U.S. private equity funds focus on PVF distribution

BY MORRIS R. BESCHLOSS
PVF and economic analyst

When residential maintenance giant Home Depot announced the divestiture of hd Supply earlier this year, many phcp distributors breathed a sigh of relief. The nightmare of this gargantuan supply behemoth steamrolling the traditional distribution channels seemed to have dissipated. Former Home Depot chairman Robert Nardelli had forecasted an unheard of $20 billion a year revenue that would have dwarfed even the undisputed industry distribution champ, Ferguson, while retaining the option of its own unique approach to accommodating the phcp industry’s thousands of installers and end users.

But now the PHCP distribution sector is facing a new approach to massive takeovers that are coming like a bolt out of the blue.

It started earlier in the year with the successful takeover bid by three private equity partner groups acquiring the now available HD Supply Group.

But Wall Street’s investment banker Goldman Sachs announcing a majority interest in two of the PVF distribution sector’s leaders, McJunkin and Red Man Pipe, almost immediately followed this unexpected coup. Although private investment consortiums don’t normally interfere in the operation of their acquisitions, they exert pressure for maximum growth.

Their long-term objective is “flipping,” either over a long- or short-term time period if the opportunity arises.

This became readily apparent when McJunkin acquired Midway-TriStar, an upstream distributor based in Jackson, Mich., that is active in the Canadian market, which McJunkin had never approached before. With Red Man already active in Canada, that makes this dynamic duo an overnight major factor in the sizzling Northern market.

Now that the private equity partners have discovered PVF distribution, you can be assured that other large pvf distributors will soon find themselves in the cross-hairs of this new global phase of takeover financing for rapid growth and possible long-term sale.

As this is written, the sub-prime mortgage crisis has forced a renegotiation of the hd Supply divestiture. But the sale is expected to go through at a discounted price.

One thing is sure. The bulk of the global investment community is only beginning to play in this brand new investment ballgame today.

With the increasing focus on pvf distribution by private equity partnerships and investment bankers, it should come as no surprise that outside investors have acquired half of the inductees into The Wholesaler Hall of Fame.

Only three of these -- Liberty Equipment, Frischkorn (purchased by Ferguson) and Piping and Equipment (bought by Fairmont Supply) -- have been taken over by fellow distributors.

McJunkin, Red Man Pipe and bankrupt USFlow -- comprised of pvf distributors Bertsch, Plotkin Brothers, Mutual Supply of Cincinnati, and p&e Georgia Corporation -- would have surely qualified as independent entrees.

One astute industry observer told us that the pvf Hall of Fame has become a hit list for potential PVF distribution acquirers. Although flattering, this eventuality will not prevent us from choosing the “best and the brightest” of industry’s independent manufacturers and distributors in the future.

Refinery crisis -- a disaster waiting to happen

As gasoline consumers continue to wring their hands over the continuing volatility of prices at the pump, no answers seem forthcoming as to remedial action promising stable energy costs and availability for the foreseeable future.

There is so much confusion surrounding this problem that even the heated discussion concerning the refinery quandary reflects a misunderstanding of the looming crisis confronting America. To make sense out of this potential disaster, the following points should at least clarify what our nation of 260 million car and truck drivers will be facing in the future months.

First, it’s important to understand the disconnect between the surge of global crude oil prices and those of its derivatives.

Although both oil and gasoline have experienced major price increases this year, their availability and price rise stems from different factors. The driving force behind both is the fear of subsequent shortages. Crude oil, especially the more difficult-to-refine heavy sulfur variety prevalent in the Middle East, is readily available today.

But future traders anticipate much higher oil demand as bottlenecked refineries are expected to step up their capacity utilization from the present high 80s percentage level to the mid-90s. This higher usage is more normal during the current intensive driving season. This would require larger crude oil inventories than are now available. In fact, there is an excess of oil being stored in Cushing, Okla., in anticipation of refineries stepping up their output through the summer. These purchases, plus increased crude oil demand around the world, continue to put upward pressure on crude oil prices. Such fear of long-term shortages are also putting a floor under current pricing.

Regarding the refinery imbroglio, there is neither an understanding nor a political will to meet this immediate crisis head-on. The following details analyze the problem:

• While no new refineries have been built in 30 years, global gasoline consumer demand has risen to all-time highs. Gasoline consumption in the U.S. during the first week of July alone touched 10 million barrels a day, the second-highest level on record. There is consensus among experts that demand could grow by 2% a year into the next decade.
• Whereas America has previously depended on imports of gasoline and other derivatives, (heating oil, jet fuel, diesel) the expansion of demand in China, India, Southeast Asia and even Iran (with only one refinery) has diminished the global surplus previously available. This will almost certainly lead to shortages and higher world prices on the open global market.
• If the government had set out to deliberately undermine the solution of the refining problem, they could not have done a better job. A short list of such impediments include an ever-increasing list of environmental regulations, the mandatory injection of ethanol to unrealistic extremes, phasing out of toxic additives, and introducing new ultra-low sulfur standards for gasoline and diesel. These have been done without consultation with the nation’s refinery owners.
• The multi-national energy companies and the largest independent refiner, Valero, have put the government on notice that they are cutting back on refining capacity expansion. They claim that since “mandatory ethanol usage, if implemented, will decrease the need for gasoline,” refineries will be left holding the bag of such excess.
• In the meantime, America’s refining infrastructure has been crumbling. This year’s capacity downturn of 5% is second only to the hurricane disaster year of 2005. There has been a rash of blazes and breakdowns at refineries in Texas, Louisiana, Indiana and California.

