same periods in fiscal 2012. The decrease in both periods was driven by the lower Depreciation and amortization expense, which resulted in an approximately 120 basis points decrease in second quarter 2013 and 160 basis points in the first six months of fiscal 2013. Selling, general and administrative expenses as a percentage of Net sales were relatively flat in both periods; increasing approximately 10 basis points in second quarter 2013 and decreasing approximately 10 basis points in the first six months of fiscal 2013. The increase in second quarter 2013 was due to the impact of investments in the business, primarily at Power Solutions and White Cap, substantially offset by the leverage of fixed costs through sales volume increases, primarily at Waterworks and Facilities Maintenance. Selling, general and administrative expenses as a percentage of Net sales decreased in the year-to-date period due the leverage of fixed costs through sales volume increases, primarily at Waterworks and Power Solutions. These improvements were partially offset by increases in Selling, general and administrative expenses as a percentage of Net sales at Facilities Maintenance and White Cap due to the impact of the investment in sales force additions and greenfields to support continued growth. Operating income (loss) Operating income increased $47 million, or 45.6%, during second quarter 2013 as compared to second quarter 2012 and $104 million, or 71.2%, in the first six months of fiscal 2013 as compared to the same period in fiscal 2012. The improvement in both periods was due to higher Net sales and Gross profit and the reduction in Depreciation and amortization expense. Operating income as a percentage of Net sales increased approximately 160 basis points in second quarter 2013 as compared to second quarter 2012 and approximately 210 basis points in the first six months of fiscal 2013 as compared to the same periods in fiscal 2012. The improvement in both periods was driven by the reduction in Depreciation and amortization expense and improvements in gross margins. Interest expense Interest expense decreased $14 million, or 8.9%, during second quarter 2013 as compared to second quarter 2012 and $33 million, or 10.2%, in the first six months of fiscal 2013 as compared to the same period in fiscal 2012. The decrease in interest expense is due to a lower average interest rate on our outstanding indebtedness, partially offset by a higher average outstanding balance. Loss on extinguishment & modification of debt In second quarter 2013, we redeemed all $950 million outstanding aggregate principal amount of HDS's January 2013 Senior Subordinated Notes at a redemption price equal to 103% of the principal amount thereof. As a result, in second quarter 2013, HDS incurred a $44 million loss on extinguishment of debt, which includes a $29 38 -------------------------------------------------------------------------------- Table of Contents million premium payment to redeem the January 2013 Senior Subordinated Notes and approximately $15 million to write off the unamortized deferred debt cost. Also in second quarter 2013, we amended HDS's Senior ABL Facility to, among other changes, lower the borrowing margin by 25 basis points and extend the maturity date of the Senior ABL Facility to June 28, 2018 (or the maturity date under HDS's Term Loan Facility, if earlier). In connection with the amendment, HDS recognized an approximately $3 million loss on extinguishment of debt for the write-off of pro-rata unamortized deferred debt costs for the portion of the amendment considered an extinguishment in accordance with ASC 470-50, Debt-Modifications and Extinguishments. In first quarter 2013, we redeemed all of the $889 million outstanding of HDS's 13.5% Senior Subordinated Notes due 2015 (the "2007 Senior Subordinated Notes") at redemption price of 103.375% of the principal amount thereof. As a result, HDS incurred a $34 million loss on extinguishment of debt, which includes a $30 million premium payment to redeem the 2007 Senior Subordinated Notes and approximately $4 million to write off the unamortized deferred debt cost. In addition, during first quarter 2013, we amended HDS's Term Loan Facility to lower the borrowing margin by 275 basis points and replace the hard call provision applicable to optional prepayment of Term Loans thereunder with a soft call option. A portion of the amendment was considered an extinguishment in accordance with ASC 470-50, resulting in a $5 million loss on extinguishment of debt, which included approximately $2 million of fees, $2 million to write off the pro-rata portion of unamortized original issue discount, and $1 million to write off the pro-rata portion of unamortized deferred debt cost. A significant portion of the amendment of HDS's Term Loan Facility was considered a modification in accordance with ASC 470-50. As a result, HDS incurred approximately $1 million in financing fees that were expensed. In connection with the refinancing of the senior portion of our debt structure in first quarter 2012, HDS