Business is looking up for distributors

As 2004 came to a close, the general consensus was that the economy was improving and would continue to do so. And in the industrial distribution marketplace, things were also on the upswing—with some companies issuing earnings reports that reflected even more optimism.

MSC Industrial

Direct, a distributor of MRO supplies, reported net sales of $955.3 million in fiscal year '04, with an increase of 13.1 percent in revenues over the previous year. MSC also reported earnings of $1.17 per share, an increase of 51.9 percent over the previous year.

Holden Lewis, senior vice president and analyst for BB&T Capital Markets, said things were, indeed, looking up for industrial distribution in general as the new year began.

"We're continuing to see good growth in industry demand and growth in order trends," Lewis said. "That clearly will affect industrial distribution at the top line... The tone of the market they face is pretty favorable right now. There may be a couple of areas, such as automotive, where that's not the case. But the general industrial landscape remains pretty favorable."

MSC's numbers, he said, are "a combination not only of the market getting better, which makes it easier for them to operate their business model, but also the compounding of events where MSC, being overly concentrated in the northeast, is now expanding out of there...."

Distributors overall have seen good growth, Lewis explained, although not with numbers as impressive as MSC reported.

Industrial distribution is a mature industry, he pointed out. So those distributors that have set themselves apart have done so through "their ability to generate leverage off their business models. That's not something they've done effectively in the past," Lewis said. "With the adoption of IT systems, for example, [distributors] have done a good job of managing their businesses 'skinnier,' and with less inventory if they choose to do so."

Other companies that had stronger, or at least improved, years included Applied Industrial Technologies and W.W. Grainger, Lewis said. Applied reported a sales increase for fiscal year 2004 of 3.6 percent, with a net income increase of 58.7 percent. Applied's net income share was $1.60, compared to $1.03 in 2003.

Applied's chairman and CEO David Pugh said in a written statement, "These financial results, among the best in our company's history, reflect operating improvements we have implemented over the past several years...Sales increases from a rebounding economy in the fourth quarter exceeded our initial expectations...In particular, our efforts to control expenses and manage assets led to significantly higher operating margins and returns for both the fourth quarter and the full year."

Successful distributors, Lewis noted, "posted record incremental margins. Unlike prior [economic] cycles, they were able to translate top line growth into better bottom line growth."

Grainger also issued a positive earnings report, ending the year with an 8 percent increase in sales over 2003.

"After some challenging times, we are starting to see strong sales growth," Grainger chairman and CEO Richard Keyser said in a prepared statement. "And it is accelerating, thanks to great execution by our entire organization. The team has also done a remarkable job of improving the efficiency and effectiveness of our operations. The top and bottom line grew this year because we served customers reliably and consistently every day."

M&A impact

Mergers and acquisitions have had an impact throughout the corporate world, and the industrial distribution sector is no exception. Lewis stopped short of saying there will be only the very large or small niche distributors before long, but noted that the mid-sized companies face unique challenges.

"Today, there's Grainger, but there's also a Wesco or an Applied Industrial, who have really closed the gap," he said. "On the other hand, you'll continue to have smaller players who fit specific niches and have specific relationships that are local and regional in nature."

He drew an analogy with what the banking industry has gone through. Lewis said companies that could be squeezed are those in the middle, "who have some scale, but not enough of it. [Yet they] are large enough that they can't be differentiated to the degree that the [smaller] distributors can."

It won't be news to successful distributors, regardless of their size, that value-added offerings are essential to growth and survival.

"If you don't ... cut your cost structures," Lewis said, "then you'll have to offer some value-added services that people will pay extra for."

The medium-sized distributors, he says, "don't have the scale of the national chains, while they also have a structure that makes it difficult for them to differentiate themselves so that they can command premium pricing. So ultimately, there may be far fewer of those..."

Lewis said the 2005 marketplace "will be reasonably healthy," while admitting that this favorable cycle may not be "by historical standards, long in the tooth, particularly when you consider how long the downturn was.... [But] this is a cycle that may have some length to go."

Many companies are holding less inventory than a few years ago—another positive sign, Lewis explained.

"There's not a lot of long-term inventory being built up.... Traditionally, good economic cycles have crashed in the past when's there's been too much inventory."