1. Can Masterton afford the conversion? (look at Exhibit 3). Support your answer!

2. What have we learned about Channel/Trade functions and the Intermediary/Middleman?

Masterton Carpet Mills, Inc. In early July 2000, Suzanne Goldman was scheduled to meet with Robert Meadows, President of Masterton Carpet Mills, Inc. Goldman expected the meeting would relate to the recent board of directors meeting. In her position as Special Assistant to the President, or "troubleshooter* as she called herself, Goldman had noticed that such meetings often led to a project of some type. Her expectations were met, as Meadows began to describe what had happened at the board meeting. The directors were generally pleased with the present state of the industry and our performance last year. Even though we lagged behind industry sales growth, we recorded a profitable sales growth of 3.6 percent. Our net profit margin of 4 percent is respectable and our cash flow is more than sufficient to fund our present initiatives. Board members were quite complimentary in their comments about senior manage ment and the recommended bonuses and raises were approved. You deserve the credit for pulling together a really professional packet of materials for the meeting. The possibility of establishing our own distribution centers or wholesale open- tion was raised, given the recent developments in the industry and our competitive position. We looked at this issue 10 years ago and concluded it wasn't strategically in our interest to do so. Besides we were too small and couldn't afford it. Would you examine such a program for me for fiscal 2001 and prepare a position paper for the October board meeting? Focus only on residential business, since we handle contract sales on a direct basis already, assume the same sales level as in fiscal 2000 to be con- servative, and address both the strategic and economic aspects of a change in distri- bution practices. Remember that our policy is to finance programs from internal funds except for capital expansion. I know you'll do the same comprehensive job that you did on the advertising and sales program last year. 1 THE U.S. CARPET AND RUG INDUSTRY U.S. consumers and businesses spend about $50 billion annually for floorcoverings. The largest category of floorcoverings is carpet and rugs, followed by resilient cov- erings (vinyl), hardwood, ceramic tile, and laminates. Carpet and Rug Industry Sales and Trends The U.S. carpet and rug industry recorded sales of $11.69 billion at manufacturer's prices in 1999. Carpet and rug retail sales were estimated to be $17.9 billion. These figures represented about a 7 percent increase in sales from 1998. Industry sales are divided between contract," or commercial, sales for institutions and businesses and res- idential sales for household replacement carpets. The residential segment accounted for about 74 percent of sales; the contract segment accounted for 26 percent of sales. It is estimated that carpet and rugs commanded 68.1 percent of total U.S. floor- covering sales in 1999, down from 73.4 percent in 1995, and 82 percent in 1985. Resilient floorcoverings have shown a similar decline in market share while hardwood, ceramic tile, and laminate floorcoverings have grown (see Exhibit 1). In addition, U.S. carpet and rug manufacturers have experienced a decline in sales outside the United States. Since 1980, the export market for U.S.-made carpet and rugs has become highly competitive. In 1970 U.S. companies supplied 51 percent of the world's carpet; by 1999, this percentage had declined to 45 percent. Some industry analysts claim that the carpet and rug industry itself is partially to blame for the present situation. Lack of marketing, particularly in the residential car- pet and rug replacement segment, is an often-cited problem area. Even though manu- facturers continue to improve the quality of their products and develop new patterns, critics say the industry has not communicated these value-added dimensions to con- sumers and differentiated carpet and rugs from other floorcoverings. They note that the industry as a whole spends 2.1 percent of its sales on consumer advertising. For comparison, other manufacturers of consumer durable products, such as household furniture and houschold appliances spend 4.2 percent and 2.5 percent of sales, respec- tively, for advertising. Instead, price had become the dominant marketing tool for much of the past decade and manufacturers focused attention on cost reduction and achieving economies of scale. A result of these efforts was an erratic upward trend in dollar sales over the past decade but marginal profitability for the industry as a whole, Competitors The U.S. carpet and rug industry is undergoing a period of consolidation begun in the mid-1980s. Mergers, acquisitions, and bankruptcies among manufacturers brought about by declining demand for carpet and rugs, excess manufacturing capacity, and dwindling profit margins reduced the number of carpet and rug manufacturers from more than 300 in the mid-1980s to about 100 companies in early 2000. This number includes 96 U.S.