A new model of business or MRO paper tiger?
By Scott Benfield
There has been much attention to the recent announcement of Amazon.com’s entry in the industrial distribution space. The Seattle based e-commerce and distribution firm, best know for its book sales, recently announced entry into the MRO space. Titled AmazonSupply, the entity touts half a million SKUs within two-day delivery time. Internet threads have been busy speculating on the relative success of an untried entry into the century-old industry. The intent of this article is to give a detailed and balanced review of Amazon’s strategy and what awaits them and their competitors.
Market Size, Ordering Preferences, and Technology
The MRO marketplace is massive. Recent estimates place the total market size at $110 billion. With a market of this size and complexity, it is no wonder that leviathans such as W.W. Grainger have less than 10% of the available market. The configurations of product and service are seemingly endless in a sizable market with many needs.
Distributors compete along numerous lines of product specialization, technical support, market proximity, and breadth, width and depth of inventory. These product and service permutations allow for numerous distributors to successfully compete in the MRO space. There has, however, been a shift in the value proposition in B2B channels that gives AmazonSupply a chance to bypass elements of traditional distribution.
As technology has increased information, transportation and ordering capabilities, the need and want of the local branch has diminished in value. Traditional wholesalers are branch-intensive with numerous branches, branch managers, product specialists and sales support in the branch. In decades past, the customer relied on local inventory, a local product knowledge expert, and sales support. Today, however, customers often Google product functionality or access the manufacturer’s Web site for technical information.
The permutation and expansion of shipping options - including parcel post, air freight, messenger service and cross-docking - gives the customer significantly more options for delivery. Reliance on the local branch, in all but spot buys, has diminished the need for local inventory. This value migration means that new entrants lacking these services aren’t necessarily out of the picture. In fact, as product platforms have matured and prices have fallen on core commodities, the chance for new entrants without the traditional tenets (and costs) of value have emerged. For AmazonSupply, not having local branches, sellers, and varying means of shipping can be an advantage as significant cost is tied up in service variations of place, technical expertise, sales support and delivery options.
The way products are ordered is also undergoing a change that favors e-commerce based suppliers. Recent research from the NAW’s Facing the Forces of Change finds that approximately 50% of wholesalers use e-commerce as an ordering option, with 32% of wholesalers admitting the technology is used in search(es) for alternative products. Current research finds that B2B buying relationships via the Internet will increase at an increasing rate, as Generation Y workers (DOB 1980s-1990s) enter the workplace. One of the demographic traits of Generation Y workers is that they prefer ordering over the Internet and don’t necessarily respond to personal selling as a way to conduct business. Additionally, trends in e-commerce find that buyers are looking to alternative channels for products as they search for different and often less expensive value propositions from non-traditional vendors.i
Because of changes in ordering technology, access to information, and advances in logistics, the traditional value proposition for wholesalers has migrated to a less personal and less costly supplier platform where purchasing and sourcing decisions are increasingly based on variables less related to personal selling and location. E-commerce, Web site content, robust search logic and access to price and availability will increase as a new generation of buyers, born into new technology, enter the workplace.
Cost Advantages of E-Business Relationships
Operating expenses for much of wholesaling’s century-old existence have held much less interest than top-line sales and gross margins. This is all but assured by sales cultures that reward a substantial part of income on margin dollars. As products have matured, globalization of manufacturing has grown, and price and availability are displayed across the Internet, our research points to operating expenses undergoing significant rationalization and change.
The globalization of manufacturing has created an explosion in product choices for distributors. Our research of four years ago, Disruption in the Channel, found that distributors had a dizzying choice of options for private label products and the average landed cost was 30% less than comparable, long-term branded suppliers, regardless of their country of manufacture. Our follow-up research finds the pricing advantage is still intact, with importers and wholesaler-direct buying relationships flourishing. But a decrease in price is not the only pressure on product pricing that wholesalers have to contend with.
After the Great Recession, and in a slow growth economy where GDP is forecasted to stay in the 2.5% range for the future, customers are now value shoppers; they flock to the Internet to search for the best value. As the saturation rate of e-commerce storefronts has reached the 50% rate, and auction pricing via e-mail is commonplace, buyers have a bevy of product and price configurations to contend with. We often find where buyers demand the best Internet price from their supplier while taking the full bundled service offering. Many wholesalers don’t have detailed cost-to-serve allocations to understand how to unbundle services and therefore offer a costly service platform in an industry that is increasingly value shopping and using technology to do so.
As product costs come down and value buyers proliferate, the margin dollars to fund the organization decrease or become more scarce. Without detailed and accurate reviews of various service bundles and their costs, wholesalers literally destroy value, as full-service offerings cost more than margin dollars yielded by the sale. In two recent and different studies, wholesalers were found to destroy value as their capital investments and service costs exceeded their net income.ii The research points to wholesalers destroying free cash flow, which is the foundation of shareholder value. The use of a full-service offering in a value-sensitive world with near perfect information on price and availability is, from the available evidence, a substantial part of the problem. Many wholesalers won’t, however, correctly identify the problem (full-service offering) from the symptom (low earnings) and we feel they will incorrectly add more services and literally sell and service themselves into low earnings and negative free cash flows for the foreseeable future.
