In the preceding year, this blog has explored the growing trend of cost coming out of the wholesale channel at a rapid pace. The research supporting channel cost excess is best summed up in last year’s Georgia Tech’s Financial Lab research, which examined more than 100 public wholesale entities for their free cash flow profile. The analysis found that wholesalers are, as a whole, producing a negative free cash flow profile of 7%, which put the industry at 39^th of 44 sectors.

A negative free cash flow profile means that, more often than not, investments for growth don’t cover the weighted average cost of capital for the firm.[i]  The research also found that nearly half the firms are increasing borrowings to grow the business as their investments aren’t producing returns above their capital costs. Extended into the future, this mode of growth funding will be unsustainable as the firm’s access to capital is limited when loan covenants are breached. The upshot of a negative free cash flow profile is that the wholesale firm literally borrows money to lose money on its investments in capacity and assets for future growth.

The measurement of free cash flow is a well-accepted financial principle and the basis for value. It is not a straightforward concept as compared to bench-marking business progress from the income statement and hence is seldom used by managers.  However, free cash flow is a fundamental measure of value creation and the negative profile for the industry, from a sample of more than 100 companies, signals that the current growth path  is unsustainable. 

Service cost and business structure

Our review of the Georgia Tech research helps explain an issue that has formed in our field work since 2006. In a dozen transaction audits where we allocated operating expenses to varying transaction types, we found where 40% of the customers comprise 130% of the operating profits. Some 20% of the customers generate a low rate of profit but below a weighted average cost of capital of 8% while 40% of the accounts do not cover their fulfillment (allocated) costs. In short, a full 60% of customers destroy financial value and these observations are, in large measure, corroborated by outside research done by Jonathan Byrnes of MIT.[ii]

The major outtake of the audits is that distribution is a business structure where a minority of the customers pays for the majority. More in-depth study found where transaction size in margin dollars, type of transaction and mix of transactions has a significant effect on the long-term value of the wholesale firm. In particular, counter transactions and non-stock transactions are overwhelmingly negative profit producers.  Counter sales are simply too small to generate enough margin dollars to cover fulfillment costs, and non-stock orders are very expensive and don’t generate sufficient margins to cover increased processing costs. In this type of “Robin Hood” existence where value-generating customers cover value-destroying customers, slight changes in the 40% average has a tremendous effect on the overall value of the firm.

In building products wholesaling, the cross-subsidizing structure has existed for the better part of a century before being challenged by lower cost structures. In the past 15 years, the use of e-commerce, along with global supply chains, better flow of information and advanced logistics, has created an environment where the basic wholesale architecture and supporting costs are under siege. The siege is accelerated by the ability of the customer to easily check price and availability with handheld devices as was found by EMA Associates’ research of 500 contractors’ buying habits. In both building contracting and MRO markets that utilize outside contractors, 58% of the firms and journeymen use handheld devices for searching  price and availability. The upshot, for all wholesale firms, is that as e-commerce and its access become more prominent, pricing becomes a more important factor in the buying decision. Our research in industries where e-commerce is the dominant means of transacting business finds that price often falls or, at the least, flattens. As pricing information becomes more readily available, it becomes increasingly difficult to hide inefficiency.

Technology and outside entrants

Amazon Inc. started in the mid-1990s. Today, the company generates more than $50 billion in sales with growth largely being organic. The firm has a reputation of delivering low-cost product and bypassing traditional brick-and-mortar industry. The company’s reputation and business model are enviable. In spring 2012, Amazon Inc. announced an entry (Amazon Supply) in the MRO markets traditionally served by wholesale distributors. Additionally, the firm has a contractor site that, as of the last review, is in beta test.

Amazon is an example of a growing type of distributor we’ve termed as transactional. Transactional distributors have little in the way of traditional services of wholesaler distributors including scant sales effort, local branches and shipping fleets.  Instead, transactional wholesalers have e-commerce for solicitation and customer service efforts, they use large distribution centers for aggregating and shipping orders and outside fleets for delivery. In addition, they source more products as private-label brands from overseas. Numerous studies find that transactional distributors go to market at 20% to 30% less than traditional distributors and often earn higher pretax returns.

As transactional wholesalers make significant use of technology including e-commerce, cost-to-serve accounting system(s), large logistic centers and outside logistic carriers, they come under the cost umbrella of traditional wholesaling. In Exhibit 1, we see a comparison between a full-service (traditional) wholesaler on the right and a transactional distributor on the left. Exhibit 1 starts with a traditional distributor’s sales of $100 with $75 cost of goods, $25 gross margin and $22.50 in operating expenses for a pretax return on sales of $2.50. This example is  an approximate income statement model for traditional distribution. On the left-hand side, we view a transactional distributor where price has been discounted 20% to $80. In addition, the cost of goods is $64 and reflects a 30% buy-side advantage from off-shoring for half of the traditional vendor base.  Margin dollars are 20% of sales but operating expenses are 15% of sales and reflect the use of technology to supplant distributor operations. The bottom line of the transactional distributor is $4 or 5% of sales and double that of the full-service firm.

