The Subprime Primer

Click here to view my all-time favorite explanation of the key issues behind the sub-prime crisis as told in the form of cartoon slideshow. It is accurate and quite funny -- but do not read if you are offended by brutal honesty!

I'm passing this along to you after spending the weekend in Savannah, Georgia, to deliver a presentation at the Association of Millwork Distributors’ 2008 Top Management Leadership Conference.

Like distributors of other building materials, this group has been hard hit by the residential construction downturn. I presented some data from my 2008 Wholesale Distribution Economic Reports. We then spent time talking about the origins of the sub-prime crisis and when housing will start to grow again.

I’ve argued for some time that this mess will infect the whole economy so you should take a few minutes to understand what’s going on.

For a more sober (and less profane) analysis, Monday’s Wall Street Journal has “Economy May Face Prolonged Pain, History Suggests.” The article has the following concise summary of the housing situation:

“For several years, U.S. home prices and home construction kept climbing past levels considered sustainable. Homes became collateral for trillions of dollars in borrowing. That depressed savings, inflated consumption, fueled rapid lending and loosened loan standards. When home prices stopped rising, the diciest mortgages began to default, triggering the crisis.”

Rather than being burned again, lenders are becoming more risk averse and tightening mortgage lending standards. But the horse got out, so locking the barn door won’t fix the current mess.

Hat tip to Greg Mankiw’s blog for pointing me to The Sub-prime Primer. (Note that my version has less profanity than the original.)

The 2008 Slowdown

The non-profit NAW Institute for Distribution Excellence just released my 2008 Wholesale Distribution Economic Reports, so it’s a good time to check up on the economic situation facing the wholesale distribution industry.

A WORD FROM OUR SPONSOR

I created these reports to help executives, analysts, and investors better understand the wholesale distribution industry. Each of the 19 separate Wholesale Distribution Economic Reports supplies a wealth of detailed channel benchmarking data for 112 sub-sectors of the wholesale distribution industry including: revenue and employment growth trends; the number and size distribution of companies; gross margins; wages; and many other operating statistics. All data are presented using a single, internally consistent format to permit direct comparisons among the sub-sectors. I also include a discussion of key economic trends related to the sector.

Here are direct links to the four most popular reports:

Industrial Distributors

Building Material and Construction Wholesale Distributors

Hardware, Plumbing, and Heating Equipment and Supplies

Electrical and Electronics Wholesalers

A YEAR OF VARIATION

Revenues of wholesaler-distributors grew by 8.6% in 2007, marking another year of strong overall performance. However, the performance of individual sub-sectors varied more than in previous years due to the distorting effects of price changes. The chart below shows the final revenue growth figures for 2007 in the 19 major industry sectors. (Click the chart to enlarge.)

The ongoing surge in commodity prices – especially food, metals, and oil – continues to ripple through wholesale distribution and the supply chain. For the first time in recent memory, grocery and foodservice wholesalers posted double-digit revenue gains, although growth is much more modest when adjusted for price changes. U.S. citizens are findings their budgets squeezed due to food and fuel inflation while poorer countries are facing societal disruption due to food prices. The Wall Street Journal reported on Monday that soaring food prices have led to rioting in Egypt, Cameroon, Ivory Coast, Senegal, and Ethiopia.

In 2005, the revenue-boosting benefits of product price inflation benefited wholesaler-distributors of building materials. But today construction materials are undergoing the painful process of deflation, which wreaks havoc with a wholesaler-distributor’s income statement. Some sectors are actually shrinking after revenues are adjusted for price inflation.

2008 AND BEYOND

Looking ahead, growth in the wholesale distribution industry will moderate in 2008 as the U.S. economy slows down or even enters a recession. I agree with The Economist magazine (The Great American Slowdown), which reckons that the recession may not be particularly severe but that the recovery could take longer than usual until growth resumes.

As I warned last December in my 2008 Economic Outlook audio conference, the residential construction boom will take at least a few years – not a few months – to unwind. Both home sales and residential construction activity are unlikely to rebound until mid-2009 and possibly later. Overall manufacturing activity has entered a cyclical downturn although pockets of strength remain. Export growth is accelerating and will cushion selected sectors.

Check out Strategies for Surviving a Slowdown, which has the (unfortunate) distinction of being my most popular post. If you purchase any of the 2008 Wholesale Distribution Economic Reports (hint, hint), please drop me a line and let me know what you think.