-based companies and 4 Canadian-based companies, most of which are privately held companies. Mergers and acquisitions since 1995 reflected a push to build further economies of scale in the production and distribution of carpet and rugs. By 1999, it was estimated that 10 companies in the industry produced 91 percent of carpet and rug sales in the United States. The sales distribution in the residential segment was even more skewed, Three companies-Shaw Industries, Mohawk Indus- EXHIBIT 1 1995 1994 U.S. Floorcovering Market Shares and Dollar Sales at Manufacturer Prices Market Share Floorcovering Type 1999 1998 1997 1996 Carpet and rug 68.1% 70.8% 71.1% 72.9% Resilient/vinyl 10.5 11.6 12.5 13.5 Hardwood 8.0 7.6 7.5 6.9 Ceramic tile 9.4 7.0 6.7 5.0 Laminate 4.0 3.0 2.2 1.7 100.0% 100.0% 100.0% 100.0% Total Mftr. sales ($ in millions) $17,166 $15,436 $14,422 $13,893 73.4% 14.5 6.4 4.6 1.1 100.0% 73.6% 14.5 6.1 5.0 .8 100.0% $13,344 $13,509 tries, and Beaulieu of America-accounted for about 85 percent of U.S. residential carpet and rug sales. The U.S. industry sales leader is Shaw Industries, with 1999 sales of $4.1 billion. The company also has the distinction of being the largest carpet and rug manufac- turer in the world. Exhibit 2 lists the top 20 North American floorcovering manufac- turers based on annual sales in 1998 and 1999. Wholesale and Retail Distribution Wholesale and retail distribution in the U.S. carpet and rug industry has undergone three distinct changes since the mid-1980s. Mid-1980s: Direct Distribution in the mid-1980s, the largest carpet and rug manufac- turers began to bypass floorcovering wholesalers (distributors) and sell directly to retail- ers in greater qumbers. In many instances, direct distribution involved establishing sales offices located in manufacturer-operated distribution centers. The intent was to capture the margins paid to floorcovering wholesalers and offset declining and often negative manufacturer profit margins at the time. Lacking the capital to invest in distribution cen- ters, smaller manufacturers continued to rely on floorcovering wholesalers that were increasingly expanding their product line to include ceramic, hardwood, and resilient floorcoverings. Although no statistics were available, it was believed that the majority of carpet and rug sales for residential use were distributed through company distribution EXHIBIT 2 WEST Sales of the Top 20 North American Floorcovering Manufacturers in 1998 and 1999 Sales ($ in Millions, United States only) Manufacturer 1999 1998 1. Shaw Industries $4,108 $3,542 2. Mohawk Industries 3,083 2,639 3. Armstrong World Industries 2,221 2,075 4. Beaulieu of America 1,850 1,500 5. Interface Flooring 745 780 6. Mannington Mills 532 475 7. Dal-Tile 510 450 8. The Dixie Group 457 415 9. Lear Corporation 440 405 10. Burlington Industries 425 410 11. Milliken Carpets 315 290 12. C&A Floorcoverings 275 170 13. Congoleum 246 14. Kraus Carpet 200 185 15. Royalty Carpet Mills 179 163 16. Springs Industries 167 155 17. Gulistan Carpet 163 155 18. Wilsonart 130 95 19. J&J Industries 125 120 20. The Burruss Company 102 93 259 centers to retailers by 1990. However, the majority of carpet and rug manufacturers still used floorcovering wholesalers. Distribution through floorcovering wholesalers remained popular with the major- ity of carpet and rug manufacturers because of the retail distribution of residential car- pet and rugs. In the mid-1980s, independent (and often small) floorcovering specialty stores were responsible for 58 percent of residential carper and rug sales volume. Department stores and furniture stores accounted for 21 percent and 19 percent, respectively, of residential sales volume. Mass merchandisers, chain stores, and discount stores were relatively minor retail outlets for carpet and rugs until the early 1990s. Early 1990s: Wholesale and Retail Consolidation The early 1990s was marked by a second significant change in wholesale and retail distribution for residential carpet and rugs in the United States. Department stores, furniture outlets, and independent retail stores were being replaced by large mass-merchandise and discount stores (Kmart and Wal-Mart) and later by home centers such as Home Depot. The growing number of large retailers that were capturing an increasing share of residential carpet and rug sales spawned a new phenomenon in the retail floorcovering industry among specialty outlets: the buying group. A retail buying group is an organization of simi- lar retailers that combine their purchases to obtain price (quantity) discounts from manufacturers. These pooled purchases allowed independent specialty floorcovering retailers to buy less inventory per order while still getting a lower price, which reduced their costs and pressure for markdowns caused by overordering. Lower car- pet and rug cost plus an emphasis on service gave independent specialty floorcover- ing retailers a basis with which they could compete against their larger competitors. Logistical aspects of shipping and storing inventory varied from group to group. Some buying groups took physical custody of goods through a central warehouse which often replaced floorcovering wholesalers. Others simply requested manufac- turers to deliver the goods directly to buying-group members from the manufac- turer's millor distribution center. By 1995, three retail buying groups--CarpetMax, Carpet One, and Abby Carpets- registered $3 billion in floorcovering purchases. Another 10 smaller buying groups made another $1 billion in purchases. According to one industry observer, almost one- half of all U.S. residential carpet and rug sales volume was accounted for when buying group purchases were combined with those of large to medium-size carpet store chains (e.g., Carpet Exchange), mass merchandisers and discount stores, and home centers (e.g., Home Depot). Although estimates varied, about 40 percent of the roughly 23,000 retail outlets that carried carpet and rugs were members of buying groups, large mass- merchandise, discount, or home center chains. By 1999, CarpetMax, Carpet One, and Home Depot would account for 45 percent of total U.S. floorcovering sales. Increased consolidation of retail purchasing evident in buying groups, chain stores, and large mass-merchandise, discount, and home center stores had either a positive or a negative effect on manufacturers. Even with price discounting, and assuming the retail buying organization operated a central warehouse, it was easier and less expensive for a manufacturer to supply one location with large orders than to supply several sepa- rate retailers with smaller orders. On the other hand, if a buying organization flexed its buying power and persuaded manufacturers to take lower-than-normal margins (prices) and ship to diverse locations, a manufacturer risked seeing a lower dollar vol- ume and profit. Direct distribution