As we go forward in distribution markets, through the end of the second decade of the new millennium, we fully expect for transactional models to become more mainstream and at the expense of full-service distribution. Our current research, using U.S. Census and Bureau of Economic Analysis statistics, finds that durable goods wholesale distribution has declined as a percent of GDP from 20% in 1995 to about 14% by 2010.  Sifting through the data and in conversations with large manufacturers who sell through distribution, we find that traditional wholesale channels have lost sales to other lower cost models of distribution. These models include new age e-commerce entities and also traditional retail firms (Home Depot, Lowe’s, etc.) that have lower cost and lessened service offerings. In essence, traditional full-service distribution appears to be in a slow, protracted decline. The weakening of the full-service model resembles the frog in the proverbial pot of lukewarm water; the heat is slowly turned up and by the time the frog realizes he’s the meal of the day, it’s too late. However, we are encouraged that a growing cadre of wholesalers are questioning the basics of their business model and are beginning to make changes to reduce service costs for the long run including matching service provision to what the customer expects and more in line with that offered by transactional entities.

Sayonara to the local branch, or not?

Given that transactional distributors are growing at the expense of traditional wholesalers, it is appropriate to ask what do wholesalers need to change. In the world of e-commerce solicitation and transactions, brick-and-mortar intensive industries are those that suffer. The graveyard of brick-and-mortar hard goods retailers is growing. A recent list of retailers from office supplies and electronics to clothiers finds many well-known retail entities announcing to shareholders upwards of 2,700 store closings for 2013.[iii]  Unknown to many wholesalers, leading industrial distributor Grainger closed approximately 17% of its brick-and-mortar locations from 2007-2011.[iv] This coupled with comments from Wolseley’s Ian Meakins on resource allocation within the “branch portfolio” to the “best” branches from “weaker” branches[v] lends credibility for focusing on brick-and-mortar investment and its importance in long-run profitability.

In decades past, greenfield sites were a common and favorite means of growing the distributorship but, today, there are scant net new branches added by wholesalers. Increasingly, we see branch location and presence of brick-and-mortar sites as an expense that wholesale executives will scrutinize. And, if the physical branch is not needed, it will be closed with resources being deployed to branches that have better financial performance  or other means to market including e-commerce. If wholesalers are skeptical of investing in e-commerce, they should access the online video of Ian Meakins at Wolseley’site (www.wolseley.com) where they will find the CEO mentioning that the company invested about $33 million in the company’s e-commerce efforts.

Branches provide a counter solution to the spot buy. No matter how well a customer plans work, there is inevitably a need for emergency service to procure an item that is not on hand. In the past, the counter and counterman were the best solution for this. However, Amazon recently announced same-day service which, based on initial review[vi] , will pose a threat for competitors who rely on brick-and-mortar sites to serve the spot buy. It is now possible, using distribution centers and outside logistic carriers, to service customers the same day without traditional branches and their counters. Lest the reader forget, we reiterate that our work in measuring the profitability of counter sales finds they are too small to cover fulfillment costs and are, in aggregate, negative profit transactions. There has been no exception to this since our transaction audits began seven years ago.

If wholesale brick-and-mortar sites decline, as we believe they will, yesteryear’s mindset of the branch manager as an employee who drives local strategy will need to be rethought. In a world with less traditional branches, how much time and energy need to be spent on the branch manager? Increasingly, we view popular titles that extol the wisdom of investing in the branch manager position as yesteryear’s fare. The fact that this fare is actively advertised by leading educational bodies speaks more to dogmatism and patronage than to relevant research that challenges and leads wholesalers in a new age. Wholesalers would do well to question much of the existing knowledge, “how to” literature and research. Too often we believe it seeks to affirm the existing business and is a questionable investment in a time when operating efficiency is front and center. We’ve yet to find transactional distributors who are leading supporters of existing knowledge and research and who actively attend industry functions.

Not all branches will succumb to outside cost pressures brought about by new technologies. In industries where the physical characteristics of handling the product are difficult and costly, we expect branches to survive. However, even where these industries exist (pipe for instance), the smaller items can be serviced from a distribution center with outside logistical providers. 

For 2013, our forecast is for a continuation of low-cost operating models to unseat full-service distribution. Some of these models will come from the outside and the more progressive wholesalers will develop accurate cost-to-serve models, apply technology and new knowledge to the operating platform and reduce costs accordingly.  As productivity is increased, the cost advantages will find their way to the marketplace and, to quote the decades-old axiom, “The low-cost producer will win.”

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