In Part 1 of this interview, Pugh discusses how Applied is responding to current economic and market conditions. Part 2 of this interview will appear in the Feb. 25, 2010, issue of MDM.

MDM: What is your take on current economic and market conditions?

 

David Pugh: I’m on the front lines talking with key suppliers and key customers, and right now we’re just not seeing a positive impact from anything out there. What’s going to bring us out of this recession? The first thing you look for is consumer spending.

 

Consumption isn’t there. I don’t see it coming back for awhile because we have record numbers of people out of work, and 40 percent of them have been out of work for over 27 weeks. There is a lot of recovery that must take place before we see consumption coming back.

 

So will we see private spending? Are companies going to go spend money to create jobs and build? Capacity and capacity utilization are both down. A lot of plants in the legacy industries – wood products, cement, steel – have closed permanently. And those that are going to be running are state-of-the-art, with higher productivity. I think heavy industry as we’ve seen in the past is gone. I don’t see private spending coming back in the near future.

 

Then you go to public spending, and there’s only so much of that can be done, especially when the state budgets are such a big piece of that. In 2009, 21 states were considered to be in severe deficit position. In 2010, 33 states are considered to be in severe deficit position.

 

How about exports? Is the rest of the world doing OK? Well if you look at the strategies of the rest of the world, they’re all saying they’re going to recover from exports.

 

MDM: When do you expect to see signs of recovery?

 

Pugh: I don’t think there’s a silver bullet or a brass ring that’s going to immediately pull us out of this. We’ve got five to eight years of truly absorbing everything that’s occurred. We’re going to see recovering start to happen, maybe, at the end of 2010. I’m more in the camp that we’re going to see recovering of any noticeable means in 2011.

 

I don’t consider a 1 or 2 percent improvement as recovery. That’s almost a statistical error. I’d like to see it get to at least 5 percent before I say things are recovering. Recovering and recovery are two different things. We will start recovering, but I think full recovery in my mind is getting back to 2001 levels, not 2006 or 2007.

 

When I’m planning, that’s what’s in my mind.

 

 

MDM: Are you seeing strength in any sectors right now?

 

Pugh: We have 31 major SICs that we view on a constant basis. In the fourth quarter of 2009, only seven of those showed any growth for us, and a number of those showed growth because we gained share, not because of market recovery. The majority of markets out there are still down. Years ago we started making moves toward less cyclical businesses. One is food and beverage. We’re doing very well in that. That’s very stable so that’s helped us stay up.

 

Another thing we did five years ago is make a significant move to supply to government facilities. It’s a long-term investment for a number of reasons. From an administrative standpoint you have to make sure you dot every “I,” and cross every “T.”

 

There are a lot of legal responsibilities there that we do not want to miss so we headed into that slowly to make sure our systems could comply with regulatory requirements. Once you do that, then you’ve got to gain awareness in a very huge purchasing organization. It takes time to do that.

 

MDM: What impact have you seen from government stimulus spending?

Pugh: With Cash for Clunkers you saw some increased business in steel mills to supply automotives to replace inventory. With housing credits you had housing sales going up and then dropping. It’s transient spending. I don’t consider that to be anything sustainable. It’s tough to forecast when you have transient spending skewing the metrics, so I want to see what the first quarter of 2010 shows. I think you’ll see some stabilization, and that will give us a clearer picture of what’s ahead.

 

The Purchasing Managers Index would lead you to be optimistic about the second half of 2010, but capacity utilization would tell you it’s going to be flat. Those two normally work together. But right now you’re seeing a real dichotomy between those two.

 

MDM: Forecasting demand must be difficult right now.

 

Pugh: It is. We’re working very closely with our customers, our suppliers, and our salespeople. Our job is to make sure product is available at the place it’s needed at the right time. You don’t want too much. You don’t want too little. Should inventory be at the supplier or should we be holding it because we have multiple customers using this? Or is this unique material that only one person uses, and they should have it on their floor?

 

We have cut massive amounts of inventory over the past six months. We’ll continue doing it for the next six months. We have customers that are still trying to send stuff back to us. We cut about $53 million of inventory in the past six months. I would be surprised if we don’t cut another $30 million over the next six months. And that’s just to get rid of excess.

 

It says something about buying habits over the past five years. I think everybody was running beyond what the market could consume in inventory. I’ve never dictated an inventory reduction program in our company. I’ve pushed hard on inventory management with the No. 1 objective as 100 percent compliance or promise. We take care of the customers first, and if that means I have more inventory than I think I should have, that’s OK. We have the cash to do it. We have the balance sheet to do it.

 

Our No. 1 job is to keep our customers up and running. And there’s not a single location I have that feels pressure to reduce inventory beyond what they need to keep their customers running.

 

MDM: In which sectors have you continued to see weakness?

 

Pugh: Anything related to construction is in the doldrums. Anything with aggregate, cement, wood products is down, and I think it’s going to stay down for a while.

 

You’ve got too much inventory in the housing market. Then you have shadow inventory that’s going to come into play in the next round of foreclosures. They’re estimating over 3,000,000 units will go to foreclosure in 2010, which is higher than 2009. That’s what we call shadow inventory. The deep shadow inventory is a result of people who have had their houses on the market, wanted to sell, and took them off because prices are so low and time on the market is so long. There is a lot of negative headwind in new housing and construction. I don’t see construction coming back anytime soon.

MDM: Have you seen margin pressures as a result of these economic and market conditions?

Pugh: It’s simply supply and demand. There is more supply out there than there is demand, and people are trying to get rid of their inventories rather than scrap, and they’re selling at fire prices. You have some of the smaller privately held companies that are probably seeing a cash crunch right now; they want to improve their cash flow. It’s a normal process.

 

We identified the current situation back in April of 2008. I look at notes from our officer meeting that month. I said: “Yes, it’s coming. The handwriting is on the wall. Start getting inventories under control. Watch the things that normally happen as the market goes down. Watch your receivables. Watch your margins. Do not succumb to this. Do not just be a passive observer, but put plans in place to prevent this now.”

 

While I think we do have good programs in place to manage this, it is such a huge force you can’t stave it off entirely. But we are certainly trying not to lead it down the hill.