Newton, MASS In recent years, there has been considerable consolidation in industrial distribution, but current economic conditions have limited merger and acquisition activity. Sales for most distributors are down and economic indicators such as industrial production and capacity utilization have plunged.

Factors including loss of volume discounts and greater accruals for bad accounts are diminishing profits. It may be surprising that some distributors have made improvements in their balance sheets in terms of debt reduction and cash flow, said CIBC World Markets senior equity analyst Holden Lewis.

While net working capital has reduced as sales have slumped, cash flow has increased, said Lewis. Distributorships are, in general, working capital intensive and these requirements decline with underlying markets, making cash flow counter-cyclical. The cash flow is then being used to pay down debt, he added.

"This will position some distributors to make well-timed strategic acquisitions and invest heavily in growth," said Lewis. "The price is much more likely to be favorable coming out of the recession."

U.S. Bancorp Piper Jaffray senior research analyst Stephen E. Jacobs said he also expects resumed merger and acquisition activity coming out of the recession. For the moment, however, the pressure is off.

"When we have economic recessions, industrial distributors that are close to their customers and have inventory in the field tend to do better than call centers and catalog houses," said Jacobs. "Plant managers have reduced their inventories and are willing to buy from a local source that will maintain their safety stock for quick access. Even 24-hour delivery is too long to wait for critical inventory."

This means customers now are looking to local and regional distributors or national distributors with a local presence, said Jacobs. Plant managers are going to national purchasing, meaning there will be renewed focus on national accounts coming out of the recession, he adds.

"At that time, the distributors trying to carry a broad base of inventory but having only a few locations will be struggling," said Jacobs. "We will begin to see more consolidation as purchasing moves away from small regional players."

He said the market is still highly fragmented, with the top 250 firms holding less than 15 percent of the market. As the position of smaller players weakens, they will become targets for acquisitions. Jacobs points out that many small niche firms will remain strong, however.

"It is the middle-level firms that will be most at risk," said Jacobs. "Some will be purchased by the larger firms. We will see the large, strong players get even bigger through targeted acquisitions."