recorded a charge of $220 million in accordance with ASC 470-50. This charge consisted of $150 million for the premium paid to the holders of the 12.0% Senior Notes dated as of August 30, 2007, as contractually required, upon early extinguishment, $46 million of unamortized deferred debt costs and $24 million to write off the remaining unamortized asset associated with Home Depot's guarantee of HDS's payment obligations for principal and interest under the Term Loan under the 2007 Senior Secured Credit Facility that was terminated in the April 2012 Refinancing Transactions. For additional information on the fiscal 2013 transactions, see "Liquidity and Capital Resources - External Financing." For additional information on the fiscal 2012 transactions, see "Note 4, Debt," in the Notes to the Consolidated Financial Statements within Item 1 of this quarterly report on Form 10-Q. Other (income) expense, net In connection with the initial public offering, we incurred approximately $20 million in related fees and expenses, including an aggregate fee of approximately $18 million paid to the Equity Sponsors to terminate our consulting agreements with them. For additional information on this transaction, see "Note 3, Related Parties," in the Notes to the Consolidated Financial Statements within Item 1 of this quarterly report on Form 10-Q. Provision (benefit) for income taxes The provision for income taxes from continuing operations in second quarter 2013 was $12 million compared to $1 million in second quarter 2012. The effective rate for continuing operations for second quarter 2013 was a provision of 19.8%, reflecting the impact of increasing the U.S. valuation allowance, increasing the deferred tax liability for U.S. goodwill amortization for tax purposes, and the accrual of income taxes for foreign and certain state jurisdictions. The effective rate for continuing operations for second quarter 2012 was a provision of 2.8%, reflecting the impact of increasing the U.S. valuation allowance, increasing the deferred tax liability for U.S. goodwill amortization for tax purposes, and the accrual of income taxes for foreign and certain state jurisdictions. The provision for income taxes from continuing operations in the first six months of fiscal 2013 was $55 million compared to $34 million in the first six months of fiscal 2012. The effective rate for continuing operations for the first six months of 2013 was a provision of 36.8%, reflecting the impact of increasing the U.S. valuation 39 -------------------------------------------------------------------------------- Table of Contents allowance, increasing the deferred tax liability for U.S. goodwill amortization for tax purposes, and the accrual of income taxes for foreign and certain state jurisdictions. The effective rate for continuing operations for the first six months of fiscal 2012 was a provision of 8.6%, reflecting the impact of increasing the U.S. valuation allowance, increasing the deferred tax liability for U.S. goodwill amortization for tax purposes, and the accrual of income taxes for foreign and certain state jurisdictions. The tax expense for the first six months of fiscal 2012 was partially offset by an adjustment to the Company's valuation allowance as a result of the Peachtree acquisition. 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. Adjusted EBITDA Adjusted EBITDA increased $26 million, or 13.5%, in second quarter 2013 as compared to second quarter 2012 and $57 million, or 17.5%, in the first six months of fiscal 2013 as compared to the same period in fiscal 2012. The increase in Adjusted EBITDA in second quarter 2013 was driven by Facilities Maintenance, Waterworks, and White Cap. Each of our reportable segments experienced an increase in Adjusted EBITDA in the first six months of fiscal 2013 as compared to the same period in fiscal 2012. The increase in Adjusted EBITDA in second quarter 2013 and the first six months of fiscal 2013 was primarily due to the increases in Net sales and Gross profit. Second quarter 2013 and the first six months of fiscal 2013 included a reduction to Adjusted EBITDA of $6 million and $12 million, respectively, due to the negotiated price reduction under the amended strategic purchase agreement between Crown Bolt and Home Depot. Adjusted EBITDA as a percentage of Net sales increased approximately 40 basis points to 9.7% in second quarter 2013 as compared to second quarter 2012 and approximately 50 basis points in the first six months of fiscal 2013 as compared to the same period in fiscal 2012, primarily due to gross margin improvements. Adjusted net income (loss) Adjusted net income (loss) increased $33 million in second quarter 2013 to $36 million as compared to $3 million in second quarter 2012 and $81 million in the first six months of fiscal 2013 to $21 million as compared to an adjusted net loss of $60 million in the first six months of fiscal 2012. The increase in Adjusted net income (loss) in both periods is attributable to the sales growth, improving gross margins, and a reduction in interest