Sneak Peek at 2008 Economic Reports

NAW just announced the availability of my new 2008 Wholesale Distribution Economic Reports, which will be delivered in a few weeks. Here’s a sneak peek at the 2007 data and my perspective on the dangerously large growth gaps that have emerged in some large sectors.

Sales of all wholesaler-distributors reached $4.3 trillion in 2007, a 9.2 percent increase versus 2006. Once again, growth in wholesaler-distributor revenues exceeded growth in U.S. Gross Domestic Product (GDP). Growth varied more widely than normal between the 19 major sectors, each of which represents one of the 19 individual 2008 Wholesale Distribution Economic Reports that break the data into 111 sub-sectors. (Click the table below to enlarge it.)
But don’t pop the champagne yet. Many sectors actually experienced low or even negative growth after revenues are adjusted for the effects of price changes. Wholesaler-distributors with exposure to oil, agricultural, and metals prices had the biggest growth gap – the difference between actual revenue growth and real (inflation-adjusted) growth. In other words, total unit shipments for wholesale distributors in some sectors was flat or even down once inflationary trends are stripped out.

A recent Wall Street Journal article highlighted the unsustainable price growth in core commodities such as wheat and oil. (See the charts and analyst quotes in Commodity Prices Surge, As Investors Seek a Haven.) As the article notes: “The price run-ups are leading some analysts to declare bubbles in the hottest markets. That raises the prospect that some commodity prices could come tumbling back down as rapidly as they have risen if they aren't underpinned by genuine demand.”

I describe the implications of this Growth Gap in Chapter Five of Facing the Forces of Change®: Lead the Way in the Supply Chain, the major research study sponsored by the NAW Institute for Distribution Excellence. When (not if) commodity price growth returns to historic norms, the revenue-boosting benefits of product price inflation will dissipate and wholesaler-distributors will have to work much harder for real growth. Until then, enjoy the boom times but be prepared for the day when the bubble bursts.

Strategies for Surviving a Slowdown

I don’t know if we are in a recession, but the evidence of a slowdown is inescapable at this point. But don’t give up hope – there are many opportunities out there, as shown by the advice from NAW Executive Summit attendees.

MY TRIP TO THE NAW EXECUTIVE SUMMIT

I attended the NAW Executive Summit last week, which was one of the most successful (and well attended) Summits. I had the privilege of facilitating a panel of top-notch executives (Dave Griffith, Modern Group Ltd; Mark Kramer, Laird Plastics; and Steve Nelson, POOLCORP). You can view their PowerPoint slides online, but the real value came from the informal networking and idea sharing. The presentations provided a superb business-focused platform for many fascinating best practices conversations.

If you attended on Thursday, then you also realized how much fun I had on the panel with my fellow NAW Institute Fellows – Brent Grover, Mike Marks, and Neil Gholson. The always-classy Tom Gale even managed to keep us (somewhat) on topic.

I also want to give a shout out to Ray York for his Chairman’s address, which was both thoughtful and personal. Many of us in the audience also enjoyed the fact that Ray didn’t hide behind a podium. Well done!!

LESSONS ON PREPARING FOR A DOWNTURN

There were hundreds of wholesale distribution executives at the event, so I took the opportunity to find out how they were preparing to make the most of an economic downturn. Here are the six strategy ideas that I heard:

Idea 1: Make Strategic Acquisitions – The other NAW Institute Fellows and I all agreed that acquisition multiples are starting to return to historical ranges, a trend that I discussed eight months ago in Is M&A Peaking?). The current cycle began in 2004, as shown in Exhibit 5-1 of Facing the Forces of Change®: Lead the Way in the Supply Chain. If your company is well-run and has access to capital, then now is the time to approach distressed competitors to discuss the value of a combination.

Idea 2: Improve Employee Productivity (by Spending) – Many wholesale distribution executives told me that they are planning for the long term future of their companies by investing in technology. (Perhaps that’s why I met so many technology vendors at the Summit.) The biggest gains are coming from substituting IT for repetitive human processing activities such as order processing, billing, inventory control, warehouse management, etc. But not all technologies are created equal. For example, I learned this weekend that giant computer-enhanced pigeons will not improve warehouse productivity.

