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What Industrial Distributors Will Survive This Nightmarish Economy?

Times will be tough for small players.

The credit crisis dealt a serious blow to industrial distributors, who saw years of growth come to a skidding halt. Reduced core demand, lower customer inventory levels, and diminished acquisition activity shut down most growth avenues. To counter this slowdown, distributors are reducing working capital investment and have initiated cost-containment measures. We think well-capitalized, large distributors will beat this cyclical downturn, but smaller distributors with significant upcoming debt maturities are likely to flounder.

In the industrial distribution space, core demand is a function of the manufacturing output of the United States. This metric grew at a 5% annual pace from 2003 to 2008. However, this growth engine slowed abruptly as the credit crisis unfolded. In the last quarter of 2008, manufacturing output fell 9% (as charted below) from a year ago. The slowdown's pace accelerated during the first quarter of 2009, when manufacturing output fell 16%, 15%, and 17% in the months of January, February, and March. While the slowdown in manufacturing output is a sizable head wind to overcome, inventory reduction at the customers' end makes this the darkest hour for distributors in the past 50 years. Manufacturing firms reduced their inventory levels 0.3%, 2.2%, and 4.2% during January, February, and March of 2009, further adding to the misery of industrial distributors. Acquisitions are proving difficult to accomplish as weak credit markets and poor firm valuations are discouraging buyers and sellers alike.

To overcome the demand shock, distributors are axing their working capital investment and capital expenditure outlays. Reduced investment outlays improve a distributor's cash generation. In fact,  Grainger (GWW),  Fastenal (FAST),  Wesco (WCC), and  Anixter  reported increased free cash flow for the first quarter even as revenues plummeted. Several distributors also incorporated salary freezes and curtailed bonuses to improve profitability. Interestingly, most distributors avoided large-scale head-count reductions to better position themselves for improved economic conditions.

We think large, well-capitalized firms will emerge stronger from the recession. Large firms enjoy higher bargaining power relative to smaller distributors and can negotiate better pricing terms with suppliers. This pricing power translates into better operating performance compared with smaller players. We think large players also manage their inventory effectively. In times of slow business demand, inventory reduction can yield better operating cash flow, but too much of a cutback will hamper customer visits. Thus, striking the right balance is important. Inventory management over hundreds of thousands of SKUs (stock keeping units) can become complicated and requires sophisticated information systems to enable management with adequate information. In this regard, we think historical investment in information technology will enable larger distributors to make better inventory decisions. Large distributors tend to have a more diversified customer base and a wider geographical presence. This breadth of revenue translates into better protection against economic downswings.

Firms with significant upcoming debt maturities will suffer if they lack the liquidity to pay down debt. Rolling over debt or issuing new bonds has become an increasingly costly proposition. Firms have seen their cost of debt skyrocket, in some cases by as much as 700 basis points, compared with previously issued debt. Higher-priced debt will constrain investment in operations as firms look to preserve cash to meet interest obligations. Underinvestment in the business--in the form of lower information technology spending, fewer product offerings, and fewer store locations--will render these firms vulnerable to competitive pressures and reduce earnings in the long run.

The demand drop-off is likely to moderate in the second half of 2009 and will improve with better economic conditions. The government's plans to spend $787 billion to perk up the economy bode well for manufacturing output and consequently industrial distributors. As industrial manufacturers increase their on-hand inventory levels, distributors will benefit. Overall, we think industrial distributors are going through a nightmare of an economy, but well-capitalized large distributors will emerge stronger than ever.

Anil Daka does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.