If you want to know where the economy is headed, keep a close eye on the industrial equipment wholesale industry. When the economy is growing, industrial companies increase production rates and start ordering more from equipment wholesalers such as Grainger (GWW 1.59%), Fastenal (FAST 1.98%), HD Supply (HDS), and MSC Industrial (MSM 1.63%). Conversely, when the industrial economy slows, the wholesalers will be the first companies to feel the pain of a slowdown from its industrial customers.

The industry is also facing some significant changes in coming years. The larger wholesalers are seeking to gain market share by expanding store numbers, introducing initiatives such as vending machines, and using information technology and e-commerce to improve efficiency and generate new sales. It's an exciting industry to follow and deserves a close look.

What is the industrial equipment wholesale industry?

The industry supplies the manufacturing and construction sectors with everything they need to run their day-to-day businesses. In industry terms this is called maintenance, repair, and operations, or MRO. Products range from items as mundane as adhesives, faucets, and paper towels, toward more heavy-duty goods such as plumbing equipment, industrial fasteners, electrical products, power tools, and safety equipment.

Source: Grainger

In a nutshell, think of the industry as supplying a large volume of low-priced items to keep industry itself going. It's literally the "nuts and bolts" of manufacturing, and wholesalers need to hold many different products in stock to service a wide range of customers. For example, MSC Industrial claims to have 760,000 distinct items for sale to its customers. In fact, building up this kind of product range is essential for MSC Industrial, Fastenal, Grainger and some of the other larger-players are going to encroach on market share.

How big is the industrial equipment wholesale industry?

Big. Grainger estimates the size of North American MRO market to be roughly $145 billion, while MSC Industrial estimates the U.S. market to be near $140 billion. It's a huge marketplace in revenue terms, and also highly fragmented, with 150,000 distributors in the U.S. alone, according to MSC Industrial.

How does the industrial equipment wholesale industry work?

As the last figure above suggests, this is an industry full of very small companies that tend to serve particular market niches or geographies. Putting this into perspective, Grainger is the largest company in the sector in the U.S., yet it only claims a 6% share of the North American market. Meanwhile, according to MSC Industrial, the top 50 companies in the U.S. only make up 30% of the market. There is plenty of room for consolidation.

Essentially, wholesalers develop long-term relationships with buyers, and this gives smaller companies an edge when dealing with niche market customers.

Source: Grainger

As a part of building up these relationships -- whether the wholesaler is large or small -- the wholesaler develops the knowledge required to ensure it can meet its customers needs. In fact, the key to understanding the industry is to appreciate the importance of supply chain efficiency (the process of getting the goods from the supplier to the consumer) and product selection (ensuring the right mix of products is in the wholesalers inventory).

What are the drivers of the industrial equipment wholesale industry?

There are two main drivers. The first is simple: manufacturing and construction activity. However, there is a more interesting aspect to that simple answer. Industrial equipment wholesalers tend to have what economists call short-cycle sales patterns. In other words, there is a small amount of time between a salesman making contact with a buyer to when a sale is made. This means wholesalers have limited visibility on future orders -- a negative in terms of being able to predict results. However, it also means that investors can be positively surprised when the company reports a a sudden pickup in orders should industrial activity improve. It's something to look out for when you follow these companies' earnings reports.

The second key driver is the opportunity to generate secular growth within the industry. The term secular growth just means growth that doesn't rely on the economy. Opportunities exist for the larger companies to consolidate the industry, principally by using their scale to encroach on the niche areas and geographies that a significant number of smaller companies occupy.

Moreover, MSC Industrial, Grainger, and Fastenal are all investing in online capability.

Source: Fastenal

The plan is to use online expansion in order to increase their product offerings, and ultimately their customer base. In addition, Fastenal and MSC Industrial have aggressively expanded the rollouts of in-store vending machines -- an operation that has seen Fastenal increase profitability.

All told, the industrial equipment wholesale sector is still a play on global growth. However, the industry is undergoing some significant changes that create secular growth opportunities for the larger wholesalers. As a consequence, potential investors should look at the sector as being capable of outpacing growth in the industrial economy overall.