by manufacturers in the mid-1980s followed by consolidated purchasing and warehousing by retailers in the early 1990s put many floorcovering wholesalers in a precarious position in the residential segment of the carpet and rug industry. Wholesalers that typically served small and medium-sized independent floor- covering specialty stores were particularly vulnerable to the ascension of retail buying groups that operated their own warehouse facility. These wholesalers advocated their role in distribution to both manufacturers and retailers. They argued that working with a buying group was worthwhile to a manufacturer only if the functions performed by the buying group were not only better than those offered by floorcovering wholesaler but also significant enough to justify the price discounts demanded by a buying group. Similarly, they argued that retailers benefited from wholesaling functions above and beyond the warehousing function. Nevertheless, the absolute number of floorcovering wholesalers had declined in recent years and was expected to decline further. The share of wholesaler floorcovering sales was projected to decline from 26 percent in 1995 to less than 23 percent in 2000. Mid-1990s: Forward Integration into Retailing In late 1995, the carpet and rug industry watched as yet another change in distribution practices unfolded. On December 12, 1995, Shaw Industries, the largest carpet and rug manufacturer and sales leader, announced plans to engage itself directly in the residential and contract segments of the floorcovering industry. It would do this by operating its own retail stores and commercial dealer network. In announcing this initiative, Robert E. Shaw, the President and CEO of Shaw Industries, said: We have realized for some time that the manufacturer must become significantly involved in the retail environment to enhance the viability of our industry Today, our industry offers products of exceptional quality and unsurpassed value, yet we con- tinue to lose consumner dollars to other product groups. Moreover, because con- sumers have traditionally price-shopped our products, profits have stagnated for years, from fiber producer to manufacturer to retailer. Although our industry has matured considerably in recent years, the current struc- ture cannot address many fundamental problems the industry is facing. A manufacturer- dealer affiliation was inevitable, since the only practical way to improve these adverse conditions is by consolidating the combined resources of the two.? Shortly afterward, Shaw Industries announced that it had purchased a number of com- mercial carper dealers and contractors and Carpetland USA, a retail chain of 55 stores. In response to this initiative, Home Depot dropped Shaw Industries as a carpet and rug supplier and switched to Mohawk Industries. Carpet One and Abbey Carpets, two buying groups, asked their members not to do business with Shaw. Other carpet manufacturers courted floorcovering specialty stores with promises to support them with product and not to enter the retail market as competitors. Shaw Industries countered these actions by creating its own retail buying group ---the Shaw Alignment Incentive Programn-which operated 275 retail stores in 26 states with annual sales of $575 million by mid-1998. Then, in June 1998, Shaw Industries announced it would sell off its retail stores to the Maxim Group, the owner of CarpetMax floorcovering stores, for about $93 million.In 1999, Home Depot was again carrying Shaw carpet. R THE COMPANY Masterton Carpet Mills, Inc., is a privately held manufacturer of a full line of medium- to high-priced carpet primarily for the residential segment. The company markets its products under the Masterton and Chesterton brand names. Contract sales to insti- tutions and businesses are also made but account for only 28 percent of company sales and occur principally in the southeastern United States. The company had no export sales. Total company sales in fiscal 2000 were $75 million, with a net profit before tax of $3 million. Exhibit 3 shows abbreviated company financial statements. Masterton Carpet Mills currently distributes its line through seven floorcovering wholesalers located throughout the United States. These wholesalers, in turn, sup- plied 4,000 retail accounts, including department stores, furniture stores, and floor- covering specialty stores. Inspection of distribution records revealed that 80 percent of residential segment sales were made through 50 percent of its retail accounts. This relationship exists within all market areas served by Masterton Carpet Mills. Meadows believed these sales-per-account percentages indicated that at the retail level the company was gaining adequate coverage, if not overcoverage. The review of distrib- ution records also indicated that it cost Masterton Carpet Mills 6 percent of its resi- dential segment sales to service the seven floorcovering wholesalers Advertising by Masterton Carpet Mills appeared primarily in shelter magazines and newspapers. The emphasis in advertisements was on fiber type, colors, durabil- ity, and soil resistance. A cooperative advertising program with retailers had been expanded on the basis of Goldman's recommendation. According to Goldman, "The coop program is being well received and has brought us into closer contact with retail accounts." The company employed two regional sales coordinators, who acted as a liaison with wholesalers, assisted in managing the cooperative advertising pro- gram, and made periodic visits to large retail accounts. In addition, they were respon- sible for handling contract sales for institutions and businesses. Floorcovering wholesalers played a major role in Masterton Carpet Mills' market- ing strategy. Its seven wholesalers had long-term relationships with the company. Two had represented Masterton Carpet Mills products for over 30 years, four had been with the company for 20 to 25 years, and one had been with the company for 10 years. Masterton