expense. Results of operations by reportable segment Facilities Maintenance Three Months Ended Six Months Ended August 4, July 29, Increase August 4, July 29, Increase Dollars in millions 2013 2012 (Decrease) 2013 2012 (Decrease) Net sales $ 638 $ 571 11.7 % $ 1,199 $ 1,068 12.3 % Operating income $ 94 $ 80 17.5 % $ 163 $ 137 19.0 % % of Net sales 14.7 % 14.0 % 70 bps 13.6 % 12.8 % 80 bps Depreciation and amortization 31 29 6.9 % 62 57 8.8 % Adjusted EBITDA $ 125 $ 109 14.7 % $ 225 $ 194 16.0 % % of Net sales 19.6 % 19.1 % 50 bps 18.8 % 18.2 % 60 bps Net Sales Net sales increased $67 million, or 11.7%, in second quarter 2013 as compared to second quarter 2012 and increased $131 million, or 12.3%, in the first six months of fiscal 2013 as compared to the same period of fiscal 2012. New growth initiatives contributed approximately $36 million of the year-over-year increase in second quarter 2013. These growth initiatives consist of investments in sales personnel, products and technology, aligned 40 -------------------------------------------------------------------------------- Table of Contents with our customers' multifamily, hospitality, and healthcare industries. Net sales in second quarter 2013 were also positively impacted by favorable market conditions in the multifamily and hospitality industries and by approximately $13 million from the acquisition of Peachtree in June 2012. Organic sales growth was 9.4% in second quarter 2013 as compared to second quarter 2012. In the year-to-date period, new growth initiatives contributed approximately $66 million of the year-over-year increase and Peachtree contributed approximately $30 million of non-organic Net sales. Organic sales growth was 9.5% in the first six months of 2013 as compared to the same period in fiscal 2012. Adjusted EBITDA Adjusted EBITDA increased $16 million, or 14.7%, in second quarter 2013 as compared to second quarter 2012 and increased $31 million, or 16.0%, in the first six months of fiscal 2013 as compared to the same period of fiscal 2012. The increase in both periods was due to new growth initiatives and the Peachtree acquisition. This increase was partially offset by increased Selling, general and administrative expense related to the hiring of additional associates to support the expanding business and drive future growth, and by other variable expenses driven by the volume increase. Adjusted EBITDA as a percentage of Net sales increased approximately 50 basis points in second quarter 2013 as compared to second quarter 2012 and increased approximately 60 basis points in the first six months of fiscal 2013 as compared to the same period of fiscal 2012. The increase in both periods was driven primarily by the expansion of gross margins. The improvement in second quarter 2013 included gross margin expansions of approximately 30 basis points and a slight decline in Selling, general and administrative expenses as a percentage of Net sales due to the leverage of fixed costs through sales volume increases. The improvement in the first six months of fiscal 2013 included gross margin expansions of approximately 90 basis points, which were partially offset by an increase in Selling, general and administrative expenses as a percentage of Net sales due to the impact of the investment in sales force additions and the Peachtree acquisition. Waterworks Three Months Ended Six Months Ended August 4, July 29, Increase August 4, July 29, Increase Dollars in millions 2013 2012 (Decrease) 2013 2012 (Decrease) Net sales $ 601 $ 527 14.0 % $ 1,124 $ 988 13.8 % Operating income $ 46 $ 13 * $ 81 $ 15 * % of Net sales 7.7 % 2.5 % 520 bps 7.2 % 1.5 % 570 bps Depreciation and amortization 4 26 (84.6 )% 7 52 (86.5 )% Adjusted EBITDA $ 50 $ 39 28.2 % $ 88 $ 67 31.3 % % of Net sales 8.3 % 7.4 % 90 bps 7.8 % 6.8 % 100 bps -------------------------------------------------------------------------------- * not meaningful Net Sales Net sales increased $74 million, or 14.0%, in second quarter 2013 as compared to second quarter 2012 and increased $136 million, or 13.8%, in the first six months of fiscal 2013 as compared to the same period of fiscal 2012. Growth initiatives, including fusible plastics, storm drainage, treatment plant initiatives, and greenfields, contributed approximately $52 million and $88 million of the year-over-year increase in second quarter 2013 and the year-to-date period, respectively. Net sales in second quarter 2013 and the year-to-date period were negatively affected by decreases in prices due to commodity price deflation, primarily PVC and ductile iron products. The December 2012 acquisition of Water Products contributed Net sales of approximately $25 million in second quarter 2013 and $48 million in the first six months of fiscal 2013. Organic sales growth was 9.5% in 41 -------------------------------------------------------------------------------- Table of Contents second quarter 2013 as compared to second quarter 2012 and 8.9% in the first six months of fiscal 2013 as compared to the same period of fiscal 2012. Adjusted EBITDA