Idea 3: Improve Employee Productivity (by Cutting) –Productivity is measured as Output divided by Input, so a number of executives discussed improving productivity by reducing headcount. Yes, it can be personally painful to make these cuts, especially when a lay off disrupts the lives of people you have known for many years. However, you don’t want to wake up in three years and regret that you didn’t make the tough calls today. One key caveat: No one was planning to make across-the-board cuts before a downturn.

Idea 4: Refocus on Customer Profitability – Not every dollar of sales or gross profit is worth chasing. More than one executive told me about their efforts to move away from a one-size-fits-all service model so as to limit the full suite of value-added services to the most profitable customers only. Some executives are challenging their management team by asking (in my words): “How can we have profitable relationships with the customers that benefit most from working with us?” My advice: Identify your most profitable customers (highest EBIT) and identify why you have a win-win relationship. (Low cost of sales? Low joint transaction costs? High gross margins?)

Idea 5: Diversify Your End-Markets -- One President of an HVAC wholesaler told me that his company had diversified into commercial and industrial segments, so overall sales and profits were up despite a loss of business on the residential new construction. Perhaps that’s cold comfort if you are tied to a single industry, but there’s no time like the present to begin broadening the customer markets that your company serves. See Why Strategy Matters for my discussion of an MRO distributor that successfully reinvented their business with diversification.

Idea 6: Explore Exporting – Related to the diversification idea, I was pleasantly surprised to hear about successes with overseas markets. As I discuss in my 2008 Economic Outlook audio conference, savvy distributors can benefit from the export trend. I even spoke to an executive who is planning to sell his company’s private label product in overseas markets. Cool!

Hopefully, these six ideas can help to jump-start your own planning. In the meantime, I’ll leave you with this limerick to ponder:

A distributor was feeling quite gray;
Because profits were melting away.
Said the consultant, "Don’t fear,
It’ll get better next year.
But please, pay my bill right away.

How to Make Money

Warren Buffett once said that there are only two rules in business:

• Rule No. 1: Never lose money.


• Rule No. 2: Never forget Rule No. 1.

If you agree with Mr. Buffett, then I have three books for you!

The Official Guide to Wholesaler-Distributor Financial Success is a new 3-volume set of books by Brent Grover of Evergreen Consulting. It is published by the NAW Institute for Distribution Excellence. (The NAW Institute also publishes Facing the Forces of Change®: Lead the Way in the Supply Chain.)

These ambitious books represent the first and most complete attempt to distill the best practices of wholesale distribution management into one compact package. In my opinion, they are a truly outstanding resource for anyone who runs a wholesale distribution company. As I discuss below, this series would also be an amazing tool for any CEO who wants to develop the next generation of leaders for his or her business.

THE STRAIGHT DOPE

Volume 1 (Exploring the Financial Fundamentals of Distribution) is my own personal favorite of the group. The topic may not sound glamorous, but understanding the content of this volume is the only way to master Mr. Buffett’s Two Rules. As you all (hopefully) know, any wholesale or retail company should measure its true profitability using Return on Investment (Pretax Profit / Owner’s Equity). Brent provides one of the most readable, concise discussions of true profit in a distribution company that I have ever read.

To be frank, I’ve personally met too many distribution business owners who are overly focused on income statement items – revenues, gross profit, or operating profit. I once worked with the owner of a $100 million wholesaler-distributor who seemed proud of the fact that he couldn’t read a balance sheet. Maybe he read the Unofficial Guide to Success?

Volume 2 (Distributor Manager's Guide to Departmental and Branch Financial Excellence) covers a lot of ground in a short amount of time, ranging from sales management to credit issues to purchasing effectiveness. It’s a solid overview for anyone moving into a branch or division management, although each chapter deserves its own book.

Volume 3 (Distributor Executive's Guide to the Art of Top-Quartile Financial Performance) is an integrative look at how top management can bring together all of the disciplines for long-term management. I found the chapter on benchmarking metrics to be the most useful and practical. Brent emphasizes the fact that benchmarking should be against other companies, not just against your own company’s past performance. I also liked the many suggestions for how to begin this process in yoru own company.

These books are very readable, despite the subject matter. Rather than a straightforward text, the books are interspersed with first-person accounts from the employees of a fictional wholesaler-distributor. For example, “Susan, Vice President and General Manager” has a friendly, chatty introduction to Operating Profit. I enjoyed this stylee because it makes the books very accessible for the non-specialist. Nonetheless, I would also appreciate a future companion reference book that boils down the essential financial content and ratios for quick reference. (Yes, that’s a request for Volume 4, Brent!)