Carpet Mills' wholesalers maintained extensive sales organizations, with the average wholesaler employing 10 salespeople. On average, retail accounts received at least one sales call per month. Goldman's carlier evaluation of the sales program revealed that wholesaler sales representatives performed a variety of tasks, including EXHIBIT 3 Masterton Carpet Mills, Inc. Financial Statements (For the Fiscal Year Ending June 30, 2000) Income Statement Net sales Less cost of goods sold Gross margin Distribution expenses Selling and administrative expenses Other expenses Net income before tax $75,000,000 56,250,000 $18,750,000 $2,250,000 11,250,000 2,250,000 $ 3,000,000 Balance Sheet Current assets Fixed assets Total assets Current Liabilities Long-term debt and net worth Total liabilities and net worth $26,937,500 24,000,000 $50,937,500 $10,312,500 40,625,000 $50,937,500 checking inventory and carpet samples, arranging point-of-purchase displays, handling retailer questions and complaints, and taking orders. About 25 percent of an average salesperson's time was spent on nonselling activities (preparing call reports, acting as a liaison with manufacturers, traveling, and so forth). About 40 percent of each one- hour sales call was devoted to selling Masterton Carpet Mills carpeting; 60 percent was devoted to selling noncompeting products. This finding disturbed company manage- ment, which felt that a full hour was necessary to represent the product linc. In addi- tion to making sales, wholesalers also stocked carpet inventory. Masterton Carpet Mills' wholesalers typically carried sufficient stock to keep the number of their inventory turnovers at five per year. Masterton Carpet Mills' executives felt that inventory levels sufficient for four turns per year were necessary to service retailers properly, however. Finally, wholesalers extended credit to retail accounts. In return for these services, wholesalers received a 20 percent margin on sales billed, at the price to retailers. At a June 2000 meeting with its wholesalers, Masterton Carpet Mills executives were informed that several wholesalers were feeling increased pressure to shave their profit margins to accommodate retailer pricing demands. It seemed that an increas ing number of their retail accounts had joined regional retail buying groups and were seeking price breaks comparable to those made possible through their group pur- chases. Subsequent probing on this topic led Masterton Carpet Mills executives to conclude that about 1,200 of the company's current retailers were members of buy- ing groups, they represented about a third of the company's residential segment sales. The meeting concluded with Masterton Carpet Mills executives agreeing to consider a reduction in its price to wholesalers that could be passed on to retailers. At the same time, wholesalers agreed to consider a modest reduction in their margins as well. The "Margin Sharing" proposal, so named by a wholesaler, would be given top billing at the next meeting in January 2001. In the meantime, price accommodations would be made where and when it was necessary to meet the competition. 1 DIRECT DISTRIBUTION EXPERIENCE OF COMPETITORS Following her meeting with Meadows, Goldman sought out information on competi- tors' experience with direct distribution. Despite conflicting information from trade publications and knowledgeable industry observers, she was able to arrive at several important conclusions. First, competitors with their own warehousing or direct distri- bution operations located them in or near seven metropolitan areas: Atlanta, Chicago, Dallas-Fort Worth, Denver, Los Angeles, New York City, and Philadelphia, Masterton Carpet Mills had wholesalers already operating in these metropolitan areas, except for Dallas-Fort Worth and Atlanta. The company serviced these two areas from wholesalers located in Houston, Texas, and Richmond, Virginia, respectively. Second, a minimum volume of approximately $5 million in wholesale sales was necessary to operate a warehouse operation economically. The average warehouse operation could be operated at an annual fixed cost (including rent, personnel, operations) of $700,000. Goldman was informed that suitable warehouse space was available in the metropolitan areas under consideration; therefore, the company would not have to embark on a building program. Third, salaries and expenses of highly qualified sales representatives would be about $70,000 each annually. One field sales manager would be needed to manage eight sales representatives. Salary and expenses would be approx- imately $80,000 per field sales manager per year. Sales administration costs (including fringe benefits) were typically 40 percent of the total sales force and management costs per year. Delivery and related transportation costs to retail accounts were estimated to be about 4 percent of sales, and inventory and accounts receivable carrying costs were 10 percent. Retail accounts receivable take about 90 days to collect, on average. Though these figures represented rough approximations, in Goldman's opinion and in the opinion of others with whom she conferred, they were the best estimates available. In late September 2000, just as Goldman was about to draft her position paper for Robert Meadows, she received a disturbing telephone call from a long-time successful wholesaler of the company's products. The wholesaler told her that he and others were disappointed to hear of her inquiries about direct distribution possibilities given what transpired at the fune meeting. Through innuendo, the wholesaler threatened a mass exodus from Masterton Carpet Mills once the first company warehouse opera- tion was opened. He implied that plans were already under way to establish a trade agreement with a competitor. This conversation would have significant impact on her recommendation if direct distribution was deemed feasible. In short, a rollout by mar- ket area looked less likely. A rapid transition would be necessary, which