An Uncertain Future for Electrical Distribution

The stock market is on a roller coaster, Wall Street is nervous, and Jim Cramer is second guessing the Fed and Ben Bernanke. So where does that leave the electrical distribution industry?

The short answer is that it depends on how wedded you are to the residential market. The long answer is that the impact of credit tightness may drive the economy into recession and take the electrical distribution industry with it.

Few are bold or foolish enough to predict a recession. It's not because of fear of saying the “R” word. It's about the responsibility of throwing a dangerous word around, and the consequences of actions taken as a result.

When we think of recession we automatically flip back to the last one in 2001-2003. That was devastating for both vendors and distributors. Regardless of whether you served the contractor or the industrial market, almost everyone bled.

Almost everyone bled, but not all, and some bled more than others. During the last recession, the distributor-served residential market did not go south, although it came close. But vendors and distributors serving the commercial construction market suffered, as did those serving the electrical distributor industrial market.

The timing of the downturn between these sectors was very different. The industrial market was the first to go — down 12 percent in 2001, followed by the contractor market in 2002, down 13 percent. The distributor-served industrial market was fully two years into its recovery before the contractor market saw daylight in the first quarter of 2004.

This was a very different scenario from what we are seeing now. I am very sure that a recession will not suddenly confront us this year. There is noticeable project activity going on. I see it in the numbers and I see it when I travel. The businesses in this industry already suffering from a downturn are those that depend on serving the residential market. Keep in mind that it is single-family homes taking the brunt of the decline. The performance of vendors and distributors serving both residential and nonresidential markets is partially balanced by these sectors going in opposite directions.

As of this writing, DISC is still operating from its July forecast, but a few important events have taken place between July and September. One important occurrence is that the Fed has been pumping money into the system to avert a credit crunch and recession. But a few short months ago the Fed was more concerned about wringing inflation out of the economy.

When it comes to protecting the economy from a recession (spelled vanishing credit or high unemployment) versus holding the line against inflation, the unemployment choice wins (at least this time it does), and that is the politically correct action.

However, I do not believe we were in much danger of an inflationary spiral, rising energy prices notwithstanding, nor the sharply rising commodities prices last year, some of which spilled over to this year.

In the early stages of an inflationary period, it seems electrical distributors have managed to make money without a push to increase volume. It's when the monetary authorities begin to turn off the tap and economic activity flattens while prices continue to rise that distributors begin to feel the pinch. When we get to that stage a downturn is almost inevitable.

Predicting a recession for the economy overall is not the same as predicting a downturn for the industry. DISC Corp. did a good job of predicting the industry downturn in the last recession, but each recession is different. It remains to be seen when the next one will occur or what it will look like in terms of how deep it will go and how long it will last.

At this point, I am not predicting a downturn for the industry this year, and will have a much better handle on what 2008 looks like after I get my hands and elbows into our October analysis.

Here's the evidence so far on the down side risks: 1) The housing market is in trouble. 2) There may be insufficient liquidity in the economy to sustain overall economic growth through next year. 3) The nonresidential construction market is having one of its best years this year, with an expected increase of around 10 percent, in deflated dollars. The fundamentals are simply not in place to continue this kind of performance. 4) The cycle was at its peak in 2006 for electrical distributors and what goes up must come down. The nonresidential market typically follows the residential market in upturns and in downturns. It's not a question of whether but when the nonresidential sector will reset to a slower rate of growth.

My recommendation, as you move through the end stages of your planning and budgeting for 2008, is to expect industry sales in the low single-digit range (in deflated dollars). There is not a lot of price in these numbers, so low single-digit growth means not a lot of volume, potentially very little profitability, and not a lot of room to maintain your service capability.

Having said that, I am not all gloom and doom. First, most of you have been down this road before, so you have experience in dealing with such a scenario. Second, the large projects may become scarce but there will be pockets where opportunities continue to exist. In general, distributor-served markets will be hotly competitive, but even in the best of times aren't distributor markets always hotly competitive?

As we head into the home stretch this year, I expect to see a solid finish for the electrical industry. Based on strength in non-residential construction spending we could easily see 10 percent growth in the distributor-served contractor market in the fourth quarter. I expect to see some of this strength spill over into the first quarter of 2008. But it is all down hill from there through the rest of 2008.

Herm Isenstein is president of DISC Corp., an economic forecasting firm based in Orange, Conn., and specializing in the electrical industry. He can be reached at (203) 799-3673, or by e-mail at [email protected].

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