The electrical industry overall is now facing better times ahead than at any time during the past two years. Nationally, we closed out 2010 up four percent with positive growth in three of the four major segments. Forecast data from DISC Corp., Orange, Conn., has revealed some good news for electrical companies in the distributor-served industrial market — it's growing faster than any year in the last 10 years, according to our records. I will explain why a bit later in this article.
Two very different downturns
In 2004, two years after the bottom of the previous industry downturn, the distributor-served industrial market increased by 9.6 percent. In the current expansion, we are expecting industrial market growth of close to 20 percent this year. This is on top of a better than 10 percent gain last year. The growth in the industrial market began with an 18-percent surge in the 2010 fourth quarter, and is expected to continue at an average two-percent rate through the first three quarters of this year, before settling in at a growth rate of approximately 15 percent in this year's final quarter. (See Table 1).
But the similarities between this electrical industry business cycle and the previous one end here. The distributor-served contractor market in the current upturn struggled to gain a scant 0.6 percent last year (the first full year of recovery), a fraction of our experience one year after the trough in the previous downturn. After one year in recovery in the earlier downturn, 2003, contractor sales advanced seven percent and in the following year, 2004, contractor sales advanced more than 10 percent, leading the overall industry recovery in 2004. But in this upturn, the distributor-served industrial market is way ahead of other market segments.
Comparisons of this kind are usually meant to allay any fears of a slowdown in industry growth or an imminent downturn. We do not see a slowdown or an imminent downturn this year or next year.
When you look at past economic cycles in the electrical market, it's important to realize no two cycles are alike in this industry. Although we have the same set of key economic drivers regardless of the business cycle, they behave differently in each cycle. Right now we see a different source of industry growth in the current cycle — industrial and not contractor. Contractor growth will come later in this cycle.
In the all-important construction sector, look for nonresidential construction spending to continue its negative performance, down almost three percent this year following double-digit declines in 2009 and 2010. At the same time, expect residential construction spending to dip again this year, down about one percent following a nearly 3.5-percent decline last year.
The power of the industrial market in this business cycle
The strong growth in the distributor-served industrial market is largely explained by strength in business investment in equipment, which includes communication equipment and other components of business equipment.
The percent changes in our economic indicators are measured in deflated dollars. We always evaluate the impact of the deflated key economic drivers on deflated industry sales. The impact of inflation comes later in our analysis.
Returning to our earlier comment on the reasons for the strong growth in the distributor-served industrial market, we don't need to look any further than a real growth of about 15 percent in equipment investment, following an increase of nine percent last year. Put an inflation rate of over seven percent in the electrical distributor market on top of the 15 percent growth in business investment in equipment and you've got 20 percent growth in the distributor-served industrial market. I have oversimplified the process, but this is basically how it all comes together. Be careful not to confuse inflation in the electrical industry with inflation in construction or inflation in other economic indicators. They are different rates measuring different aspects of changing prices.
MRO versus OEM business
In the current environment business, spending for equipment is primarily for maintenance and repair, not in the original equipment manufacturing (OEM) element of their businesses. With distributor-served industrial sales advancing at historically high growth rates it's clear distributors, manufacturers and reps are benefiting from this business spending focusing on MRO markets.
To give you a sense of proportion, DISC estimates the electrical distributor-served MRO market is about 80 percent of the overall distributor-served industrial market.
Eyeballing the contractor market
The more you understand about the sub-segments of your business, the better you can manage your resources. Distributors whose sales reporting systems capture segment sales have a much greater capability of measuring the performance of their people and managing inventories. Earlier in this article, I showed how differently the major segments behave through the downturns and upturns of the industry's business cycle.
If you are only looking at your total sales, you may be missing a chunk of vital information that will help you get a better handle on why your business is performing as it is and what you can do about it. With that understanding, you will be in a much better position to manage your contractor market thrust and your industrial market thrust, etc. Investing in a sales reporting system that captures sales by segment, at the least, will pay enormous and ongoing dividends.
Distributor sales to the nonresidential and residential markets
Let's take it a step further and discuss the overall distributor-served contractor market. For many years, I have been asked for a better understanding of the difference between sales to the nonresidential and the residential markets. We have always bundled both under the umbrella of contractor market. But now we are able to separate the distributor-served residential and nonresidential markets. We are making a point of distinguishing this from residential construction spending and nonresidential construction spending. Here we are dealing with electrical industry sales to the residential and nonresidential markets. (See Chart 1 on page 34).
Clearly, the impact of each sub-segment on the total distributor-served contractor market simplifies resource allocation decisions between these two often diverging markets.
Between 2005 and 2010, the average annual distributor sales growth in the residential market was -15.2 percent. At the same time, average annual growth in the nonresidential market was 2.7 percent. In the distributor-served contractor market, average annual growth was 0.9 percent over the five-year historical period between 2005 and 2010.
In five of the seven years between 2005 and 2012, industry sales growth to the nonresidential market is expected to outpace those to the residential market. Clearly, over this time frame the nonresidential market is a more lucrative growth market.
Outlook for 2011 and 2012
We see a solid recovery in the electrical industry this year and next year but we do have concerns. Overall industry sales are expected to increase more than 12 percent this year after a meager four percent gain last year. But with the upturn now taking hold we are looking for another double-digit gain in 2012. (See Chart 2 on page 34).
Here are my major concerns. First, nonresidential construction is negative through this year and next year. Embedded in this key indicator are commercial construction and industrial construction, which are both down significantly this year. Many distributors and manufacturers track these indicators very closely. For them, this year is a continuation of the recent downturn, but not anywhere near as bad. Because there's so much vacant space we won't see any improvement in commercial and industrial construction spending this year.
Second, the recovery this year is driven by one key economic indicator and an inflation rate that by itself accounts for more than half this year's gain in total industry sales. I would be happier if there were more balanced growth in the key indicators.
Third, we finally expect the residential market to rebound next year leading to a nearly 30 percent increase in distributor sales to that market. Considering our earlier analysis of the impact of residential sales on total distributor sales, a 30-percent gain still leaves total industry sales up only 10.8 percent. The bottom line is that the distributor-served residential market is not a big contributor to total electrical industry sales. While the residential market has suffered from a steep decline in the most recent downturn, we can't blame all of the industry's economic ills on this market segment. Because of the huge impact the nonresidential market has on the sales of so many electrical distributors, manufacturers and reps, it also shares much of the blame.
Summary
While the economic picture is definitely improving, I wish we were seeing more balanced growth in the economic drivers of the electrical industry. Nevertheless, I am confident we are on a reasonable growth path for the next few years. DISC data points toward the distributor-served industrial market leading the gains this year, while the contractor market is in position to show good double-digit growth next year. We also see commercial and industrial construction registering single-digit growth next year after steep declines this year.
All in all, 2011 will be a good growth year for the industry. In 2012, you can expect all distributor-served areas to show gains, including the residential market.
Herm Isenstein is president of DISC Corp., Orange, Conn., the leading forecasting company in the electrical industry. He can be reached by phone at (203) 799-3673 or by e-mail at [email protected]. Learn more about DISC Corp at www.disccorp.com.