would require sizable cash outlays and an aggressive sales force recruiting program. Masterton Carpet Mills, Inc. In early July 2000, Suzanne Goldman was scheduled to meet with Robert Meadows, President of Masterton Carpet Mills, Inc. Goldman expected the meeting would relate to the recent board of directors meeting. In her position as Special Assistant to the President, or "troubleshooter* as she called herself, Goldman had noticed that such meetings often led to a project of some type. Her expectations were met, as Meadows began to describe what had happened at the board meeting. The directors were generally pleased with the present state of the industry and our performance last year. Even though we lagged behind industry sales growth, we recorded a profitable sales growth of 3.6 percent. Our net profit margin of 4 percent is respectable and our cash flow is more than sufficient to fund our present initiatives. Board members were quite complimentary in their comments about senior manage ment and the recommended bonuses and raises were approved. You deserve the credit for pulling together a really professional packet of materials for the meeting. The possibility of establishing our own distribution centers or wholesale open- tion was raised, given the recent developments in the industry and our competitive position. We looked at this issue 10 years ago and concluded it wasn't strategically in our interest to do so. Besides we were too small and couldn't afford it. Would you examine such a program for me for fiscal 2001 and prepare a position paper for the October board meeting? Focus only on residential business, since we handle contract sales on a direct basis already, assume the same sales level as in fiscal 2000 to be con- servative, and address both the strategic and economic aspects of a change in distri- bution practices. Remember that our policy is to finance programs from internal funds except for capital expansion. I know you'll do the same comprehensive job that you did on the advertising and sales program last year. 1 THE U.S. CARPET AND RUG INDUSTRY U.S. consumers and businesses spend about $50 billion annually for floorcoverings. The largest category of floorcoverings is carpet and rugs, followed by resilient cov- erings (vinyl), hardwood, ceramic tile, and laminates. Carpet and Rug Industry Sales and Trends The U.S. carpet and rug industry recorded sales of $11.69 billion at manufacturer's prices in 1999. Carpet and rug retail sales were estimated to be $17.9 billion. These figures represented about a 7 percent increase in sales from 1998. Industry sales are divided between contract," or commercial, sales for institutions and businesses and res- idential sales for household replacement carpets. The residential segment accounted for about 74 percent of sales; the contract segment accounted for 26 percent of sales. It is estimated that carpet and rugs commanded 68.1 percent of total U.S. floor- covering sales in 1999, down from 73.4 percent in 1995, and 82 percent in 1985. Resilient floorcoverings have shown a similar decline in market share while hardwood, ceramic tile, and laminate floorcoverings have grown (see Exhibit 1). In addition, U.S. carpet and rug manufacturers have experienced a decline in sales outside the United States. Since 1980, the export market for U.S.-made carpet and rugs has become highly competitive. In 1970 U.S. companies supplied 51 percent of the world's carpet; by 1999, this percentage had declined to 45 percent. Some industry analysts claim that the carpet and rug industry itself is partially to blame for the present situation. Lack of marketing, particularly in the residential car- pet and rug replacement segment, is an often-cited problem area. Even though manu- facturers continue to improve the quality of their products and develop new patterns, critics say the industry has not communicated these value-added dimensions to con- sumers and differentiated carpet and rugs from other floorcoverings. They note that the industry as a whole spends 2.1 percent of its sales on consumer advertising. For comparison, other manufacturers of consumer durable products, such as household furniture and houschold appliances spend 4.2 percent and 2.5 percent of sales, respec- tively, for advertising. Instead, price had become the dominant marketing tool for much of the past decade and manufacturers focused attention on cost reduction and achieving economies of scale. A result of these efforts was an erratic upward trend in dollar sales over the past decade but marginal profitability for the industry as a whole, Competitors The U.S. carpet and rug industry is undergoing a period of consolidation begun in the mid-1980s. Mergers, acquisitions, and bankruptcies among manufacturers brought about by declining demand for carpet and rugs, excess manufacturing capacity, and dwindling profit margins reduced the number of carpet and rug manufacturers from more than 300 in the mid-1980s to about 100 companies in early 2000. This number includes 96 U.S.-based companies and 4 Canadian-based companies, most of which are privately held companies. Mergers and acquisitions since 1995 reflected a push to build further economies of scale in the production and distribution of carpet and rugs. By 1999, it was estimated that 10 companies in the industry produced 91 percent of carpet and rug sales in the United States. The sales distribution in the residential segment was even more skewed, Three companies-Shaw Industries, Mohawk Indus- EXHIBIT 1 1995 1994 U.S. Floorcovering Market Shares and Dollar Sales at Manufacturer Prices Market Share Floorcovering Type 1999 1998 1997 1996 Carpet and rug 68.1% 70.8% 71.1% 72.9% Resilient/vinyl 10.5 11.6 12.5 13.5 Hardwood 8.0 7.6 7.5 6.9 Ceramic tile 9.4 7.0 6.7 5.0 Laminate 4.0 3.0 2.2 1.7 100.0% 100.0% 100.0% 100.0% Total Mftr. sales ($ in millions) $17,166 $15,436 $14,422 $13,893 73.4% 14.5 6.4 4.6 1.1 100.0% 73.6% 14.5 6.1 5.0 .8 100.0% $13,344 $13,509 tries, and Beaulieu of America-accounted