Channel Wars - January 2011

By Santo Torcivia

Through the 1990s and first half of this decade, many of the great, large flooring retail chains saw their demise: Color Tile, Shaw Retail, Carpetmax, Giant Carpet along with home center chains like Hechinger’s and Builder’s Square. These and others are all now footnotes in flooring industry history. The fallen retailers were clear casualties of their own flawed strategies and the rising power of Home Depot and Lowe’s. Through it all, however, the small flooring stores—the mom-and-pop types that gross less than $3 million annually—largely survived due to a number of factors, including the fact that they have greater profitability than their larger competitors. But will the time come when these small retailers are threatened as well?

In other industries, economies of scale have given a distinct advantage to larger firms, and this advantage has allowed them to squeeze out their smaller competition, creating competitive concentration in the process. A weak economy, such as the one we’re currently experiencing, would only facilitate this culling process by magnifying the economic forces on the weaker competition. In the past, this process was slowed among flooring retailers because the smaller retailers were actually stronger than the larger ones. Thus the smaller retailers have been able to resist the major home centers better than their larger brethren.

This situation had been the result of the fact that smaller flooring retailers were the most profitable. How do I know? Well, the Risk Management Association (RMA) tells me so. The RMA accumulates data from commercial banks that submit the financial statements of their customers so that bankers, credit issuers, and analysts like me can assess and compare the financial statements of potential customers to industry norms and evaluate risks and trends. An analysis of 366 statements that RMA compiled of 2008 sales at floorcovering stores indicates that the “large” flooring stores are less profitable than the “small” and “medium” ones (see box on right).

The analysis compares gross profit margin (expressed as a percent of net sales) and inventory turns (the cost of goods sold divided by average merchandise inventory). These statistics are then multiplied to derive the gross profit multiple, which measures the profitability (gross profit) of the merchandise sold, adjusted for the rate of speed that the merchandise turns (how often the gross margin is earned annually).

Another factor supporting smaller retailers is that local distributors (and direct mills) generally provide very high levels of service. They maintain significant inventories, provide training, and deliver accurately and on time. Thus distributors and direct mills have taken on many of the operating costs usually born by retailers in other industries, and this fact has diminished barriers to entry for retailers. Smaller retailers do not have to risk stocking inventory that may not sell if the distributor or direct mill is willing to make it available to them in a timely fashion. In many other industries, retailers are required to take that risk. The dynamics of apparel retailing or car dealerships or department stores make it imperative that the inventory the retailer decides to acquire is that which will sell reasonably quickly. This is not true in flooring stores. Yes, the retailer can make a higher margin on the product he stocks, but he also risks a lot if the inventory he decides to invest in does not sell quickly enough. So many retailers, especially smaller ones, get by through drawing from the distributor or direct mill’s inventory because it is less risky and it is available.

Further, buying groups and similar co-ops allow individual stores to present themselves to distributors and manufacturers as a major chain, gaining price concessions and attention beyond what they could accomplish on their own. Such retailers also gain access to the group’s private label products that potentially provide them a higher margin. For example, a single location retailer in the Abbey franchise group is treated by his suppliers as though he is a member of a 500+ store retail chain, and this goes a long way to leveling his competitive situation. I believe the recent rise in the medium sized retailer’s profitability is in large part the result of advantages they have garnered from group and co-op participation.

THE RISE OF THE FLOORING CONTRACTOR
A growing cadre of installers, also called contractors, has made it easier for retailers of all sizes to find trained, qualified tradesmen to install flooring. As the number of flooring retailers has declined, down 11.7% from 2002 to 2010, the number of flooring and ceramic tile contractors has grown. This is in the face of the fact that, according to the U.S. Economic Census, all other retail types selling flooring have risen, along with the two contractor types (see box on right).

The number of contractors has risen as the number of home centers and other retailers have also risen. While some flooring and ceramic tile contractors work for a flooring store, others install for a home center, and still others work for one by day and the other (or themselves) by night. These installers that work both sides are like the gun runners in the old Western movies, selling weapons to both sides in a range war. The growth of new flooring outlets like Sam’s Club and Lumber Liquidators, and for that matter Home Depot and Lowe’s, could not have been possible without the growth of flooring contractors to install product they sold. It is obvious to me that one spurred the other and visa versa.

On-hand inventory, good service and delivery, a large pool of installers, and the ability of single location retailers to leverage their position as if they were a large chain (when part of a group or co-op) allow small retailers to act like large ones. These facts serve to bolster retailer profitability and diminish the value of economies of scale. How flooring contractors will impact this equation in the coming years is yet to be seen.

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