Adjusted EBITDA increased $11 million, or 28.2%, in second quarter 2013 as compared to second quarter 2012 and increased $21 million, or 31.3%, in the first six months of fiscal 2013 as compared to the same period of fiscal 2012. The increase in both periods was due to new growth initiatives and, to a lesser extent, the Water Products acquisition, partially offset by increased Selling, general and administrative expense, primarily personnel and variable costs due to the increased volume. Adjusted EBITDA as a percentage of Net sales increased approximately 90 basis points in second quarter 2013 as compared to second quarter 2012 and increased approximately 100 basis points in the first six months of fiscal 2013 as compared to the same period of fiscal 2012. The improvement in both periods was due to the expansion of gross margins and a decline in Selling, general and administrative expense as a percentage of Net sales. Both periods included gross margin expansions of approximately 50 basis points primarily driven by growth initiatives, product sourcing and the Water Products acquisition. Selling, general and administrative expense as a percentage of Net sales declined approximately 40 basis points and 50 basis points in second quarter 2013 and the year-to-date period of fiscal 2013, respectively, primarily due to the leverage of fixed costs through sales volume increases. Power Solutions Three Months Ended Six Months Ended August 4, July 29, Increase August 4, July 29, Increase Dollars in millions 2013 2012 (Decrease) 2013 2012 (Decrease) Net sales $ 456 $ 440 3.6 % $ 918 $ 855 7.4 % Operating income $ 12 $ 14 (14.3 )% $ 24 $ 22 9.1 % % of Net sales 2.6 % 3.2 % (60 )bps 2.6 % 2.6 % - Depreciation and amortization 6 6 - 12 12 - Adjusted EBITDA $ 18 $ 20 (10.0 )% $ 36 $ 34 5.9 % % of Net sales 3.9 % 4.5 % (60 )bps 3.9 % 4.0 % (10 )bps Net Sales Net sales increased $16 million, or 3.6%, in second quarter 2013 as compared to second quarter 2012 and increased $63 million, or 7.4%, in the first six months of fiscal 2013 as compared to the same period of fiscal 2012. The increase in Net sales in both second quarter 2013 and the year-to-date period was attributable to increasing sales volume with our utilities customers, primarily driven by increases in transmission projects and product and service expansion. Adjusted EBITDA Adjusted EBITDA decreased $2 million, or 10.0%, in second quarter 2013 as compared to second quarter 2012 and increased $2 million, or 5.9%, in the first six months of fiscal 2013 as compared to the same period of fiscal 2012. The decrease in Adjusted EBITDA in second quarter 2013 was driven by an increase in Selling, general and administrative expenses as compared to second quarter 2012 due to investments in growth initiatives, marketing and expansion of products and services, partially offset by an increase in Net sales volumes. The increase in Adjusted EBITDA in the year-to-date period was primarily due to volume increases in Net sales and the leverage of fixed costs through sales volume increases and efforts to control expenses. Adjusted EBITDA as a percentage of Net sales decreased approximately 60 basis points in second quarter 2013 as compared to second quarter 2012 and approximately 10 basis points in the first six months of fiscal 2013 42 -------------------------------------------------------------------------------- Table of Contents as compared to the same period of fiscal 2012. The decrease in second quarter 2013 was due to an increase in Selling, general and administrative expense as a percentage of Net sales, partially offset with improvements to gross margin. Adjusted EBITDA as a percentage of Net sales in the year-to-date period of 3.9% was relatively flat as compared to the same period in the prior year. White Cap Three Months Ended Six Months Ended August 4, July 29, Increase August 4, July 29, Increase Dollars in millions 2013 2012 (Decrease) 2013 2012 (Decrease) Net sales $ 336 $ 307 9.4 % $ 646 $ 573 12.7 % Operating income $ 15 $ 10 50.0 % $ 20 $ 10 100.0 % % of Net sales 4.5 % 3.3 % 120 bps 3.1 % 1.7 % 140 bps Depreciation and amortization 9 8 12.5 % 18 16 12.5 % Adjusted EBITDA $ 24 $ 18 33.3 % $ 38 $ 26 46.2 % % of Net sales 7.1 % 5.9 % 120 bps 5.9 % 4.5 % 140 bps Net Sales Net sales increased $29 million, or 9.4%, in second quarter 2013 as compared to second quarter 2012 and increased $73 million, or 12.7%, in the first six months of fiscal 2013 as compared to the same period of fiscal 2012. Growth initiatives contributed approximately $21 million of the year-over-year increase in second quarter 2013, of which approximately $8 million was driven by greenfield initiatives and approximately $7 million was driven by our Managed Sales Approach ("MSA"), with the remainder driven by category management and direct marketing initiatives. MSA is a structured approach to drive revenue at a regional level through analysis, tools and sales management. Growth initiatives contributed approximately $50 million of the year-over-year increase in the first six months of fiscal 2013, of