for about 85 percent of U.S. residential carpet and rug sales. The U.S. industry sales leader is Shaw Industries, with 1999 sales of $4.1 billion. The company also has the distinction of being the largest carpet and rug manufac- turer in the world. Exhibit 2 lists the top 20 North American floorcovering manufac- turers based on annual sales in 1998 and 1999. Wholesale and Retail Distribution Wholesale and retail distribution in the U.S. carpet and rug industry has undergone three distinct changes since the mid-1980s. Mid-1980s: Direct Distribution in the mid-1980s, the largest carpet and rug manufac- turers began to bypass floorcovering wholesalers (distributors) and sell directly to retail- ers in greater qumbers. In many instances, direct distribution involved establishing sales offices located in manufacturer-operated distribution centers. The intent was to capture the margins paid to floorcovering wholesalers and offset declining and often negative manufacturer profit margins at the time. Lacking the capital to invest in distribution cen- ters, smaller manufacturers continued to rely on floorcovering wholesalers that were increasingly expanding their product line to include ceramic, hardwood, and resilient floorcoverings. Although no statistics were available, it was believed that the majority of carpet and rug sales for residential use were distributed through company distribution EXHIBIT 2 WEST Sales of the Top 20 North American Floorcovering Manufacturers in 1998 and 1999 Sales ($ in Millions, United States only) Manufacturer 1999 1998 1. Shaw Industries $4,108 $3,542 2. Mohawk Industries 3,083 2,639 3. Armstrong World Industries 2,221 2,075 4. Beaulieu of America 1,850 1,500 5. Interface Flooring 745 780 6. Mannington Mills 532 475 7. Dal-Tile 510 450 8. The Dixie Group 457 415 9. Lear Corporation 440 405 10. Burlington Industries 425 410 11. Milliken Carpets 315 290 12. C&A Floorcoverings 275 170 13. Congoleum 246 14. Kraus Carpet 200 185 15. Royalty Carpet Mills 179 163 16. Springs Industries 167 155 17. Gulistan Carpet 163 155 18. Wilsonart 130 95 19. J&J Industries 125 120 20. The Burruss Company 102 93 259 centers to retailers by 1990. However, the majority of carpet and rug manufacturers still used floorcovering wholesalers. Distribution through floorcovering wholesalers remained popular with the major- ity of carpet and rug manufacturers because of the retail distribution of residential car- pet and rugs. In the mid-1980s, independent (and often small) floorcovering specialty stores were responsible for 58 percent of residential carper and rug sales volume. Department stores and furniture stores accounted for 21 percent and 19 percent, respectively, of residential sales volume. Mass merchandisers, chain stores, and discount stores were relatively minor retail outlets for carpet and rugs until the early 1990s. Early 1990s: Wholesale and Retail Consolidation The early 1990s was marked by a second significant change in wholesale and retail distribution for residential carpet and rugs in the United States. Department stores, furniture outlets, and independent retail stores were being replaced by large mass-merchandise and discount stores (Kmart and Wal-Mart) and later by home centers such as Home Depot. The growing number of large retailers that were capturing an increasing share of residential carpet and rug sales spawned a new phenomenon in the retail floorcovering industry among specialty outlets: the buying group. A retail buying group is an organization of simi- lar retailers that combine their purchases to obtain price (quantity) discounts from manufacturers. These pooled purchases allowed independent specialty floorcovering retailers to buy less inventory per order while still getting a lower price, which reduced their costs and pressure for markdowns caused by overordering. Lower car- pet and rug cost plus an emphasis on service gave independent specialty floorcover- ing retailers a basis with which they could compete against their larger competitors. Logistical aspects of shipping and storing inventory varied from group to group. Some buying groups took physical custody of goods through a central warehouse which often replaced floorcovering wholesalers. Others simply requested manufac- turers to deliver the goods directly to buying-group members from the manufac- turer's millor distribution center. By 1995, three retail buying groups--CarpetMax, Carpet One, and Abby Carpets- registered $3 billion in floorcovering purchases. Another 10 smaller buying groups made another $1 billion in purchases. According to one industry observer, almost one- half of all U.S. residential carpet and rug sales volume was accounted for when buying group purchases were combined with those of large to medium-size carpet store chains (e.g., Carpet Exchange), mass merchandisers and discount stores, and home centers (e.g., Home Depot). Although estimates varied, about 40 percent of the roughly 23,000 retail outlets that carried carpet and rugs were members of buying groups, large mass- merchandise, discount, or home center chains. By 1999, CarpetMax, Carpet One, and Home Depot would account for 45 percent of total U.S. floorcovering sales. Increased consolidation of retail purchasing evident in buying groups, chain stores, and large mass-merchandise, discount, and home center stores had either a positive or a negative effect on manufacturers. Even with price discounting, and assuming the retail buying organization operated a central warehouse, it was easier and less expensive for a manufacturer to supply one location with large orders than to supply several sepa- rate retailers with smaller orders. On the other hand, if a buying organization flexed its buying power and persuaded manufacturers to take lower-than-normal margins (prices) and ship to diverse locations, a manufacturer risked seeing a lower dollar vol- ume and profit. Direct distribution by manufacturers in the mid-1980s followed by consolidated purchasing and warehousing