April 29, 2004: Distribution Channel Commentary (DCC) # 68

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THIS WEEKíS TOPICS

  1. THEMATIC QUOTES.
  2. DISTRIBUTOR IMPLORES MANUFACTURERS TO "RAISE YOUR PRICES".
  3. SURVEY SHOWS 19% OF BUSINESSES HAVE "PRICING POWER"; CASES.
  4. "DISTRIBUTOR MARGINS HOLDING STEADY".
  5. HEALTH (BENEFIT) SAVINGS ACCOUNTS APPEAL TO 73% OF BUSINESSES.
  6. DOWNSIZE, UPGRADE AND REINVENT A COMMODITY PRODUCT- CASE STORY.
  1. THEMATIC QUOTES.
  2. "A great many people think they are thinking when they are merely rearranging their prejudices."

    William James

    "It isn't that they can't see the solution. It is that they can't see the problem."

    G. K. Chesterton

    "I never give them hell. I just tell the truth and they think its hell."

    Harry S. Truman

    "Humankind cannot bear very much reality."

    T. S. Eliot

    "All progress is precarious, and the solution of one problem brings us face to face with another problem."

    Martin Luther King, Jr.

  3. DISTRIBUTOR IMPLORES MANUFACTURERS TO "RAISE YOUR PRICES".

A few weeks ago, I had the privilege to address both manufacturers and distribution executives from an equipment and supply channel on a "Re-thinking Our Competitive Strategy". My presentation was to follow a breakfast session that concluded with an award to and a 30-minute speech from an "Outstanding Distributor". The honored executive was a likeable chap with an impressive, 20-minute corporate story.

In his final 10 minutes, he unexpectedly made a case for and then asked specific manufacturing CEOís in the audience when they were going to raise their prices. I was stunned. Since I started attending distribution channel gatherings in the mid-Ď70ís, I have heard countless lawyers warm up meetings with warnings to not talk about pricing and terms in anyway, or we would all be busted by the Feds. This time there had been no legal warnings, and Iím guessing that both manufacturers and distributors had been going through an extreme cost-inflation/product-pricing deflation squeeze. So, this unusual public conversation happened.

All three of the manufacturing executives who were individually addressed by the distributor were surprised, unprepared and vague. Here is what I read into their collective comments: "You're right, we are getting killed by raw material price increases. But, because we are all making equally-excellent commodity products for which there is a growing, global, excess production capacity, my firm canít raise prices without losing market share. We donít think enough of our competitors would follow our lead."

"Pricing power" may yet come to this group of manufacturers and distributors. Because of the global shortage of commodities that is growing due to both the China infrastructure boom/bubble with speculative forward buying and hoarding added on, price increases will eventually work there way through many of the mines-to-market supply chains. The price increases will also work their way up the product pyramid from the most simple, basic-material intensive products to the most value-added products made from most exotic alloys and shapes. If and when price increase relief arrives, it may provide:

  • Some old inventory re-evaluation (a paper profit).
  • Some price increases that can be passed along to help cover the already higher operational cost increases due to health care, insurance, energy, etc.
  • Some "new demand", because everyone in the supply chain has to increase their inventory safety-stock, if not speculative-investment stock as lead times lengthen.

But, free markets quickly react to higher prices and shortages by increasing supply and/or curtailing demand, then all of the relief conditions above will reverse. How many players will be net better off on an after-tax, free cash-flow basis when the boom/bust cycle is over? Then, what will they do? Can any of the attendees in the room or elsewhere make sustainable, superior profits by selling commodities in a mature industry environment on a last-look to match the price basis? Wonít the weakest, when-will-they-ever-go-out-of-business competitor keep offering low prices that prevent incumbent suppliers from making a "fair" return?

I think too few attendees at the meeting or players in any distribution channel have the following set of competitive assumptions:

  • Boom-bust price and demand relief isnít a sustainable solution.
  • Waiting for excess capacity to shrink below average demand to allow superior profits isnít going to happen in a global, free-market economy.
  • Successfully fixing prices and curbing market share ambition amongst too many competitors isnít going to work.
  • We have to augment the naked commodity with service value that is truly valued by a target niche of customers and consistently available only from our firm. The customerís perceived value must exceed our price that exceeds our cost to insure the profit margin we want.
  • Not all customers need the same product/service formula, nor do the ones that all want a specific formula value it the same. We should only sell those customers who value what we are selling enough to make a profit.
  • We must first be profitable, then seek more profitable growth only from customers who will value and pay for what we are offering. Volume is vanity, profit is sanity.
  • Even if we could target the right customers and then co-create with them the right product-service formula for the right price and terms, how will we get all of our employees to be part of the consistently excellent, flexible, service-value-creation solution?

