Uh-oh! Where did my distributor go?
by Scott Benfield
Durable goods manufacturers have enjoyed a stable, profitable relationship with wholesale distributors for decades. While there were isolated incidents of channel conflict in the past, the coming decade promises “perfect storm” conditions for an all out shooting war. Navigating the storm will require the best of manufacturer marketers and channel managers; no one will be left unscathed.
Durable goods distribution is an approximately $2 trillion sales entity of the U.S. GDP. Many distributors have been in business for a century, with the industry tracing its earliest roots to supplying Union factories in the Civil War. In a world of globalized manufacturing, real-time information technology at one’s fingertips, third-generation family firms, and a slow growth GDP, distributors have change thrust upon them. Many firms will not survive in their current form. An increasing number of distributor firms will sell out, import new management, or simply liquidate for asset value; some will become competitors. The risk for established manufacturers is immense.
Globalized manufacturing has been a boom market for most Fortune rated U.S. manufacturers, with most firms earning approximately 40% of profits from overseas.i In the early years of the move overseas, manufacturers were able to reduce product costs and sell existing product lines in mature U.S. markets at established prices, which made gross margins balloon, in many cases, to 40%, 50% or more. Our research in 2008, however, found that distributors were sourcing foreign goods at a growing rate, with landed cost advantages that averaged 30% less than branded products often originating in the same country. Today, most distributors source some level of private label products with larger wholesalers establishing direct supply chains with foreign manufacturers.
Wholesalers that direct-source goods, according to a recent posting by channel consultancy Frank Lynn & Associates, are competitors.ii The first part of the perfect storm for manufacturers stems from globalized manufacturing:
1) If you are trying to reap inordinate profits from mature, easily copied product lines, don’t be surprised if your distributor direct sources the item and, overnight, becomes your competitor. Also, as a corollary, if you are a service provider to distributors and have an inordinately high price relative to the competition, you should be able to justify value. This foreign sourcing trend will rise over time as many manufacturers too often “milk” product lines that have numerous supply chain redundancies. This further inflates distributor cost, making them uncompetitive in an increasingly value sensitive market.
The effect of the Internet on distributors is just now beginning to take hold. Some 30% to 40% of distributor orders are transacted via e-commerce.iii As price and availability information is near perfect, distributor customers are taking advantage by checking the best combinations of both variables on hand-held devices. A recent survey of 500 contractors by EMA Associates found that, for the maintenance and construction sectors and where hand-held devices were used, 58% of customers used them to check price and availability. Ergo, distributors are literally under a microscope to keep price competitive. In a razor margin business, the ability to get higher prices, especially on fast-moving items, is negligible, which brings us to caution No. 2:
2) If you can’t keep your high sales/commodity items competitive, don’t expect your distributor to stock them as they really can’t sell them. The fight for margin dollars and requisite skills to manage a distribution business relies not only on purchasing cost but on the distributor understanding and managing service costs. Manufacturers can’t affect this as much as product cost, but they should know how to identify winning partners who are planning for this dynamic and how not to exacerbate the issue.
In a March 2012 survey of 122 public distribution companies, the Financial Analysis Lab at Georgia Tech found that wholesalers were 39th of 44 industry sectors in generating free cash flow. Using a metric called Free Cash Flow Profile (FCP), the research found that wholesalers had a negative FCP of -7%. In essence, distributors weren’t earning enough operating income less taxes to fund investment in capital expenditures for future growth. Half of those surveyed were borrowing to fund growth which, in the long run, is an unsustainable model of business. We narrowed the problem down to a full-service model where distributors are, for all intents and purposes, serving customers with the same group of services. This creates an environment where 40% of customers create value while 60% destroy value.iv The full bundled service model that generates a negative free cash flow won’t last which brings us to the third caution for manufacturers:
3) Prospering and possibly surviving distributors will begin to discriminate services to accounts including sales calls, full technical service, and free deliveries. Manufacturers that insist their distributors add more sellers, make frequent joint calls, and put a full press on leagues of existing and new accounts may find themselves in trouble with their distribution. Distributors have to be very cautious about working with manufacturers and the service cost(s) of the target market. If the target customer(s) can’t cover their service costs, the distributor will walk away or, more likely, say nothing and quietly replace the insistent manufacturer. The negative FCP is a big problem that most distributors are just beginning to understand. Distributors literally invest in customers and market segments and if these entities are perennially negative profit, as many are, distributors have little choice in a slow-growth, value conscious market but to reduce services, as increasing price is less of an option.
The final caution note involves distribution ownership. As the vast majority of distributors are private and family held, they are increasingly at risk of selling or fizzling out and selling for asset value. The cliché is that family firms go from “shirtsleeves to shirtsleeves” in three generations. Using a test basis of 500+ family firms from 1994 to 2000, Harvard professor Belen Villalonga found that “Family management. . .destroys value when descendants serve as Chairman or CEO.”v In family-owned and operated distributor firms there will be much change. Our observation is that family firms with top executive slots dominated by family members begin to run into trouble at the $100MM in sales mark and if changes aren’t made by the $150MM to $200MM in sales size, they tend to enter a spiral of stagnant or decreasing sales and earnings. The cautionary note for manufacturers for distributor firms is:
4) Knowing the management make-up, sales size, and financial performance of distributor partners is increasingly important, especially in firms where executive management is full of family and dominates the C and V level slots. Too often, family firms become captive to extended relative shareholders who are risk averse and fund their lifestyle with dividends. They under-invest in the business and try to preserve performance instead of creating and generating value through ongoing investment. Many of these firms will sell or fizzle out and manufacturers need to know the likelihood of this by distributor and have contingency plans. Often, family distribution firms sell out after years of languishing performance and the buying firm replaces competing brands. Manufacturer marketers who are surprised when their staid old family-run distribution partner sells out and the buying distributor switches out lines simply aren’t doing their job. The signals for this are available years in advance of the event.
These four cautions will become increasingly visible and important as e-commerce, hand-held technology, global manufacturing, and generational family ownership grows. They will be pronounced because of a slow growth economy where the 2% to 2.5% average GDP growth doesn’t cover up problems like the 5.4% average GDP growth did from 1995 to 2007. Manufacturer management, especially C and V level executives and marketing channel managers, should understand these challenges and recognize that many of them are, largely, outside of their distributors’ control. They are the result of technological, global, and generational changes and have matured and become problematic because of a nominal growth economy. There are many things manufacturers can do to both understand and partially alleviate these issues. Qualified channel experts who have worked and advised in B2B channels are a good place to start. Denying or remaining insensitive to these new dynamics, however, will only escalate channel conflict and cost manufacturers profitable sales.
Scott Benfield is a B2B channel consultant for distributors and manufacturers. He has over two decades of site experience with Fortune manufacturing firms in channel management roles and with nationally ranked distributors. He has served mid-cap to large distributors and manufacturers from his Chicago-based consultancy since 1998. He can be reached at email@example.com, (630) 428-9311 or at www.benfieldconsulting.com.
Newman, R. “Why U.S. Companies Aren’t so American Anymore, US News and World Report, June 30, 2011
“Marketing Through Distribution Channels,” Frank Lynn and Associates Newsletter, July 13, 2012.
Benfield, S., Griffith, S. “The Battle for Capacity,” White Paper at benfieldconsulting.com, March 2012.
Ibid, Page 2.
Villalonga, B, Amit, R. “How do Family ownership, control, and management affect firm value?” Journal of Financial Economics, pg. 30, 2006.