This is Part 2 of an interview with David Pugh, CEO of industrial distributor Applied Industrial Technologies. In this piece, Pugh talks about new markets, fluid power, e-commerce, integrated supply and the impact of the recession on channel relationships. Find Part 1 of this interview here.
MDM: You have made some key acquisitions in the fluid power segment. How does that fit into your growth plans going forward?
David Pugh: We started our fluid power growth in the mid-‘90s. I am not sure we truly understood the business when we headed into it because we pictured it to be a lot like bearing and power transmission. The manufacturers supplying the industry have a different mindset with regard to how they use distribution and how they authorize distribution. That was an eye-opener for us.
We also went into it thinking it was going to be a national roll-up that would be run from headquarters. What we found is that each of these acquisitions is provincially strong, and what somebody’s doing in Baltimore, MD, with one customer has nothing to do with what someone’s doing in Silicon Valley with another customer. So we decentralized it and put a different style of management into place. We have really come a long way with that. The gentleman who is running that for us is doing an excellent job.
We were fortunate to pick up Fluid Power Resource, LLC in August of 2008. Though the market collapsed right after we made the acquisition, that acquisition will be excellent for the company in the coming years.
MDM: What are some of the challenges and opportunities for Applied in the fluid power market?
Pugh: One thing I continue to believe is that there will be a reconciliation of distribution philosophy, customer needs and how fluid power manufacturers look at distribution. There’s a gap with our national accounts who want us to provide them consistent service and a consistent product across the country, but the manufacturers are still unwilling to authorize on a national basis. It’s challenging. We understand the manufacturer’s position.
We continue to work with them in a way that’s beneficial to all, but at end of the day we really have to together be able to service the customer, or it’s not going to be good for either of us. We expect to continue to grow in the fluid power business. It’s been good for us. I feel really good about what lies ahead. We’re going to be doing some new things with regard to updating our information technology within that group to give us better capabilities, and we’re making good investments both externally and internally.
MDM: How is Applied approaching alternative energy markets, including the wind industry?
Pugh: Wind energy is an enigma right now because it’s still one of the highest cost per kilowatt generation of power. It’s green, it’s renewable, and it fits in with the strategy of our current administration. But without government subsidies, it will be dead in the water.
Also, there’s not been a true solidification on a design of these windmills. If you’ve seen one, you’ve seen one. Even if it were up and running the role of distribution has not been clearly defined. This is being handled more on a manufacturer-direct basis right now. There are also challenges with repair – a lot of the repair services are built into maintenance contracts of the initial sale of the manufacturer. We have received some nice pieces of business on a one-time basis here and there. But we haven’t seen a steady stream.
One question I have revolves around the long-term viability of the business. If it is viable, what are the standards going to be, and can you get this down to something that you can wrap your arms around? And will the manufacturers have us in the supply chain?
MDM: What has this recession done to the relationships between manufacturers and distributors, and distributors and customers? Has it changed how manufacturers have gone to market, or how they work with you? What shifts if any have you seen?
Pugh: The recession has put pressure on traditional relationships with suppliers. For example, you have customers in critical situations asking us to bring in offerings from low-cost countries.
MDM: They are asking for that more?
Pugh: Yes. Not only asking but demanding that we bring offerings from low-cost countries. That’s a challenge because that flies in the face of our traditional tier-one suppliers. You’ve seen some distributors address that with private branding, but I don’t think that is a long-term viable solution because you’re probably going to end up putting the same product on the shelf under two or three different names. You’re increasing your asset base with no great value.
The margin pressures are key. Somebody’s got to make it for you. Distributors don’t make this product so you have to select one manufacturer, and irritate three or four, so I just don’t see that as being the distributor’s role. We have got to figure out with our existing suppliers, what is the best way to meet those needs? I don’t know that any of this is different from what has happened in the past in crisis mode, and honestly when I look back on the evolution of distribution post-World War II, we continue to evolve in ways that make sense and have stability.
You have crisis points along the way, and things get in, and then get thrown back out, but it really hasn’t changed the mode that we’ve been in and the relationships that we’ve had, so I think we’re going to come back to the traditional relationships that we had seen before the crisis. A lot of it is customer-driven, and I think together distributors and their suppliers have to go to the customers and explain to them the long-term benefits of not making a panic decision.