which approximately half was driven by our MSA, with the remainder driven by category management, direct marketing and greenfield initiatives. In addition, Net sales were positively impacted in both periods by the gradual improvement in the residential housing market. Adjusted EBITDA Adjusted EBITDA increased $6 million, or 33.3%, in second quarter 2013 as compared to second quarter 2012 and increased $12 million, or 46.2%, in the first six months of fiscal 2013 as compared to the same period of fiscal 2012. The increase in Adjusted EBITDA in both periods was primarily driven by growth initiatives, market volume, and product mix. This increase was partially offset by increased Selling, general and administrative expense related to the hiring of additional associates to support the expanding business and drive future growth. Adjusted EBITDA as a percentage of Net sales increased approximately 120 basis points in second quarter 2013 as compared to second quarter 2012 and increased approximately 140 basis points in the first six months of fiscal 2013 as compared to the same period of fiscal 2012. The increase in both periods was primarily due to gross margin improvements of approximately 190 basis points in second quarter 2013 and approximately 180 basis points in the year-to-date period, driven by sourcing initiatives and product mix. This improvement was partially offset by an increase in Selling, general and administrative expenses as a percentage of Net sales due to the impact of the investment in sales force additions and greenfields to support continued growth in our business. Liquidity and capital resources Sources and uses of cash 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. 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. 43 -------------------------------------------------------------------------------- Table of Contents On July 2, 2013, Holdings completed an initial public offering of its common stock, resulting in net proceeds of approximately $1,038 million, net of underwriters' discounts and commissions and paid and unpaid offering expenses of approximately $17 million (including the payment to the Equity Sponsors of a transaction fee of approximately $11 million). The net proceeds from the initial public offering were used to (1) redeem all $950 million of HDS's outstanding January 2013 Senior Subordinated Notes, including the payment of a $29 million premium to redeem the notes and $29 million of accrued interest through the redemption date, and (2) pay related fees and expenses, including the payment to the Equity Sponsors of an aggregate fee to terminate the consulting agreements of approximately $18 million. The remaining net proceeds were used for general corporate purposes. During the first six months of fiscal 2013, the Company's use of cash was primarily driven by the payment of interest on debt and net debt repayments, substantially offset by the net proceeds of the initial public offering and the receipt of cash from the sale of short-term investments of cash restricted for the extinguishment of the 2007 Senior Subordinated Notes. This net use of cash was partially offset by cash receipts from operations. As of August 4, 2013, our combined liquidity of approximately $946 million was comprised of $109 million in cash and cash equivalents and $837 million of additional available borrowings (excluding $51 million of borrowings on available cash balances) under our Senior ABL Facility, based on qualifying inventory and receivables. Information about the Company's cash flows, by category, is presented in the Consolidated Statements of Cash Flows and is summarized as follows: Net cash provided by (used for): Amounts in millions Six Months Ended Increase August 4, 2013 July 29, 2012 (Decrease) Operating activities $ (577 ) $ (324 ) $ (253 ) Investing activities 879 215 664 Financing activities (333 ) 88 (421 ) Working capital Working capital, excluding cash and cash equivalents, was $1,172 million as of August 4, 2013, increasing approximately $193 million as compared to $979 million as of July 29, 2012. The increase was primarily driven by an increase in Receivables and Inventory reflecting higher sales volumes, partially offset by an increase in Accounts Payable and a decrease in deferred tax assets. Operating activities Cash flow from operating activities in the first six months of fiscal 2013 was a use of $577 million compared with cash used by operating activities of $324 million in the first six months of fiscal 2012. The use of cash in the first six months of fiscal 2013 was driven by the payment of $364 million of original issue discounts and PIK interest related to the extinguishment of the 2007 Senior Subordinated Notes and a portion of the Term Loans. Additionally, cash interest paid in the first six months of fiscal 2013 unrelated to extinguishments was $304 million, compared to $351 million in the first six months of fiscal 2012. Excluding the cash interest payments, including PIK interest and original issue discounts paid, in both periods, cash flow from operating activities increased $64 million in the first six months of fiscal 2013 as compared to the first six months of fiscal 2012. Investing activities During the first six months of fiscal 2013, cash provided by investing activities was $879 million, primarily due to the proceeds of $936 million from the sale of short-term investments of cash restricted for the extinguishment of the 2007 Senior Subordinated Notes, partially offset by $64 million of capital expenditures. During the first six months of fiscal 2012, cash provided by investing activities was $215 million, primarily driven by $464 million of proceeds from the sale of a business, net, offset by $196 million payments for a business acquisition and $52 million in capital expenditures. 