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.

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.

Why You Should Care About the Mortgage Crisis

In my Wholesale Distribution Economic Outlook 2008 webcast last Thursday, I described how the current state of housing and residential construction markets will ripple throughout the wholesale distribution industry. (Click here to order the audio CD, handouts, and transcript of this event from Modern Distribution Management.)

Historically, the housing market was a symptom rather than a cause of economic conditions. Something different is happening today, which why you hear so much in the news about the sub-prime mortgage situation. Right now, the residential housing market is a leading indicator of economic activity.

Wholesale distribution executives who don’t spend time in construction markets may not fully appreciate the degree of interconnectedness or how housing will affect their markets.

I suggest you read yesterday’s excellent front page article from The Wall Street Journal entitled U.S. Mortgage Crisis Rivals S&L Meltdown. The article implies that the ultimate extent of the crisis will depend largely on how steeply the price of the average American home falls. So, here’s some data that I presented on the webcast showing the national index of home prices.

Yikes!

As I described on the webcast, I expect residential housing conditions – both home sales and construction activity – will worsen and are unlikely to rebound in 2008. Residential remodeling activity will also trend down in 2008.

Unfortunately, it will take years to blow off the excesses from the speculative bubble in housing. The wholesale distribution industry will face some major changes during this adjustment period.
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Next week, I’ll cover another hot topic from the webcast: how the U.S. dollar's devaluation will affect prospects for private label products from wholesaler-distributors.

2008 Economic Growth and You

Last Tuesday, the Federal Reserve released the minutes of its October 30-31 Open Market Committee meeting, which for the first time included the projections for economic growth, unemployment, and inflation through 2010. I don’t recommend that you read the full report unless you are an economics geek like your friendly neighborhood blogger.

Here are the primary forecasts for 2008 made by Federal Reserve Governors and Reserve Bank Presidents:

• Real U.S. Gross Domestic Product (GDP) will grow between 1.8% and 2.5%
• The overall inflation rate will moderate somewhat between 1.8% and 2.1%
• The inflation rate excluding food and energy will range from 1.7% to 1.9%
• Unemployment will remain below 5%

These forecasts made me wonder: How is the growth of individual wholesale distribution sectors related to overall U.S. economic growth?

Wholesale distribution and GDP

To find out, I statistically correlated year-over-year growth in U.S. GDP to growth in the overall wholesale distribution industry. I used real, inflation-adjusted figures to compute growth rates.

The overall relationship shown in the chart below is very strong over time, although growth in wholesale distribution is more volatile than overall economic growth. (Click the charge to enlarge it.) The correlation of growth rates is 78%.

As I highlighted in 2007 Growth and the 2008 Economic Outlook, the wholesale distribution industry has been growing faster than the U.S. economy during the past three years.

GDP and Your Industry

Yet this overall correlation masks substantial variability between different sectors of the industry. So I statistically correlated year-over-year growth in U.S. GDP with growth in each of the nineteen sectors covered in 2007 Wholesale Distribution Economic Reports. Again, all data are adjusted for price changes.

As the table below illustrates, industrial sectors are more closely tied to the overall economic cycle, while staples such as food and drugs have little relationship to U.S. GDP. Surprisingly, revenue growth in the chemical and oil & gas sectors have little correlation to GDP growth due in part to the unusually close relationship between underlying commodity prices and revenues.

What’s Ahead for 2008?

To learn more about the 2008 economic outlook for wholesale distribution and its primary sectors, please join me on my Wholesale Distribution Economic Outlook audio conference on Thursday, December 6.

You’ll be able to ask me real-time questions during this live event. You can also email me your 2008 economic questions in advance.

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IN MEMORIUM: Erin Anderson

I am sad to report that Erin Anderson, a leading academic authority on distribution channels and co-author of the MBA textbook Marketing Channels, passed away tragically last week. You can view the memorial page at INSEAD.

Erin was the intellectual and professional mentor who sparked my interest in wholesale distribution while I was a PhD student at Wharton. We also co-authored an academic paper on channel management and taught together in the Executive Education program at the Kellogg School. I would not be working in the industry, conducting research, or even writing this blog if not for Erin’s counsel, encouragement, and intellectual enthusiasm.

The Erin Anderson Excellence in PhD Education Fund has been established in recognition of her many contributions to student education. Please consider a tax-deductible contribution to this fund as a way to ensure support for high-quality academic research on distribution channels.

• Donation Form for the Erin Anderson PhD Fund
• Instructions for US-based donors

2007 Growth and the 2008 Economic Outlook

As we start to get ready for 2008, it’s a good time to check in the state of wholesale distribution in 2007 so far.

The overall news is very good. Total sales of wholesale distribution companies are on track to exceed $4 trillion dollars based on the first three quarters of the year (January through September). Once again, the wholesale distribution industry is growing faster than the overall U.S. economy’s Gross Domestic Product (GDP). (See chart below. Click to enlarge.)
Growth varies widely between the 19 major sectors. The table below (click to enlarge) compares 2006 to 2007 using the sectors covered in my 2007 Wholesale Distribution Economic Reports, which are available from the NAW Institute for Distribution Excellence.
Wholesale distributors of building materials and construction supplies had the biggest decline in revenues due to the residential real estate downturn. Other sectors continue to benefit from commodity price inflation, including agricultural products and finished food products. Industrial distributors continue to enjoy healthy growth due to strength in U.S. manufacturing, which is enjoying the export-driven benefits of a weaker dollar.

Getting Ready for 2008

As you start planning for 2008, I want to let you know about my Wholesale Distribution Economic Outlook audio conference on December 6, 2007.

During this call, I’ll give you my exclusive first look analysis at how U.S. economic trends are shaping up for wholesaler-distributors in 2008. I’m partnering with Modern Distribution Management to provide this cost-effective planning tool for wholesale distribution companies. We arranged the conference so that there is only one fee per dial-in number, so an entire management team can listen for just one price.

This will be a live event, so you’ll be able to ask me real-time questions. As always, I welcome your feedback and questions on macro-economic trends and their impact for wholesale distribution. Please be sure to email me your 2008 economic question at least one week prior to December 6. I’ll try to answer as many as possible during the event.