Refining disruptions have been much higher than in previous years. These averaged 1.5 million barrels a day in the first quarter, compared with 700,000 to 900,000 barrels a day from 2001 to 2005. In 2006, in the aftermath of Katrina and Rita, refining losses averaged 1.35 million barrels a day.

With the cost of maintenance and increased capacity skyrocketing, the lack of major investments by the global refinery sector has set the stage for further deterioration.

For instance, in late March, a compressor fire in Whiting, Ind., led to power disruptions in neighboring Chicago. This caused the price of a gallon of gasoline to briefly touch $4. This is just a forerunner of similar incidents to come in the future.

Although the margin between the price of crude oil and the ultimate value of refined gasoline has shot up to $25, compared with only $5 per barrel a few years ago, the major refineries are fearful of investing into a future vacuum of uncertainty.

Angry U.S. legislators have reacted by proposing punishing tax hikes for such price “gouging.”

Although this potential refinery catastrophe will be settled by higher prices and less availability in the short term, it’s highly doubtful that constructive approaches to resolve this problem can be expected from America’s decision makers.

Budget deficit keeps improving

As most of the nation’s attention is riveted on the continuing contretemps in Iraq and Afghanistan and the hotly contested presidential races, little attention is being given to the good news of a remarkable budget deficit downturn.

With Defense Department spending expanding exponentially, the Bush budget planners expected a $400-billion annualized budget deficit during the President’s second term, shrinking to a possible 50% reduction in the out-years to 2012, after the President leaves the White House.

But even the most optimistic experts never expected the deficit reduction to shrink to the lowest level in five years, as fiscal 2007 comes to a close on October 1 of this year.

With three months left to be reported for fiscal 2007, the budget deficit is $121 billion, compared with $206 billion over the same period for fiscal year 2006. With June data recording a surprising monthly surplus of $27.5 billion, it’s a sure bet that final fiscal year results will be improved substantially over the White House’s ecstatic forecast of $205 billion, issued on July 21. This will be the second year in a row that the administration’s revised forecast will have been substantially improved upon.

In a total reversal of expectations, tax revenue gains are outpacing increases in government expenditures. Through the first nine months, receipts are up 7.5% over a year ago, while outlays have been held to just over 2.5%.

There are several reasons why this happy confluence of circumstances is coming together, despite the ongoing financial hemorrhaging generated by the worldwide war on terror:

• The labor market is proving much stronger than expected, maintaining an ongoing 4.5% unemployment rate. With America’s workforce near full employment, wages have increased to a level allowing discretionary buying power to continue asserting itself.
• U.S. corporations have reported record profits. Since the Bush Administration lowered taxes on capital gains and most dividends, while capping the upper bracket at 35%, capital markets both here and abroad have quickened their pace and generated far greater total revenues.
• Despite both producer and consumer price increases, these have been contained below an annualized 3% level. This trend has not severely impinged on the buying power of America’s service sector, which comprises 70% of the nation’s $13.75-trillion gross domestic product.
• Despite the stock market’s recent volatility, the record volume of stocks and bonds traded has generated all-time high revenues for the U.S. Treasury Department’s ever-widening coffers.
• The U.S. economy has retained its resiliency despite a recessionary trend in residential construction and the domestic automotive sector. These have been offset by commercial and industrial construction and expanding U.S.-based foreign automotive plans and employment. Exports are continuing to reach monthly highs, while energy-related industries are booming like never before.

The surprising annualized 3.4% gross domestic product results for the second quarter, recently reported with moderate inflation, indicated that the overall U.S. economy may come in stronger this year than previously reported.

On the government spending side, the existing balance between the executive and legislative branches is putting a crimp on spending. Even a threat of a presidential veto has put a damper on Congressional expenditures which have gotten out of hand in recent years.

Such a continuation of governmental power balance could even mean a balanced budget by fiscal 2009, if military spending is contained. But both of these aspects depend on the problematical 2008 election and a Mideast troop reduction.

But even the current lower deficit has the U.S. Treasury Department cutting back on the number of securities it is issuing. In May, the Treasury stopped selling new three-year notes. Some economic experts even call for the Treasury to begin buying back debt.

With a smaller supply of new debt hitting the bond market, there will be less pressure on interest rates and could even influence the Federal Reserve Board to lower the federal funds rates if the economy needs a stimulus later in the year.

Such a turn of events could also mitigate the fear of a credit crunch, set in motion by the sub-prime mortgage crisis and the subsequent stock market correction late in July.

Morris R. Beschloss, a 50-year veteran of the pipe, valve and fitting industry, is PVF and economic analyst for The Wholesaler.