44 -------------------------------------------------------------------------------- Table of Contents Financing activities During the first six months of fiscal 2013, cash used in financing activities was $333 million, primarily due to net debt payments of $1,340 million, including an aggregate $59 million in contractually required premiums paid to extinguish the 2007 Senior Subordinated Notes and January 2013 Senior Subordinated Notes prior to maturity, and payments of $34 million for debt issuance and modification costs. This was substantially offset by $1,040 million in net proceeds from the initial public offering of our common stock. During the first six months of fiscal 2012, cash provided by financing activities was $88 million, due to net debt borrowings of $161 million, offset by payments of $73 million for debt issuance costs. External Financing As of August 4, 2013, we had an aggregate principal amount of $5.7 billion of outstanding debt, net of unamortized discounts of $21 million and including unamortized premiums of $19 million, and $888 million of additional available borrowings under our Senior ABL Facility (after giving effect to the borrowing base limitations and approximately $56 million in letters of credit issued and including $51 million of borrowings available on qualifying cash balances). From time to time, depending on market conditions and other factors, we may seek to repay, redeem, repurchase or otherwise acquire or refinance a portion or all of our indebtedness. We may make such repurchases in privately negotiated transactions or otherwise. HDS's long-term debt as of August 4, 2013 and February 3, 2013 consisted of the following (dollars in millions): August 4, 2013 February 3, 2013 Outstanding Interest Outstanding Interest Principal Rate %(1) Principal Rate %(1) Senior ABL Facility due 2017 $ 500 1.69 $ 300 1.96 Term Loans due 2017, net of unamortized discount of $21 million and $26 million as of August 4, 2013 and February 3, 2013, respectively 969 4.50 969 7.25 First Priority Notes due 2019, including unamortized premium of $19 million and $21 million as of August 4, 2013 and February 3, 2013, respectively 1,269 8.125 1,271 8.125 Second Priority Notes due 2020 675 11.00 675 11.00 October 2012 Senior Unsecured Notes due 2020 1,000 11.50 1,000 11.50 February 2013 Senior Unsecured Notes due 2020 1,275 7.50 1,275 7.50 January 2013 Senior Subordinated Notes due 2021 - - 950 10.50 2007 Senior Subordinated Notes due 2015 - - 889 13.50 Total long-term debt $ 5,688 $ 7,329 Less current installments (10 ) (899 ) Long-term debt, excluding current installments $ 5,678 $ 6,430 -------------------------------------------------------------------------------- (1) Represents the stated rate of interest, without including the effect of discounts or premiums. On August 1, 2013, HDS redeemed all $950 million outstanding aggregate principal amount of its January 2013 Senior Subordinated Notes at a redemption price equal to 103% of the principal amount thereof and paid accrued and unpaid interest thereon through the redemption date. As a result, in second quarter 2013, HDS incurred a $44 million loss on extinguishment of debt, which included a $29 million premium payment to redeem the January 2013 Senior Subordinated Notes and approximately $15 million to write off the unamortized deferred debt cost in accordance with ASC 470-50, Debt-Modifications and Extinguishments. On June 28, 2013, HDS amended its Senior ABL Facility to (i) reduce the applicable margin for borrowings under the Senior ABL Facility by 0.25%; (ii) reduce the commitment fee applicable thereunder by 0.125%; (iii) extend the maturity date of the Senior ABL Facility to June 28, 2018 (or, if earlier, the maturity date under HDS's Term Loan Facility); (iv) make certain changes to the borrowing base and (v) reduce the sublimit available for letters of credit under the Senior ABL Facility from $400 million to $250 million. In connection with the 45 -------------------------------------------------------------------------------- Table of Contents amendment, HDS paid approximately $2 million in financing fees which will be amortized into interest expense over the remaining term of the amended facility in accordance with ASC 470-50. A portion of the amendment was considered an extinguishment, resulting