October 2022 − In this issue:
Our market, like the broader economy, is taking steps to get beyond these COVID related challenges. We see that in this edition with signs of slower growth, an improving supply chain, and the return of “cash is king.”
Market Demand is Slowing
HARDI distributor sales growth through August is the latest example that the market is finally slowing after two years of unusually strong demand. Average participant sales growth for the month was nearly 25% and the dollar weighted growth was 21%. This sales growth received an extra boost from an extra billing day than August of 2021. We estimate the average participant’s sales growth would have been closer to 19.5% with the same number of billing days, or in the 15.5% area on dollar weighted basis. The average annual growth rate, the dark green line, is looking tired after holding in the 24% to 25% range since the beginning of the year, thanks to some historic support. The red line is the Producer Price Index for our industry which has had a historic increase during the past eighteen months. It is amazing to see how the red price increase line has influenced the dark green sales growth line. These phenomenal price increases are a funhouse mirror to distributor’s reported sales growth. The following are some comments by HARDI members regarding the impact of the price increases on sales growth:I think the significant yr-to-yr growth is predominately inflation and not volume driven.Unit sales were kind of flat, so it appears that inflation is definitely ruling the day.  Most of the growth is in pricing not units. If that continues will price start to push down demand?HARDinomics has been tracking the underlying reasons for slower unit demand. The best summary of the macro perspective is available at “Will This Slowdown Earn a Name.” Those conclusions were supported by the data updates included in the September HARDInomics that is available to TRENDS participants and Enhanced level members. The recent FieldEdge data is also indicating a market shift is underway.
Slowing Demand Drives DSO IncreasesBy Tim Fisher
Since reaching an inflation-adjusted peak of 17 percent in November 2021, the median 12 month moving sales total for HARDI distributors has steadily declined to the current (August 2022) level of 7 percent. Yet, while 7 percent inflation-adjusted growth still represents excellent performance by distributors, it masks the real slowdown in contractor demand observable in days sales outstanding totals.
Source: HARDI TRENDS Report
On a 12-month moving average basis, distributor days sales outstanding – a measure of the average number of days that it takes distributors to collect payments after a credit sale has been made – has increased by 1 percent (from 39 days to 40 days). Interestingly, despite the slowdown (visible in revenue performance in the chart below), the actual volume of quotes and invoices provided by contractors to end-users still shows growth through August.
Source: HARDI TRENDS Report, FieldEdgeNote: Contractor business data provided by FieldEdge have been seasonally adjusted.
In the chart above, we see that inflation-adjusted invoice and quote totals provided by contractors to end-users have been in decline since the early-spring of this year. As we would expect, declines in real contractor sales performance leads to concurrent increases in our 12-month average DSO totals.
Source: FieldEdgeNote: Contractor business data provided by FieldEdge have been seasonally adjusted.
However, as we allude to in the previous paragraph, the actual volume of quotes and invoices provided were still increasing on an annual basis through August (3 percent and 5 percent, respectively). What are we to make of the conflicting details on recent contractor business performance? There are likely two explanations, though neither of them offers good news for HARDI members. One possible explanation is that end-user demand for new systems – which is primarily visible is the quantity of new quotes provided – remains high, but that high prices are driving consumers to repair or find cheaper alternatives (which would explain the declines in invoice and quote totals). The second possible explanation is that there are enough gaps in distributor inventories (i.e. out-of-stock products) that despite large in-stock unit totals, contractors are largely unable to find the right part(s) to complete replacement jobs. Of course, neither explanation is mutually exclusive, and it’s likely that some combination of these two factors is at play in different markets around the country. Nevertheless, one thing is abundantly clear: demand is slowing, and distributors must take care to manage costs as DSO totals are likely to grow in the future.
Cash is King
Cash is king. Inventory had a brief reign while the supply chain was compromised. Now that is recovering while the channel is well stocked and demand is easing, so once again cash is king.
The cash conversion cycle is oxygen to the king. The cycle is calculated by adding the average collection period to the inventory holding period, then subtracting the days payable. The ballpark number for HVAC oriented distributors is in the 145 day area. Inventories had to be twice as large to accommodate a supply chain that was twice as long. The Cash Conversion Cycle has been contained by the healthy demand and customers were paying their bills much faster than usual. This balance is poised to shift again.
This is the Days Sales Outstanding as captured and calculated in our monthly TRENDS report. It is not as accurate as what we get from our annual benchmarking program DPD in the cycle chart, but it is consistent so able to provide valid guidance. The Days Sales Outstanding in our TRENDS report has increased for two consecutive months. The DSO has a seasonal pattern. Each month has a normal level consistent with the seasonal nature of HVACR distribution. The light green bars in the chart above show the normal rate for August. The pre-COVID normal for August was 44 to 45 days while post-COVID was closer to 40. You see a year-to-year increase from August 2021 to August 2022. July 2022 had a similar increase. We have always believed the Cash Flow Cycle components would shift back to pre-COVID levels. That could be starting to happen because this is the first back-to-back increase since last summer, but one of those months was an insignificant change when demand was healthy. This time the underlying demand is easing while inventories are elevated, and the supply chain is improving.
Supply Chain Update
The supply chain is improving. This has taken longer than we expected or hoped, but it is happening. This chart is the Manufacturing Backlog index and the Manufacturing Supplier Delivery Index. These are part of the widely followed monthly Manufacturing ISM® Report On Business®. The red line marks the difference between stress and slack in the system. On the left side is pre-COVID when delivery times were a bit challenged to support the elevated backlogs, the green line. As backlog eased, so the pressure within the system and lead times were very manageable. The shaded area begins our two-and-half year journey through COVID and the challenges associated with that disruption. Backlogs are easing and deliveries are becoming more reliable. Mr. Timothy R. Fiore, CPSM, C.P.M., Chair of the Institute for Supply Management® (ISM®) Manufacturing Business Survey Committee, noted, “In September, 83.2 percent of panelists reported ‘same’ or ‘faster’ deliveries, compared to 80.4 percent in August. Panelists’ comments reiterate that suppliers performed better in September compared to previous months.”
A different perspective on lead-times is available through the Manufacturing Surveys prepared each month by several of our Federal Reserve Banks. These lines were well above zero during 2021, consistent with the ISM Backlog and Lead Times. The lead times in the Federal Reserve Banks surveys have also been improving throughout this year.
Our favorite tool for tracking the supply chain recovery is the Pressure Gauge by the high quality team at Wells Fargo Economics. Reading from left to right we see the verdant pre-COVID normal, then the inflamed 2021, and more recently some shades of green again in four of the five categories. The second section with the most green is the improving “time” component we have been reviewing above. Below that with more green is the lower costs. We expect to see more green to grow in the fourth section, “inventory” that will lead to more green in the top section, “volume.” The supply chain is improving.