Distribution Evolution - April 2007

By Frank O'Neill

I just spent most of the morning reading Berkshire Hathaway’s 2006 annual report. I think that’s something that every business owner should do, just to tap into the enormous homespun wisdom of one of the world’s all time great investors. Besides, Warren Buffett can be awfully entertaining and disarmingly open about what he considers his own failings. 

One of the most telling parts of this year’s report, which is written solely by the master himself, is his reflections on the continuing weakness of the dollar, which he blames on spending money we don’t have. Here’s what he says about that:

“Like a very wealthy but self-indulgent family, we peeled off a bit of what we owned in order to consume more than we produced. The U.S. can do a lot of this because we are an extraordinarily rich country that has behaved responsibly in the past. The world is therefore willing to accept our bonds, real estate, stocks and businesses. And we have a vast store of these to hand over.

“These transfers will have consequences, however. Already the prediction I made last year about one fall-out from our spending binge has come true: The ‘investment income’ account of our country—positive in every previous year since 1915—turned negative in 2006. Foreigners now earn more on their U.S. investments than we do on our investments abroad. In effect, we’ve used up our bank account and turned to our credit card. And, like everyone who gets in hock, the U.S. will now experience ‘reverse compounding’ as we pay ever increasing amounts of interest on interest.

“I want to emphasize that even though our course is unwise, Americans will live better ten or 20 years from now than they do today. Per capita wealth will increase. But our citizens will also be forced every year to ship a significant portion of their current production abroad merely to service the cost of our huge debtor position. It won’t be pleasant to work part of each day to pay for the over consumption of their ancestors. I believe that at some point in the future U.S. workers and voters will find this annual ‘tribute’ so onerous that there will be a severe political backlash. How that will play out in markets is impossible to predict—but to expect a ‘soft landing’ seems like wishful thinking.”

SHAW’S CONTRIBUTION

In spite of the downturn in the residential floorcovering business last year, Shaw Industries still managed to show higher sales and earnings for the year (we’ll have a full report next month). Here’s what Warren Buffett had to say about the firm in his annual report:

“Bob Shaw, a remarkable entrepreneur who from a standing start built Shaw Industries into the country’s largest carpet producer, elected last year, at age 75, to retire. To succeed him, Bob recommended Vance Bell, a 31 year veteran at Shaw, and Bob, as usual, made the right call. Weakness in housing has caused the carpet business to slow. Shaw, however, remains a powerhouse and a major contributor to Berkshire’s earnings.”

HOME DEPOT’S AMBIVALENCE

One of the many criticisms of Bob Nardelli right before he got the boot as CEO of Home Depot was that HD Supply, the $12 billion contract supply business he’d been building for the past four years, was going to be a white elephant, a business that took the company away from its core competence and promised little long term profit potential. So when Frank Blake replaced Nardelli, one of the first things he mentioned was the possibility of spinning off HD Supply. But on the last day of February, HD Supply acquired GSI Materials, a chain of construction supply centers owned by Geo-Synthetics Inc. of Waukesha, Wisconsin. That one’s hard to figure.

That acquisition came the same day that Blake told analysts that 2007 would be a tough year for Home Depot. Just a few days later, the big retailer closed the curtains on its seven year old experiment, the Floor Store, which began with a single 45,000 square foot flooring only store in the Dallas suburbs and expanded into nine similar stores throughout Texas and Florida. 

It seems apparent that Home Depot wants to get back to its core cash and carry business, especially now that it’s shut down the Floor Stores, but then why buy a contract supply chain? To further confuse matters, about the same time that acquisition was completed, the Financial Times said three investment groups (they include KKR, Bain Capital and Goldman Sachs) are considering bids for the business. So far, nothing to confirm that.

As I’ve said many times, the primary reason Home Depot should sell HD Supply is not only because it’s a cyclical, low margin business, but also because it’s a heavily service oriented business, and there’s no way Home Depot can compete effectively in service with companies like the independent builder retailers in the flooring business. One of the primary reasons the company closed the Floor Store was that it can’t run service oriented businesses effectively. We’ve seen over and over again in the floorcovering industry that corporations can’t run entrepreneurial businesses. Witness the failure of the manufacturer owned retail and contract networks in our industry. It’s just very difficult to hire managers to run service oriented stores with relatively low margins. That job is best handled by owners, by people with skin in the game.

Long live the mom and pop retailer and contract dealer.

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It’s still very likely we’ll see Home Depot sell HD Supply, but this is hardly a good time to do so. New home sales have been down dramatically in recent months, and HD Supply’s business comes almost exclusively from new home sales. Who’s going to buy a new home supply business when that market’s in a deep slump? Unless, of course, Home Depot puts it on the block at a bargain price.

Looking further down the road, I wouldn’t be surprised if Frank Blake takes a hard, cold look at Home Depot’s installed product businesses. The company has been having all kinds of problems with that business, from unethical salespeople to serious service problems. Blake seems to have his feet planted a little firmer on the ground than Nardelli, and doesn’t seem to be as interested in speculative ventures like service oriented businesses that are so contrary to the blueprint that made Home Depot such a powerhouse in the first place—cash and carry, out-the-door-and-be-done-with-it type products.