in an approximately $3 million loss on extinguishment of debt for the write-off of pro-rata unamortized deferred debt costs. On February 15, 2013, HDS amended its Term Loan Facility (as defined below) to lower the borrowing margin by 275 basis points. The Term Loans (as defined below) are subject to an interest rate equal to LIBOR (subject to a floor of 1.25%) plus a borrowing margin of 3.25% or Prime plus a borrowing margin of 2.25% at HDS's election. The amendment also replaced the hard call provision applicable to optional prepayment of Term Loans thereunder with a soft call option. The soft call option provides for a premium equal to 1.0% of the aggregate principal amount of Term Loans being prepaid if, on or prior to August 15, 2013, HDS enters into certain repricing transactions. In connection with the amendment, HDS paid approximately $30 million in financing fees, of which approximately $27 million will be amortized into interest expense over the remaining term of the amended facility in accordance with ASC 470-50. A portion of the amendment was considered an extinguishment, resulting in a $5 million loss on extinguishment of debt, which included approximately $2 million of fees, $2 million to write off the pro-rata portion of unamortized original issue discount, and $1 million to write off the pro-rata portion of unamortized deferred debt cost. The portion of the amendment considered a modification resulted in a charge of $1 million. On February 8, 2013, HDS redeemed its remaining $889 million outstanding aggregate principal amount of 2007 Senior Subordinated Notes at a redemption price equal to 103.375% of the principal amount thereof and paid accrued and unpaid interest thereon through the redemption date. As a result, in the first quarter of fiscal 2013, HDS incurred a $34 million loss on extinguishment of debt, which included a $30 million premium payment to redeem the 2007 Senior Subordinated Notes and approximately $4 million to write off the unamortized deferred debt cost. Senior Credit Facilities HDS's Senior Term Facility consists of a senior secured Term Loan Facility (the "Term Loan Facility," the term loans thereunder, the "Term Loans") providing for Term Loans in an aggregate principal amount of $1,000 million. The Term Loan Facility will mature on October 12, 2017 (the "Term Loan Maturity Date"). The Term Loans amortize in equal quarterly installments in aggregate annual amounts equal to 1% of the original principal amount of the Term Loan Facility with the balance payable on the Term Loan Maturity Date. HDS's Senior Asset Based Lending Facility ("Senior ABL Facility") provides for senior secured revolving loans and letters of credit of up to a maximum aggregate principal amount of $1,500 million (subject to availability under a borrowing base). Extensions of credit under the Senior ABL Facility are limited by a borrowing base calculated periodically based on specified percentages of the value of eligible inventory and eligible accounts receivable, subject to certain reserves and other adjustments. A portion of the Senior ABL Facility is available for letters of credit and swingline loans. As of August 4, 2013, HDS has $888 million of additional available borrowings under the Senior ABL Facility (after giving effect to the borrowing base limitations and approximately $56 million in letters of credit issued and including $51 million of borrowings available on qualifying cash balances). The Senior ABL Facility also permits HDS to add one or more incremental term loan facilities to be included in the Senior ABL Facility or one or more revolving credit facility commitments to be included in the Senior ABL Facility. The Senior ABL Facility will mature on June 28, 2018 (or the maturity date under HDS's Term Loan Facility, if earlier). Secured Notes HDS's 81/8% Senior Secured First Priority Notes due 2019 (the "First Priority Notes"), bear interest at a rate of 81/8% per annum and will mature on April 15, 2019. Interest is paid semi-annually in arrears on April 15th and October 15th of each year. 46 -------------------------------------------------------------------------------- Table of Contents HDS's 11% Senior Secured Second Priority Notes due 2020 (the "Second Priority Notes") bear interest at a rate of 11% per annum and will mature on April 15, 2020. Interest is paid semi-annually in arrears on April 15th and October 15th of each year. Unsecured Notes HDS's 11.5% Senior Notes due 2020 (the "October 2012 Senior Unsecured Notes") bear interest at 11.5% per annum and will mature on July 15, 2020. Interest is paid semi-annually in arrears on April 15th and October 15th of each year. HDS's 7.5% Senior Notes due 2020 (the "February 2013 Senior Unsecured Notes") bear interest at 7.5% per annum and will mature on July 15, 2020. Interest is paid semi-annually in arrears on April 15th and October 15th of each year. Debt covenants HDS's outstanding debt agreements contain various restrictive covenants including, but not limited to, limitations on additional indebtedness and dividend