Amazon’s advantage, in industrial supply, appears to be a significant operating cost reduction per transaction over full-service, traditional rivals. Amazon offers no outside sales and has, as of the most recent count, 26 fulfillment centers covering North America. The AmazonSupply operation ostensibly uses most or all of the fulfillment centers to support the forecasted $50 billion-plus in sales for 2012. Our recent call to AmazonSupply inquiring about prices for a seven-figure MRO client found that the price listed was, according to our inside seller, non-negotiable. Our further checking on pricing for power tools found they were competitive and a tad south of parity pricing across other Internet advertised sites. Our research in e-commerce stock transactions not supported by inside and outside sales forces, finds that, on average, they are $50 less than full sales-supported transactions. Overall, fully supported inside and outside sales costs for traditional distributors typically range from 35% to 50% of operating expenses.
Amazon does not have the plethora of brick-and-mortar locations common to traditional wholesalers and doesn’t offer counter service or spot buys. Brick-and-mortar facilities for traditional wholesalers typically range 2% to 4% of sales. Spot buys for traditional wholesalers often destroy value, as they don’t generate sufficient margin dollars to cover their fulfillment costs. We believe Amazon understands, quite well, their supply chain costs and has numerous ways of structuring the buying channel to compensate for costly and low-value transactions including non-stock specials and small revenue size transactions. One should remember that Amazon has been profitable in distributing books where the average transaction size for a new print is less than $30. Too, they successfully develop linkages with numerous small suppliers who perform the fulfillment while Amazon’s value in the channel is as a lead generator and transaction portal. Finally, Amazon is highly automated and recently spent $775 million for Kiva systems, a manufacturer of warehouse robots with the explicit intent of using the acquisition to improve “warehouse capacity and efficiency.” iii
New Knowledge and Making Financial Sense of Amazon
The knowledge of marketing on the Web and via e-commerce is less than two decades old. Amazon was taken public in 1997 and has had 15 years to learn about personalizing the shopping experience via the Web and supporting knowledge of performance algorithms, customer score rankings, and purchasing suggestions based on prior usage. The field of marketing automation where leads are scored, qualified and converted via “drip” campaigns is foreign to most sales-intensive distributors. For Web marketers, however, these concepts are crucial to the success or non-success of their business. Wholesalers that successfully compete against e-commerce offerings will need to understand these concepts and how to use them against firms that are substantially ahead in experience.
Making financial sense of Amazon from publicly available data is more an exercise in faith than realizing value from traditional due diligence. The firm currently has an operating profit in the 1.5% to 2% of sales range. This, according to guidance, is expected to fall as Amazon recently announced the building of 13 new fulfillment centers in 2012.iv Currently, the stock price is 180 times trailing earningsv and the stock recently jumped because of an increase in gross margins. If one is to buy into the vision of Bezos, where traditional brick-and-mortar industries with outdated cost structures are vulnerable to the Amazons of the world, then one can conceivably justify the sky-high stock valuation.
Separating Amazon from Changes in the Distribution Channel
Whether or not one can support Amazon’s stock price with the fundamentals is less of an issue than the overall success of their strategy. Amazon has, without a doubt, shown that a well-planned, cost-effective and detailed understanding of transaction costs combined with an online business model can upset traditional labor intensive brick-and-mortar establishments. Wholesale distributors will need to understand how to use e-commerce and new economics of transaction costing to drive cost out of their platform. Our research leads us to a dismantling and reformation of traditional value streams and away from the full bundling of services offered by most distributors. The disciplines to operate in this new world include accurate cost-to-serve allocations that measure labor capacity, robust e-commerce models combined with automated marketing techniques, and management that understands how to get cost out of the channel while delivering a buying experience that ensures repeat business. The adaptation of these new bodies of knowledge by wholesalers is just starting. A few firms, including Grainger and MSC Industrial, have experience and success in this venue. More traditional firms in smaller vertical markets have a bit more time but should be searching for solutions on unbundling service platforms and reforming them for a better and less costly value proposition.
The article includes excerpts from Benfield Consulting’s new book, BuildingValue, Driving Wholesaler Returns Through Strategic and Tactical Investment, now on sale at benfieldconsulting.com. Scott Benfield is a consultant for distribution channels and can be reached at email@example.com or (630) 428-9311.
ii Benfield, S. “Bad Structure and the Battle for Capacity,” White Paper by Benfield Consulting, www.benfieldconsulting.com/uploads/battleforcapacityandstrategyby20207.pdf, page 1, March 2012.
The problem with local stores is that distributors lose money with most of their spot buy sales. Hence the value bundle of different types of transactions, supported by outside sales forces, is being undone in distribution as it is simply too expensive. Amazon has no outside sellers, few inside sellers and no branch managers. Yet, they are expected to thrive in the MRO space. So, people may shop locally as long as they are OK with paying a higher price for bricks and mortar and lots of sales support. My bet is that they will increasingly move away from the old value chains of wholesale to new value chains that are a lower cost and lower price.
Interesting thesis, but going by your analysis, you don't believe people will shop locally going forward? Can anything beat instant gratification?
Other markets (media) have been revolutionized and industries disrupted by the Internet. Ecommerce is a part of our lives, driven by convenience and selection. It's staying and has to be embraced.
But with stores, as Apple has proven, you have an opportunity to both offer instant gratification and a physical connection with customers.
They've shown the world that those who both sell good products and a good shopping experience can still enjoy customer satisfaction AND profits.
That's the key here for merchants; a good customer experience every time they shop, and off course, good products.