Treading Water

The KeyBanc/Electrical Wholesaling survey found electrical distributors finishing a tepid third quarter of 2011 with inventory and pricing on their minds.

The broad themes around moderating demand for the electrical distribution industry were key takeaways for the third quarter of 2011, according to a recent survey by KeyBanc Capital Markets, Cleveland, in partnership with Electrical Wholesaling magazine. Survey results indicated demand in the 3Q11 was slightly below the normal seasonal sequential demand uptick associated with the construction cycle but they do not seem to indicate a substantial contraction. From an end market perspective, industrial demand seems to continue to exhibit strong sequential growth, but construction markets have yet to recover. In addition, it appears the pricing environment may turn favorable (most likely for the December quarter) as distributors have yet to concede a full reduction in selling prices equal to the full amount of the declines in underlying commodities. Respondents believed their customers' outlooks (i.e., contractors) for 2011 have remained stable from last quarter (but cautious), which has led them to retain employees and add overtime when deemed necessary.

KeyBanc and EW recently completed the fifth in a planned series of quarterly surveys of conditions in the U.S. electrical distribution market. All responses were anonymous and have been aggregated in order to comprise what should be a clear and up-to-date picture of trends in demand, pricing, inventory levels and future outlook in the electrical distribution market. Below are the results of the quarterly survey for July through September 2011, based on more than 120 responses.

In 3Q11, sequential demand trends continued to moderate from the historic seasonal pattern. According to our respondents, end demand improved sequentially in 3Q11 with notable strength cited in industrial MRO, institutional construction (government, educational and health care), voice-data-video, utility and industrial OEM markets (Figure 1). Given relatively soft readings in the Architectural Billings Index (ABI published by the American Institute of Architects (AIA), and U.S. Census Dept. data on construction put-in-place over the past few months, it is not surprising that residential construction remains the weakest market from a demand perspective. Specifically, this market has had sequential declines over the past four quarters (down 5% quarter-to-quarter in 3Q11 vs. down 6% quarter-to-quarter in 2Q11, down 7% quarter-to-quarter in 1Q11 and down 5% in 4Q10). While overall demand rose 6% sequentially in the 3Q11 and performed better than last year's sequential performance, demand trends are still lower than the typical seasonal uptick associated with the construction season (Fig. 2).

This may be partially attributable to channel participants reducing inventory levels following inventory restocking in 3Q10 and 4Q10 as industrial demand improved faster than what the supply chain had anticipated. In addition, we think the data also validate a commonly held belief of a slow-growth recovery from the most recent recession.

Inventory levels suggest a moderation of future demand. It appears forward-looking sentiment on future inventory builds has declined as expected from the last quarter as 39% of respondents expect to reduce inventory for the 4Q11, which is significantly more than the 25% of respondents who noted they would reduce inventory for the 3Q11 (Figure 3). We note the survey did not take into account the dollar value of inventory, which fell during the 3Q11 as commodity costs have precipitously declined since the 2Q. Intriguing is the approximate 29% of respondents who noted they are reducing the amount of capital spent on inventory for the upcoming quarter (4Q11) in line with seasonality, which suggests the bulk of the reduction is not based on fears of a significant contraction in demand (Figure 4). The survey results are consistent with what our companies under coverage have said about planned capital allocation on inventory for the remainder of 2011. Additionally, given recent moderation in commodity costs, we would not be surprised if some respondents are postponing stock replenishment in anticipation of further declines in commodities in order to prevent purchasing higher cost inventory.

Price/cost dynamic could help margins in second half. As mentioned previously, primary input costs for goods that distributors sell (e.g., copper, steel and resin) have fallen substantially over the past quarter. Given most distributors have implemented price increases since the beginning of the year (in January and in April) to combat higher commodity costs, as a whole, it's likely that they will not have to concede a reduction in selling prices equal to the full amount of the decline in the underlying commodity. We believe this outcome is likely to help offset any slowdown in volume during the quarter and should help 4Q11 results as distributors will likely be slow to concede price. Our belief is underscored by survey results that show only 36% of customers are now requesting price reductions, with 23% noting customers were still accepting price increases (Figure 5). On average, results from the survey indicated industrial MRO and OEM markets were able to realize the most pricing latitude during the quarter, while non-residential construction and institutional construction markets were forced to concede the most price.

Impact from Hurricane Irene appears minimal. We get the sense that the ancillary impact to distributors' sales performance during the quarter from Hurricane Irene has been somewhat insignificant at this point. The majority of survey respondents noted no impact as a result of the major outage events in the Midwest and along the East Coast, however; nearly 1/3 of respondents realized somewhat of a positive tailwind from this tragic event. Not surprisingly, for those that noted a net benefit from the hurricane, generators, transformers and utility cable were the primary drivers of the increased sales contributions.

2011 outlook still uncertain, hiring slightly improved From 2Q11. The employment situation indicates a stabilization of hiring practices since last quarter, with most respondents noting their customers (i.e., contractors) have largely retained existing levels of employment (Figure 6). Approximately 53% of respondents in the 3Q11 suggested their customers (i.e., contractors) are maintaining current employment levels and, at the same time, only 28% of contractors are either laying off current employees or suffering from idle capacity by being forced to reduce hours to existing employee workload. The amount of layoffs/reduced employee hours is down from 37% in 2Q11 and 43% in the year ago period.

Looking at distributors themselves, most did not add or cut headcount during the 3Q11 (46% in 3Q11 vs. 61% in 2Q11); however, those who added employee hours or hired additional employees rose sequentially and year-over-year (36% in 3Q11 vs. 22% in 2Q11 and 25% in 3Q10). Prospects for increased hiring at the distributor level may reflect the channel's confidence level, as distributors are typically one of the last players in the value chain to hire in an up-cycle. That said, it appears most contractors are exhibiting a “wait-and-see” approach until the demand outlook is clearer. As such, it's no surprise respondents believed their customers' outlooks for 2011 remained unchanged in the 3Q11 (Fig. 7).

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