While all this is probably good news for the floorcovering specialist, don’t think for a minute that Home Depot, or Lowe’s, its quieter, more consistent cousin, are going to give up the floorcovering business completely. Both still do quite well with cash and carry floorcoverings, particularly laminates and ceramic. And if the new management focuses more attention on its core business, they might even get better at selling carpet, hardwood and area rugs, as long as they stick to cash and carry.

Smart retailers aren’t going to dismiss the big boxes. You’re going to learn from their mistakes, and be sure you don’t go head to head with them in the areas they excel in. Make sure you look carefully at Santo Torcivia’s breakdown of floorcovering retail sales on page 22. You’ll see just how powerful the big boxes have become in their head to head competition with mom and pop stores. Santo does something no other statistical analysis has done before—he breaks the entire retail business down so you can finally compare apples to apples.

GREEN COMES HOME

Last month, the Greenguard Environmental Institute celebrated its fifth anniversary, and Carl Smith, its president, said the biggest change he’s seen in those five years is the shift in environmental interest from commercial buildings to homes. 

Not only are homeowners beginning to show interest in the environment, but so are manufacturers of consumer products. In the floorcovering industry, Shaw Industries just started marketing the green attributes of residential carpets made with its Anso nylon, and it opened its Evergreen recycling plant, which puts some real teeth into its environmental efforts. On a smaller scale, Blue Ridge Carpets is also marketing carpets with recycled content to consumers.

Even more importantly, we’re finally seeing signs that the process of collecting all those used carpets needed to make recycled fiber is taking shape in a big way, both in the commercial and the residential markets. Not only is Shaw’s vaunted network of trucks picking up used carpets from its retail customers, but CARE, the Carpet America Reclamation Effort, added 24 reclamation sites across the U.S. in 2006 alone. Before that, there were only 16 sites around the country, so the ability to collect carpet and recycle it into new fiber or other products was very limited.

Last month, the Madison, Wisconsin contract dealer, Sergenian’s, became the 39th company to join the nationwide CARE carpet reclamation system. Sergenian’s is also a member of StarNet, the contract dealer co-op that aligned with CARE last year. StarNet has more than 150 members who will be contributing recycled carpet to the system.

As much as the carpet industry has done to become sustainable, both through making its manufacturing operations more energy efficient and by making recyclable products, I think we’re just beginning a second, much more powerful stage of sustainability in this forward thinking industry.

GETTING FLOORED

Abbey Carpet, the 620 dealer franchise group, has changed its name to Abbey Carpet and Floor, reflecting the dramatic shift we’ve seen over the past decade in the product mix at the typical retail store. A decade ago, carpet was by far the dominant product at most flooring retail stores, while today, most retailers carry at least as much hard surface product as carpet. 

The company has also launched a new business called Abbey Floors at Home, in direct response to the success of Empire Home Services, the shop-at-home retailer which has grown from a successful $30 million Chicago business a decade ago to a $500 million nationwide business today. Empire has managed to grow so dramatically by spending in the neighborhood of $10 million a year on TV advertising, which promises next day delivery on carpet and other flooring. 

THE FOREIGN INVASION

Two months ago, Galleher Hardwood, a distributor whose president, Jeff Hamar, is one of the most thoughtful and forward thinking guys in that part of our industry, was sold to a Japanese company. Galleher isn’t the first American distributor controlled by Asian or European bosses, and it certainly won’t be the last. As long as the dollar keeps weakening against most of the world’s currencies, we’re going to have a lot of foreign companies setting up shop here, both in the distribution and the manufacturing sectors. 

Take another look at the quote from Warren Buffett in the first entry in this column if you’re not convinced that’s going to happen.

For years now, it looked like Shaw and Mohawk would be the only companies the rest of the industry’s manufacturers would have to worry about, as they continued to eat up the more price oriented parts of the industry with their economies of scale and nationwide distribution systems. But the weakness of the dollar has changed all that, making it easy not only for low cost labor economies like China to compete, but for the rest of the world as well.

What’s the floorcovering industry going to look like in ten years? Don’t be surprised if Shaw and Mohawk have plenty of competition from companies with exotic sounding names. And don’t be surprised if many of the nation’s distributors are owned by people whose primary language is not English.

CHANGES IN THE LAMINATE SECTOR

Well, it’s official. The Swedish company Pfleiderer now owns Pergo. Right now, Pergo is neck and neck with Shaw for the top spot among U.S. laminate producers, but this acquisition gives Pergo a huge push in that race. Pfleiderer is not only integrated backwards in its extensive European operations, but as I mentioned last month, it also owns Uniboard, the Canadian laminate flooring producer, which is one of just two North American firms that are integrated back into coreboard.

Consolidation can often be bad for downstream players (in this case, North America’s flooring retailers), but this acquisition will just heat up the competition. Prices should be very favorable for retailers. There’s got to be a lot more consolidation before prices stabilize in the bread and butter part of the laminate market.

If you have any comments about this month’s column, you can email me at foneill898@aol.com.

Copyright 2007 Floor Focus Inc