In the spirit of full disclosure, Brent and I both serve as Fellows of the NAW Institute and are both on the Advisory Board of Supply Chain Equity Partners. Nonetheless, I am giving you the straight dope on these books. They are well worth your investment.

BUILDING FUTURE LEADERS

In Building Future Leaders, I describe how George Pattee, CEO of Parksite Group, used my Facing the Forces of Change®: Lead the Way in the Supply Chain book as a management development tool for building the next set of leaders in his business.

I encourage wholesale distribution CEOs or Presidents to use Brent’s books in a similar fashion. Form a virtual book club for all senior executives and managers in your company. Go through these books one chapter per week and schedule weekly conference calls to discuss how your company really operates and makes money. In 16 weeks (chapters), I guarantee that you’ll gain unique insight in your own company and the capabilities of your next generation of leaders

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I’ll be at the NAW Executive Summit in DC this week. If you’ll be there, please let me know what you think about this blog – good, bad, whatever.

Private Labels Will Boom in '08

I project that 2008 will be a banner year for private labels in wholesale distribution. Growth will be driven by customer demands for lower-cost alternatives in a weakening economic environment. I also see a number of compelling reasons why the U.S. dollar's fall (shown on the right) will not necessarily stop import-led private label growth.

Trading Down

As I document in Facing the Forces of Change®: Lead the Way in the Supply Chain, roughly four out of ten distributors sell some kind of a private label product.

As customers start to feel more economic pressure, they often trade down to private labels. This pattern is playing out right now for consumer products, where private label sales for 10 household and personal care products grew by 21% in the second half of 2007 although overall industry sales were only up 1 to 2 percent. (See Even Package Goods Not Immune in Advertising Age.)

I believe that the same pattern is occurring in business-to-business markets. Customers may be more receptive than ever to moving away from a national brand in categories where the manufacturer's brand does not add enough value to the customer. (See Brand Killers.)

Dollar Devaluation

The flipside to this story is the value of the dollar. The trade weighted value of the U.S. dollar has fallen by more than 25% relative to other currencies since 2002, leading to a boom in exports from the U.S. (See slide 20 of my 2008 Economic Outlook presentation and the audio discussion for how savvy distributors can benefit from the export trend.)

Since almost 60 percent of wholesaler-distributors with private labels source their product from an overseas plant, we might expect the cost advantage between private labels and imports will narrow as the dollar depreciates and imports become more expensive.

However, there are at least four reasons why a currency-related increase in private label imports will not necessarily get passed on to customers.

1) China is the most important source of imported products for wholesaler-distributors with private labels. However, the yuan has appreciated much less against the dollar than other currencies since China stopped pegging the yuan’s value to the dollar in July 2005. (That said, the Chinese yuan has still risen ~14% against the dollar.)

2) Many so-called “US manufacturers” actually outsource production to China, too. So dollar depreciation is being felt by both private labels and the “national” brands.

3) Customers will only see a portion of the cost increase because most distributors will not want to pass on substantial cost increases in a weak economy. Historically, less than one-quarter of currency depreciation gets passed through as higher prices for imports.

4) It's unlikely that the dollar's record drop in 2007 will continue. (See Weak Dollar Might Change Course.)

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My bottom line: I see private label strategies accelerating as the economy weakens. Wholesaler-distributors will be able to stabilize or improve their margins with private labels even as economic conditions worsen, if appropriate for their business and done with selected product categories for the right customers.

Wholesale Distribution in the Economy

Happy New Year!

As you know, I’ve been on vacation and have not been blogging. Unfortunately, there was no wi-fi access on the beach and our hotel did not subscribe to Modern Distribution Management or Industrial Distribution. You can surely see my disappointment in the photo on the right.

I want to start off 2008 with a key point from my recent Wholesale Distribution Economic Outlook presentation: Distribution as a whole is still a stable and substantial part of the U.S. economy.


Many people are surprised by this point because they think “the middleman is dead.” Yet more than $4 trillion dollars in products flowed through wholesaler-distributor warehouses in 2007. Plus, wholesale distribution’s share of the U.S. economy has not changed much in the past 50 years. In the 1950s it was about seven percent. Today it’s still about seven percent. Lindsay Young picked up on this point on the MDM blog in Distribution's Part in the Economy.