If anyone out there wants more on this last set of assumptions, I refer you to three annotated slide shows at my web site at www.merrifield.com in the suggested order below. Here are the links:

Identify_Customer_Niches.pdf,

Dist_VAlue_proposition.pdf,

Fees_for_Services_slides.pdf.

Since the unusual 10-minute industry conversation, I have been noticing some "pricing power" case studies that I have summarized in the next topic.

    3.    SURVEY SHOWS 19% OF BUSINESSES HAVE "PRICING POWER"; CASES.

What was behind the 0.5% increase in the consumer price index in March? The apparel manufacturing industry registered a 0.9% increase. But, the apparel category reflected some special circumstances. March is traditionally a good month for apparel, and an unseasonably cold February kept many shoppers at home.

More typical is the broad range of manufactured goods in which prices have fallen or remained flat - including new cars, personal computers and shoes.

At Phoenix Footwear, whose H. S. Trask line of shoes for men sell for $100 to $185 and its Trotters brand for women goes for as much as $75, price increases have not been part of the strategy for many years. The only way the company has been able to get more money for its shoes is to introduce new, improved models - not by increasing prices on existing lines.

For years, as more competing producers have set up shop in low-wage countries, Phoenix, like other shoe manufacturers, has mostly protected its profit margins by driving down costs. It closed its last plant in the United States in 1999 and now makes its shoes in China and elsewhere.

How many companies in which industries producing what type of products have "pricing power? The National Federation of Independent Business said in its April report that 19% of small businesses had been able to raise prices -- the highest rate in years. I was unable to get any detailed breakdown on this surveyís results, but I suspect that many of the businesses may have been in agricultural supply chains where the prices of feedstock are driving up all sorts of prices. Besides, all soy products, milk, eggs, etc. have gone up, even modest value-added products like Spam have been increased by 5% (Hormel Corp.)

Health care facilities seem to be able to continue to raise prices. The Memorial Sloan-Kettering Cancer Center in Manhattan is an example I came across. They donít face foreign competition, and wages represent 50 percent to 60 percent of their costs. They have been able to cover escalating wages in the New York City area (due to the booming financial sector) by raising prices around 3 percent, on average, every six months.

One domestic manufacturer that I know little about, Genlyte, a company that designs, manufactures and sells lighting fixtures and controls, reported that: "We are experiencing extreme cost increases from steel, ballasts, medical insurance, pension expense, freight, energy, and packaging materials. The market price of cold rolled steel has surged by 68% from December of last year. Insurance costs are up over 24% and energy costs are also up significantly. The impact of these cost increases outweighs the benefit of 1.8% increase of the comparable sales. We have announced a price increase ranging by product from 5% to 8% to offset some of these cost increases. We are optimistic that these price increases will hold in the marketplace." Do any readers in the electrical distribution channel know these guys and have any insight as to whether they will be able to make the increases stick?

In an earlier DCC, I noted that consumer paper product price increases were going up, because the three producers that produce 80% of the volume had all raised prices. But, here was the underlying story. The last time that industry leader, P&G, raised paper product prices was in April 2000, even though the company's costs have surged for two of its primary commodities. Paper pulp is up 20 percent in the last 18 months, while natural gas is up about 40 percent.

With too much global and volume-greedy competitive capacity, P&G first tried cutting all other costs as fast or faster than raw input prices went up. For instance, the company stopped wrapping the individual rolls sold in its Bounty 15-packs. It reduced printing on some of the packaging. It tried to induce consumers to buy Charmin toilet paper rolls containing more sheets - which meant making fewer rolls and reduced Procter's outlays for the cardboard tubes.

It was not until February, even as its competitors continued to eat their cost increases, that Procter finally gave in. The company announced it would raise prices for its Bounty and Charmin brands by about 6 percent in July. Within weeks, as if on cue, Kimberly-Clark, a competitor to Procter, said that it would also raise its prices by 6 percent. Then, Georgia-Pacific followed. In the airline industry, big share players have announced both fare increases and fuel surcharges, but have not been able to make them stick.

My conclusions from what Iím reading is that maybe we shouldnít try to raise prices on products across the board before we first raise prices and/or reduce or unbundle services for customers on whom we lose money. Most customer profitability ranking reports that I have worked with have super-profitable customers at the top that average profit margins that are 2 to 4 times greater than what a company would like to average. But, the accounts at the bottom are horrendous losers. Working with such customers to make them profitable or to let them drain the competition while we redeploy and/or layoff our activity and overhead costs that used to over serve them is the first "price increase" that you should be attempted.

    4.    "DISTRIBUTOR MARGINS HOLDING STEADY".