MDM: Which is sometimes easier said than done, right?
Pugh: It is, and it makes selling more difficult and time-consuming, but it’s something that has to be done.
MDM: You are in Mexico and Canada. Do you have plans to continue to grow in those countries or expand to others?
Pugh: I think Mexico is a very good opportunity for us. We made our first acquisition there in 2001 to gain a footprint and understand the culture and decide whether we could do business there. We liked what we saw. Our first acquisition lost money, but it was a learning experience and an investment. Our second acquisition got us management talent that has continued to lead us forward. That was a key acquisition for us. We’re pleased with the way that’s going, and we certainly expect to make further acquisitions and grow our business in Mexico.
Canada has been excellent. We would love to be in Eastern Canada. That’s been a real challenge. Western Canada has been a big stronghold for us. You know we certainly will keep an eye on the latest acquisition that was done up there by one of our key competitors, and we’ll see what that means to us. But I feel good about our position out there.
China is an enigma. China is a huge opportunity, but it’s also a huge risk. I’ve not seen any of our North America distribution really go in there and be successful. Most of our suppliers tell me that it’s not ready for us right now. We have no plans at this point to move into China.
MDM: Have you been asked by customers to expand overseas?
Pugh: It’s not a demand. It’s a “If you were there we’d love to have you, but …” They have different operating modes from what they have in the U.S. If I were to go to a place, India might be better than China just simply because you don’t have any language barriers. The form of government, the form of judicial system, the form of contractual arrangements all are much easier to understand for us, and much more controlled. I think India would be lower risk.
We’re also looking at South America, and since we have operations in Mexico and Puerto Rico, a Latin American expansion probably would be easier for us. It’s not in our core strategy right now, but it’s a potential as an expansion of our strategy.
MDM: Does Applied do integrated supply or have plans to do integrated supply?
Pugh: No we do not do integrated supply. That’s a great debate even within our own company as to how, when, or whether. I have a bias against integrated supply more for my background on the manufacturing side. When I look at the logic – integrated supply means that from the manufacturing side you get rid of your own expertise, and you turn it over to someone else. I just cannot imagine long-term having all of my materials, my nomenclature and my acquisition systems being owned by someone else who could shut me down in a nanosecond.
We were in it at one point, and 90 percent of what we sold was outside of our core competencies. We are a value-added distributor. If 90 percent of what you’re selling is something to which you can’t add value, you should ask: “Why are you doing it?” Where’s our buying leverage? I fail to see what we truly add to the end-use customer with integrated supply, but we do have people asking for it.
We have teams in our company looking at how we would do it but there are still a lot of unanswered questions with regard to how you get into that and make it work and truly deliver value to your customer.
MDM: People call integrated supply many different things these days.
Pugh: You’re exactly right. It’s kind of like windmill design. If you’ve seen one version of integrated supply, you’ve seen one. Because for some it is come in and do all my purchasing and run everything for me down to sweeping floors and getting the grass cut. You have others that just say OK, I buy some of this mill supply stuff that’s outside your core competency. I’m willing to pay a little bit extra for you to bring that in and deliver it rather than dealing with three or four other people that are supplying it today. We will do that. But the broad scale of supplying everything is something we don’t think is good.
MDM: What role will e-commerce play for Applied going forward?
Pugh: E-commerce had a lot of hype in the early 2000s. Much more hype than reality in our type of business. Over time it will grow simply because you have more generations of what I call the “digital kids” coming into the workplace.
In our business where 50 percent of customers coming to us don’t know what they need, e-commerce loses some of its value. In addition, time is critical. If you need a bearing to get that multimillion-dollar piece of equipment back up and running, and it’s costing a million dollars an hour when down, then timing is critical.
So rather than relying on what shows up on an inanimate screen in front of me versus hearing a warm voice on the other end of the phone saying, “Not only does it show on the screen. I walked out in the warehouse, and yes it’s sitting on the shelf. I have it in my hand and I can bring it over to you in 15 minutes.” I don’t think you’re going to ever get rid of that in our business because of the criticality of getting equipment back up and running.