The key to understanding this surprising factoid is that regardless of where manufacturing takes place, distribution is a local service business. Naturally, the specific products that are distributed today are much different than what was distributed 50 years ago. There are fewer distributors of industrial products but many more distributors of products that sell into service industries such as food service, commercial office buildings, MRO supplies, construction, healthcare, entertainment, recreation and lodging.

Despite some poor economic news over the past few weeks, the future of wholesale distribution looks solid.

Distribution Trends: 2007 Year in Review

Believe it or not, it’s time for my final post for 2007. In the spirit of the season, I take a quick look back at this year’s posts to highlight the major themes of Distribution Trends.

As you may know, I started writing this blog to help people get the most out of Facing the Forces of Change®: Lead the Way in the Supply Chain, a research study sponsored by the NAW Institute for Distribution Excellence. Many posts have been organized around the four major trends identified in the report, although other themes – economic trends and consolidation activity – generated very high levels of readership, too.

Here is a brief rundown of the year’s posts.

Trend 1: Private Label Products – The impact of private labels on channel relationships turned out to be an especially controversial topic. As I discussed in Brand Killers, private labels will continue to grow in categories where the manufacturer's brand does not add enough value to the customer. The debate in the electrical industry was particularly open because Graybar took a public stance against private labels. (See Private Label Static from Electrical Products.) I still think that private label products can be a way to strengthen manufacturer-distributor relationships by enabling the creation of jointly developed products.

Many private label products come from Asia, a fact that hit home over the summer with the recall of Chinese toys. Personally, I believe that The Risks of Chinese Sourcing have been overblown for political reasons, although private labels offer both Opportunity and Risk to a wholesaler-distributor. Perhaps we will even see a counter-trend toward Near-Shoring Private Labels from Canada and Mexico.

Trend 2: Demand-Driven Channels – The trend toward more data sharing between channel partners challenges many preconceptions about the wholesale distribution industry. I highlighted examples on the blog in channels as diverse as construction equipment and beer distribution. (I do not recommend combining the products from those industries!) Nevertheless, I believe that wholesaler-distributors should only share point-of-sale data with supplier organizations that have rigorous internal security policies for data management. (See Trust and Channel Data Sharing.)

Trend 3: New Profit Models – As I point out in Chapter Three of Lead the Way, many wholesaler-distributors are now successfully selling fee-based services and positioning themselves as suppliers of products with related services instead of only reliably providing goods. I highlighted examples from electronics distribution and industrial distribution. The new profit models trend also refers to the fact channel compensation is becoming more data-based and performance-oriented, as examples from John Deere and Coca-Cola demonstrated. I was also impressed with pay-for-performance forecasting in the beer industry.

Trend 4: Connected Customers – This trend was perfect for a blog because it refers to the growing interconnectedness of manufacturers, customers, and distributors. I advised wholesaler-distributors to Be Found Online, pay attention to Online Customer Communities, and recognize the power of Leads Searching for You. The Future is Already Here was one of the top posts this year on Distribution Trends.

Other Trends – Loyal readers know that I’ve strayed beyond the confines of the four major trends to look at other major issues.

My most popular posts (based on number of web hits) were analyses of economic trends, especially 2008 Economic Growth and You and 2007 Growth and the 2008 Economic Outlook.

As always, consolidation was a hot topic, especially as we all watched the twists and turns of HD Supply this year in Is M&A Peaking? (June), The Fallout from HD Supply (September), and HD Supply Begins to Unroll-Up (December).

Two posts on strategic planning also had very high readership. In Why Strategy Matters, I reminded wholesale distribution executives to pay attention to long-term economic trends when building a long-term vision for your company. In Building Future Leaders, I described how one CEO uses Facing the Forces of Change®: Lead the Way in the Supply Chain as a leadership development tool for managers.

What’s ahead for 2008?

I'm grateful for the positive response to this blog and very much appreciate the many positive emails and comments that I have received since launching 8 months ago.

As I told you in my 2008 Wholesale Distribution Economic Outlook, many wholesaler-distributors will face the toughest economy in nearly five years. Therefore, I plan to cover broader macro-economic developments throughout 2008 while continuing to interpret the news for wholesale distribution executives and their suppliers. Please feel free to email me if you have suggestions for topics or articles.

I'll wrap-up the year with some homegrown supply chain humor, straight from the pages of The Wall Street Jovial:

Santa's Supply Chain Keeps Pace, Despite Changes

I will be back during the week of January 8. Until then, I wish you a healthly and happy new year!

All the best,
Adam