Modern Distribution Management reported that contrary to impressions about verbal whining, the average margin percentage for most distribution channels has held steady for the past 10 years. There were a few channels that had risen slightly and a few channels in which they had dropped, like electrical and paper in which input commodity prices had dropped a lot during the Ď90s (copper, pulp and energy). Hereís the link for subscribers: http://www.mdm.com/pub/34_7/features/2159-1.html.

Perhaps other equally big questions/issues around margin percentages might be:

  • Have operational costs of distributors risen faster than the inflation/price increases in the product lines that are being marked up at a constant rate? This is what is happening in the story covered in topic #1.
  • Have the average order sizes increased or decreased? If the average order size or gross margin dollars (not percentage points) per order can be increased faster than the fixed cost of processing and delivering an order, then profits can improve quite dramatically.
  • Is average order size up because distributors have learned to focus on one niche of customers at a time for which they then: a) round out their one-stop-shop offering; b) increase their average fill-rate service in comparison to the competitor; and c) work with customers to co-create order replenishment processes that increase average order size to the benefit of both parties. (For more on this powerful, strategic marketing concept go to the following links to read an article and its support notes.)

4_9.asp,

SupportNotes4-9packet.pdf.

    5.    HEALTH (BENEFIT) SAVINGS ACCOUNTS APPEAL TO 73% OF BUSINESSES.

Because containing health cost benefits is a huge issue for all businesses in the US, the newspaper USA Today seems to be tracking the progress of the all new, still being legislatively refined Health Benefit Savings Accounts. These are tax-free accounts linked to high-deductible health insurance that are something akin to 401K accounts, but the final details on how they might work from an employerís tax perspective will not be settled until the end of June.

The initial employer interest in these accounts that should encourage many employees to save, be well and shop aggressively for the best value health solutions is potentially transformationally huge. Mercer Human Resource Consulting released the results of a survey within the past week that concluded that 73% of employers were likely to offer the new accounts to their workers by 2006.

Here are links to two USA Today articles to clue you in to this huge potential healthcare cost opportunity:

How HASís are progressing:

http://www.usatoday.com/money/industries/health/2004-03-31-hsa_x.htm.

The Mercer findings:

http://www.usatoday.com/money/industries/health/2004-04-25-hsas_x.htm.

    6.    DOWNSIZE, UPGRADE AND REINVENT A COMMODITY PRODUCT- CASE STORY.

If you have skimmed through this DCC this far, you might be thinking:

  • Iím selling commodities for a price with no sustainable pricing power solution near term or long term.
  • Reinventing my business and/or downsizing to upgrade my business is not my current religion and just can't be done in my industry. Volume has been everything forever; bigger is better.
  • Service value is nice, but I donít believe what Bruce is prescribing can really be done in my channel, because my commodity products are just too price sensitive.

Well, for further encouragement, I can offer you two case studies. One was covered in DCC #65.5 on how Costco pays their employees 42% more than Samís Club and yet out performs Samís on every financial metric in a business in which they are selling naked commodity products (all services stripped away) for the lowest price. Hereís the link to check that one out: 65commentary.asp.

And here is another dose of courage/case study for this week Ė itís about Smurfit-Stone selling corrugated boxes to a shrinking customer base that also wants shrinking box sizes. Here is the link: http://www.businessweek.com/magazine/content/04_05/b3868111_mz009.htm.

For those who just want the highlights, some key facts:

  • Demand for corrugated products has declined 7% since 1999. The industry has closed about 50 plants with somewhere in the neighborhood of 5.5 million tons of capacity, or more than 10%. Pricing has fallen 12% from its peak in 2000. But recently, it has been fairly stable.
  • Is cost-cutting a sustainable way to do business? It is sustainable until you get to the point where you have the right supply base for demand. It won't work forever, of course. But we're in a gray period. We don't know how big the industry needs to be. It's a question of how much growth you can get from what remains here.
  • It's no secret that what they're building in China today is technologically on a par with or superior to what we have in North America. But our customer needs are very wide-ranging. So all our plants don't have to be the biggest, newest, or flashiest. You can be the biggest player in a smaller market and produce attractive returns for shareholders over time. There are U.S. companies that are world-class manufacturers. We're moving in that direction, but we're not there.

Here are a few take-away ideas to contemplate:

  • Downsize, upgrade all elements of our business.
  • Re-focus on most profitable core customers to
  • Re-invent our total value proposition for those select customers and
  • Revive our growth to them by selling more old and new products to them
  • Diversify only from a super-strong core and then carefully

But, how can we do any of these things if all of our employees donít want to be part of the change and value reinvention solution? If you would like help on any of these revolutionary issues, I would love to offer you some consulting time. Feel free to call!

And, thatís it for this week!

 

Bruce

Bruce@merrifield.com

919/933-7474