payments and stipulations regarding the use of proceeds from asset dispositions. As of August 4, 2013, HDS is in compliance with all such covenants that were in effect on such date. Critical accounting policies Our condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. Preparation of these statements requires management to make judgments and estimates. Some accounting policies have a significant impact on amounts reported in these consolidated financial statements. The Company's critical accounting policies have not changed from those reported in Management's Discussion and Analysis of Financial Condition and Results of Operations in the Company's Registration Statement. New accounting guidance Comprehensive income: reclassifications - In February 2013, Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2013-02, "Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income" ("ASU 2013-02"), to supersede and replace the presentation requirements for reclassifications out of accumulated other comprehensive income in ASU 2011-05, which were deferred indefinitely under ASU No. 2011-12, "Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05" ("ASU 2011-12"), issued in December 2011. The amendments in ASU 2013-02 require an entity to provide additional information about significant reclassifications out of accumulated other comprehensive income by the respective line items of net income. The Company adopted the provisions of ASU 2013-02 on February 4, 2013. The adoption of ASU 2013-02 did not have an impact on the Company's financial position or results of operations. Release of cumulative translation adjustment - In March 2013, the FASB issued ASU No. 2013-05, "Parent's Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity or of an Investment in a Foreign Entity" ("ASU 2013-05"), which resolves diversity in practice regarding the release of the cumulative translation adjustment into net income when a parent either sells a part or all of its investment in a foreign entity or no longer holds a controlling financial interest in a subsidiary or group of assets within a foreign entity. The amendments in ASU 2013-05 are effective prospectively for fiscal years, and interim periods within those years, beginning after December 15, 2013. Early adoption is permitted. The adoption of ASU 2013-05 will not have a material impact on the Company's financial position or results of operations. Presentation of unrecognized tax benefits - In July 2013, the FASB issued ASU No. 2013-11, "Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists" ("ASU 2013-11"), which resolves diversity in practice on the financial statement 47 -------------------------------------------------------------------------------- Table of Contents presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. An unrecognized tax benefit, or a portion of an unrecognized tax benefit, should be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward, except in certain situations, as defined in ASU 2013-11. The amendments in ASU 2013-11 are effective prospectively for fiscal years, and interim periods within those years, beginning after December 15, 2013. Early adoption is permitted. The Company is currently evaluating the impact of adopting ASU 2013-11. Disclosure under Section 13(r) of the Exchange Act Under Section 13(r) of the Exchange Act as added by the Iran Threat Reduction and Syrian Human Rights Act of 2012, we are required to include certain disclosures in our periodic reports if we or any of our "affiliates" (as defined in Rule 12b-2 thereunder) knowingly engage in certain activities specified in Section 13(r) during the period covered by the report. Because the SEC defines the term "affiliate" broadly, it includes any entity that controls us or is under common control with us ("control" is also construed broadly by the SEC). Our affiliate, CD&R, has informed us that an indirect subsidiary of SPIE S.A. ("SPIE"), an affiliate of CD&R based in France, maintained bank accounts during the period covered by this report at Bank Melli with the approval of the French financial regulator (applying European Union law) and, since May 21, 2013, with the approval of the Office of Foreign Assets Control in the U.S. Treasury Department ("OFAC"). Bank Melli is an Iranian bank designated under Executive Order No. 13382. We had no knowledge of or control over the activities of SPIE or its subsidiaries. CD&R has informed us that the SPIE subsidiary has not used the accounts during the period covered by this report, that SPIE and its subsidiaries obtained no revenue or profit from the maintenance of these accounts, that CD&R and SPIE have disclosed past transactions in the accounts to OFAC, that SPIE and its subsidiaries intended to comply with all applicable laws, and that SPIE and its subsidiaries intend to conduct only such transactions and dealings with Bank Melli in the future as are authorized by the applicable French governmental authority and OFAC. 48 -------------------------------------------------------------------------------- Table of Contents |