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.