by retailers in the early 1990s put many floorcovering wholesalers in a precarious position in the residential segment of the carpet and rug industry. Wholesalers that typically served small and medium-sized independent floor- covering specialty stores were particularly vulnerable to the ascension of retail buying groups that operated their own warehouse facility. These wholesalers advocated their role in distribution to both manufacturers and retailers. They argued that working with a buying group was worthwhile to a manufacturer only if the functions performed by the buying group were not only better than those offered by floorcovering wholesaler but also significant enough to justify the price discounts demanded by a buying group. Similarly, they argued that retailers benefited from wholesaling functions above and beyond the warehousing function. Nevertheless, the absolute number of floorcovering wholesalers had declined in recent years and was expected to decline further. The share of wholesaler floorcovering sales was projected to decline from 26 percent in 1995 to less than 23 percent in 2000. Mid-1990s: Forward Integration into Retailing In late 1995, the carpet and rug industry watched as yet another change in distribution practices unfolded. On December 12, 1995, Shaw Industries, the largest carpet and rug manufacturer and sales leader, announced plans to engage itself directly in the residential and contract segments of the floorcovering industry. It would do this by operating its own retail stores and commercial dealer network. In announcing this initiative, Robert E. Shaw, the President and CEO of Shaw Industries, said: We have realized for some time that the manufacturer must become significantly involved in the retail environment to enhance the viability of our industry Today, our industry offers products of exceptional quality and unsurpassed value, yet we con- tinue to lose consumner dollars to other product groups. Moreover, because con- sumers have traditionally price-shopped our products, profits have stagnated for years, from fiber producer to manufacturer to retailer. Although our industry has matured considerably in recent years, the current struc- ture cannot address many fundamental problems the industry is facing. A manufacturer- dealer affiliation was inevitable, since the only practical way to improve these adverse conditions is by consolidating the combined resources of the two.? Shortly afterward, Shaw Industries announced that it had purchased a number of com- mercial carper dealers and contractors and Carpetland USA, a retail chain of 55 stores. In response to this initiative, Home Depot dropped Shaw Industries as a carpet and rug supplier and switched to Mohawk Industries. Carpet One and Abbey Carpets, two buying groups, asked their members not to do business with Shaw. Other carpet manufacturers courted floorcovering specialty stores with promises to support them with product and not to enter the retail market as competitors. Shaw Industries countered these actions by creating its own retail buying group ---the Shaw Alignment Incentive Programn-which operated 275 retail stores in 26 states with annual sales of $575 million by mid-1998. Then, in June 1998, Shaw Industries announced it would sell off its retail stores to the Maxim Group, the owner of CarpetMax floorcovering stores, for about $93 million.In 1999, Home Depot was again carrying Shaw carpet. R THE COMPANY Masterton Carpet Mills, Inc., is a privately held manufacturer of a full line of medium- to high-priced carpet primarily for the residential segment. The company markets its products under the Masterton and Chesterton brand names. Contract sales to insti- tutions and businesses are also made but account for only 28 percent of company sales and occur principally in the southeastern United States. The company had no export sales. Total company sales in fiscal 2000 were $75 million, with a net profit before tax of $3 million. Exhibit 3 shows abbreviated company financial statements. Masterton Carpet Mills currently distributes its line through seven floorcovering wholesalers located throughout the United States. These wholesalers, in turn, sup- plied 4,000 retail accounts, including department stores, furniture stores, and floor- covering specialty stores. Inspection of distribution records revealed that 80 percent of residential segment sales were made through 50 percent of its retail accounts. This relationship exists within all market areas served by Masterton Carpet Mills. Meadows believed these sales-per-account percentages indicated that at the retail level the company was gaining adequate coverage, if not overcoverage. The review of distrib- ution records also indicated that it cost Masterton Carpet Mills 6 percent of its resi- dential segment sales to service the seven floorcovering wholesalers Advertising by Masterton Carpet Mills appeared primarily in shelter magazines and newspapers. The emphasis in advertisements was on fiber type, colors, durabil- ity, and soil resistance. A cooperative advertising program with retailers had been expanded on the basis of Goldman's recommendation. According to Goldman, "The coop program is being well received and has brought us into closer contact with retail accounts." The company employed two regional sales coordinators, who acted as a liaison with wholesalers, assisted in managing the cooperative advertising pro- gram, and made periodic visits to large retail accounts. In addition, they were respon- sible for handling contract sales for institutions and businesses. Floorcovering wholesalers played a major role in Masterton Carpet Mills' market- ing strategy. Its seven wholesalers had long-term relationships with the company. Two had represented Masterton Carpet Mills products for over 30 years, four had been with the company for 20 to 25 years, and one had been with the company for 10 years. Masterton Carpet Mills' wholesalers maintained extensive sales organizations, with the average