DISC Corp. Sees 2008 As A Time Of Contraction For The Electrical Industry

Electrical distributors, manufacturers and reps have heard the word “recession” so frequently in the last few months that they are beginning to expect it to occur later this year as a matter of course. Hold on just a bit. No hard data supports a recession scenario just yet. The first quarter GDP numbers showed an unexpected increase, very weak, but nonetheless positive growth, on top of very weak positive growth in the 2007 fourth quarter. So a fundamental checkpoint of recession, two consecutive quarters of negative growth has not happened — yet. The bad news is that there are strong reasons to believe we are in for difficult times ahead. Here are the negatives:

• Employment, real wages, home prices and stock-market wealth are all falling.

• Credit conditions are tightening.

Tax rebates are the only positive in the national economy right now. In previous columns, I have talked about what constitutes a recession so there’s no point in revisiting that issue. What I want to drive home is the difference between an overall economic recession and a recession in our industry. Chart 1 (see page 2) demonstrates my point by comparing overall economic growth beginning with the last recession in 2001 and ending with a projection of gross domestic product (GDP) in 2009. Compare this record with what happened in the electrical industry over the same time frame. This chart shows both series of data in deflated dollars, so we are comparing apples to apples.

On a year-over-year basis, GDP never was negative in the last recession, although on a quarterly basis it was negative. But the electrical industry exhibits significant declines in its recession years. I think “recession” in electrical industry terms is a misnomer. A better term is “contraction,” which more accurately describes negative performance.

Now take a look at Chart 2 on this page, which compares the key GDP indicators that are truly drivers of the electrical industry sales. In Chart 1, I don’t see any negatives in the key GDP indicators in recent years. Chart 2 shows why I think the electrical industry is in for tough sledding over the 2008-2009 time period.

Many vendors, reps and distributors are asking themselves, “What recession?” If you do not serve the residential market or if most of your products are nonresidential, then you are still seeing positive growth in your business, a weak economy notwithstanding.

I want to clarify the point of Charts 1 and 2. The distributor sales are in deflated dollars, so we are looking at real physical volume. The rising prices have been removed, so that puts a different spin on managing your business through the next seven quarters. Managers manage resources on the basis of real changes, not inflated changes.

As we move through the second quarter and into the third quarter of 2008, your margins are being squeezed by rising input prices. However, your revenues are holding up because the impact of weakening final demand for your product doesn’t occur in full force until later this year and through next year. When residential and nonresidential construction spending are both going down, it begins to bite hard.

Furthermore, in the face of generally rising prices and weakening demand, it’s difficult to pass these price increases along. There’s motivation in the face of weakening demand to cut prices in order to preserve or take share. I view that strategy as operating from a position of weakness, not strength. The message to your competitors is that your company’s resources cannot compete effectively with their resources unless you cut prices. You can be sure that if you are cutting prices your competition knows it. That’s intelligence they will tuck away and eventually use against you. A strong competitor will try to determine where your weaknesses are and drive their strengths into your weaknesses.

The best time to strengthen your service capabilities is when times are good and business is brisk, because that’s when you have the financial means to make prudent investments in your total resources in order to effectively position your business when demand is weak.

I don’t expect much relief from increasing commodity prices until early next year. But as these prices moderate, you can expect final demand for supplies and apparatus to weaken further. That’s why I think electrical distributors, manufacturers and reps will find themselves caught between a rock and a hard place for the next year.

There is some good news. Total industry sales are the sum of several parts, and that means the indicators impacting distributor sales are expected to behave differently than during the last economic downturn. In the current cycle, my firm expects the construction indicators to take over and drive the distributor-served contractor market into negative growth territory during the last three quarters of this year and through all of next year. The industrial drivers will cause the distributor-served industrial market to slip into low single-digit negative growth territory this year but make a weak comeback in 2009.

The brunt of the contraction is expected to come in the first half of 2009, with the distributor-served contractor market decreasing about 12 percent on average. This will generate a negative 5 percent growth in total industry sales in the first half of 2009 and a 6 percent negative growth in the second half of the year.

I can be a bit more optimistic and tell you that I can imagine a delay in the weakening of industry sales by about a quarter because we may be underestimating the legs of nonresidential construction. We are more confident that the weak residential market still has a way to go before it turns the corner. Finally, defining the next six or seven quarters as an industry contraction by definition means that an expansion is just over the next hill. We will call it the first quarter of 2010.