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Stock Strategist Industry Reports

Our Outlook for Industrial Distributors

Industrial distributors have a reason to smile.

After a nightmare of a year, we believe industrial distributors will post decent sales growth on the back of renewed industrial activity and an elevated inventory refill. While operating margins will likely improve slightly, we think free cash flow is likely to suffer from higher working capital investment.

Sales
In the industrial distribution space, core demand is a function of U.S. manufacturing output. This metric grew at a 5% annual pace from 2003 to 2008. However, this growth engine slowed abruptly as the credit crisis unfolded. In an earlier article, "Which Industrial Distributors Will Survive This Nightmarish Economy," we opined that the demand slump is likely to moderate during the second half of 2009. This scenario played out as expected, as industrial production dropped 2% in November and improved 3% in December, year over year, when compared with the double-digit declines during the first six months of 2009. In 2010, this upward trend should continue for two reasons. First, core demand will improve in tandem with the economy. We think industrial production will increase in 2010 on the back of higher consumer spending, and as firms increase their capital expenditure outlays.

Second, after slashing their inventories to the minimum, industrial companies appear to be restocking their inventories on the back of higher production and lower cash concerns. As their customers rebuild inventories, industrial distributors will see enhanced sales growth surpass that of underlying end-market demand.

Operating Margins
Typically, when sales improve, operating margins increase due to the effect of operating leverage. Companies can spread their fixed costs over a greater quantity of goods sold, so firms enjoy higher profitability when sales improve. While this phenomenon foretells better margins for distributors, higher operating expenses will mute a strong expansion in operating margins. Responding to the financial crisis, most distributors reduced employee benefits, which prevented a meltdown in operating margins during 2009. This year, as business conditions improve, we think firms will increase their employee payout to the detriment of profitability. On the balance, the effect of operating leverage will overcome higher expenses, and we think operating margins will improve.

Free Cash Flow
The free cash flow cycle of a distributor is counter-cyclical. During periods of economic expansion, distributors carry higher inventory levels, and free cash flow growth is minimal. However, when the economy declines, companies slash inventory and generate prodigious free cash flow. After witnessing record free cash flows during 2009, distributors will see their operating cash flows ease as improving sales demand more inventories at hand. Further, as firms plan for growth and increase their capital expenditure outlays, free cash flow will likely dip.

We continue to believe large industrial distributors will gain market share in a fragmented distribution market. 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. Further, we believe large distributors maintained customer service levels during downturns when compared with smaller distributors, enabling them to capture customers--perhaps forever.

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