wholesaler employing 10 salespeople. On average, retail accounts received at least one sales call per month. Goldman's carlier evaluation of the sales program revealed that wholesaler sales representatives performed a variety of tasks, including EXHIBIT 3 Masterton Carpet Mills, Inc. Financial Statements (For the Fiscal Year Ending June 30, 2000) Income Statement Net sales Less cost of goods sold Gross margin Distribution expenses Selling and administrative expenses Other expenses Net income before tax $75,000,000 56,250,000 $18,750,000 $2,250,000 11,250,000 2,250,000 $ 3,000,000 Balance Sheet Current assets Fixed assets Total assets Current Liabilities Long-term debt and net worth Total liabilities and net worth $26,937,500 24,000,000 $50,937,500 $10,312,500 40,625,000 $50,937,500 checking inventory and carpet samples, arranging point-of-purchase displays, handling retailer questions and complaints, and taking orders. About 25 percent of an average salesperson's time was spent on nonselling activities (preparing call reports, acting as a liaison with manufacturers, traveling, and so forth). About 40 percent of each one- hour sales call was devoted to selling Masterton Carpet Mills carpeting; 60 percent was devoted to selling noncompeting products. This finding disturbed company manage- ment, which felt that a full hour was necessary to represent the product linc. In addi- tion to making sales, wholesalers also stocked carpet inventory. Masterton Carpet Mills' wholesalers typically carried sufficient stock to keep the number of their inventory turnovers at five per year. Masterton Carpet Mills' executives felt that inventory levels sufficient for four turns per year were necessary to service retailers properly, however. Finally, wholesalers extended credit to retail accounts. In return for these services, wholesalers received a 20 percent margin on sales billed, at the price to retailers. At a June 2000 meeting with its wholesalers, Masterton Carpet Mills executives were informed that several wholesalers were feeling increased pressure to shave their profit margins to accommodate retailer pricing demands. It seemed that an increas ing number of their retail accounts had joined regional retail buying groups and were seeking price breaks comparable to those made possible through their group pur- chases. Subsequent probing on this topic led Masterton Carpet Mills executives to conclude that about 1,200 of the company's current retailers were members of buy- ing groups, they represented about a third of the company's residential segment sales. The meeting concluded with Masterton Carpet Mills executives agreeing to consider a reduction in its price to wholesalers that could be passed on to retailers. At the same time, wholesalers agreed to consider a modest reduction in their margins as well. The "Margin Sharing" proposal, so named by a wholesaler, would be given top billing at the next meeting in January 2001. In the meantime, price accommodations would be made where and when it was necessary to meet the competition. 1 DIRECT DISTRIBUTION EXPERIENCE OF COMPETITORS Following her meeting with Meadows, Goldman sought out information on competi- tors' experience with direct distribution. Despite conflicting information from trade publications and knowledgeable industry observers, she was able to arrive at several important conclusions. First, competitors with their own warehousing or direct distri- bution operations located them in or near seven metropolitan areas: Atlanta, Chicago, Dallas-Fort Worth, Denver, Los Angeles, New York City, and Philadelphia, Masterton Carpet Mills had wholesalers already operating in these metropolitan areas, except for Dallas-Fort Worth and Atlanta. The company serviced these two areas from wholesalers located in Houston, Texas, and Richmond, Virginia, respectively. Second, a minimum volume of approximately $5 million in wholesale sales was necessary to operate a warehouse operation economically. The average warehouse operation could be operated at an annual fixed cost (including rent, personnel, operations) of $700,000. Goldman was informed that suitable warehouse space was available in the metropolitan areas under consideration; therefore, the company would not have to embark on a building program. Third, salaries and expenses of highly qualified sales representatives would be about $70,000 each annually. One field sales manager would be needed to manage eight sales representatives. Salary and expenses would be approx- imately $80,000 per field sales manager per year. Sales administration costs (including fringe benefits) were typically 40 percent of the total sales force and management costs per year. Delivery and related transportation costs to retail accounts were estimated to be about 4 percent of sales, and inventory and accounts receivable carrying costs were 10 percent. Retail accounts receivable take about 90 days to collect, on average. Though these figures represented rough approximations, in Goldman's opinion and in the opinion of others with whom she conferred, they were the best estimates available. In late September 2000, just as Goldman was about to draft her position paper for Robert Meadows, she received a disturbing telephone call from a long-time successful wholesaler of the company's products. The wholesaler told her that he and others were disappointed to hear of her inquiries about direct distribution possibilities given what transpired at the fune meeting. Through innuendo, the wholesaler threatened a mass exodus from Masterton Carpet Mills once the first company warehouse opera- tion was opened. He implied that plans were already under way to establish a trade agreement with a competitor. This conversation would have significant impact on her recommendation if direct distribution was deemed feasible. In short, a rollout by mar- ket area looked less likely. A rapid transition would be necessary, which would require sizable cash outlays and an aggressive sales force recruiting program