After following a yo-yo pattern in the wake of the Great Recession, distributor performance appears to have leveled off. The following analysis by Al Bates, director of research for Profit Planning Group and principal of the Distribution Performance Project, examines key profit drivers in wholesale distribution across 31 lines of trade. This article includes historical data from the past five years and trends in 2014, the latest year for which full data is available.
During 2014 – the latest year for which complete information is available – distributors, as a group, experienced solid sales growth, enough to offset the impact of inflation. But gross margin growth didn’t keep pace with the sales growth, which translates into lower profitability.
The up-and-down pattern over the last several years suggests that real profit improvements are still somewhat illusory.
The following paragraphs review key findings from analysis of key profit drivers across 31 lines of trade. Distributors in all lines of trade share a collective group of problems. There is always price competition, employee productivity and so on. All distributors want to improve internal operations.
Despite this common set of concerns, the underlying economics of distribution vary widely by line of trade. Gross margin across the lines of trade included in this report, for example, range from 6.4 percent of sales to 45.7 percent. Similarly, inventory turnover levels range from 2.4 times to 20.9 times.
Such differences make it difficult, but not impossible, to compare performance across lines of trade. The analysis can’t simply look at how one industry’s gross margin compares to other industries. Some adjustments must be made to allow for direct comparisons (for details on the adjustments, see the methodology section).
Ultimately, factors such as gross margin, operating expenses and inventory turnover come together to determine overall profitability.
This analysis looks at how six components trended in 2014 across three broad distribution industry segments:
- Industrial includes firms selling largely to the factory floor.
- Construction represents firms selling a wide range of building materials and supplies.
- Consumer firms are those selling consumer products or products utilized by retailers of all types.
Return on Assets
The best measure of financial performance is return on assets (ROA). This is calculated by taking pre-tax profits and dividing by total assets. The least-profitable industry in this report produced an ROA of 4.3 percent in 2014; the highest-ROA industry comes in at 19.2 percent. These are fundamental differences in performance.
The ROA differences between industries are almost entirely structural, or due to factors such as the barriers to entry, the degree of commoditization and the underlying growth rate for the products being distributed.
Structural factors tend to be locked in place. An industry plagued by a lack of barriers to entry is unlikely to become a competitively isolated one any time soon. As a result, some industries will be more profitable than others, probably into perpetuity. The role of management is to utilize the critical profit variables (CPVs) – such as gross margin or inventory turnover – to produce the highest possible ROA within the constraints of the industry.
Figure 1 shows the differences in ROA between different lines of trade. Since ROA is ROA, regardless of the industry, direct comparisons can be made.
At the lower-profit end of the graph, the typical firm generated an ROA below or near 5 percent. For most analysts, 5 percent is the minimum return required to ensure the long-term prosperity of the distributors in the industry. At the other extreme, a number of industries had typical firms with ROA in excess of 10 percent. For distribution, 10 percent as an industry median level of profitability is very strong.
Ignoring economic extremes, the majority of lines of trade tend to produce an ROA between 5 percent and 10 percent. To a certain extent this has become a comfort zone. The problem is that the comfort zone eventually becomes the calcification zone, with most firms content to stay there rather than look for significant improvement.
Even though there is usually stability in ROA over time, there are occasions when performance changes appreciably. Most often such changes are tied to economic conditions which impact one industry segment more than others.
Figure 2 outlines the ROA performance for the 31 lines of trade for 2010 through 2014. The overall pattern reflects a modest drop in ROA for 2011 followed by sustained increases for the next two years and a plateau for 2014. The pattern is fairly typical for years following an economic downturn.
ROA performance by segment varied only slightly in 2014, as shown in Figure 3. All three segments fell into the 5 percent to 10 percent comfort zone.
While the variations are slight, they tend to produce a
large cumulative impact over time as higher profit provides greater funds for reinvestment in growing the business. In every segment, some firms produced an outstanding ROA while others suffered low returns or operated at a loss during the year.
The ability to increase sales systematically is one of the key drivers of profit. But exceptional rates of growth are not required. What is needed is enough growth to allow the firm to offset the impact of inflation on expenses with some relative ease.
In today’s moderate inflation environment, growth of about 5 percent is sufficient to beat the inflation rate. Any cushion beyond that would be beneficial. However, when sales growth moves north of 15 percent, the rapid sales growth often creates as many problems as it solves. Supporting the increased sales often necessitates an expanded employee base, new operating systems and even enlarged facilities.
Sales growth for the 31 lines of trade in 2014 was exactly 5 percent, as shown in Figure 4. Both the industrial and construction segments were above 5 percent while the consumer segment lagged significantly.
Overall gross margin fell in 2014 (Figure 5), with reductions in the industrial and consumer segments but a modest increase in construction.
In 2014, the gross margin percentage for all lines of trade was 26.7 percent of sales, compared to 26.9 percent in 2013. The gross margin difference, which appears small, is critical. The ratio reflects the change in the gross margin dollars that the typical firm would have experienced if sales had remained constant.
The overall performance for all 31 segments is a decline of 0.7 percent, meaning if sales had remained constant, the gross margin dollars generated would have declined by 0.7 percent. Because sales increased by 5 percent, total gross margin dollars actually increased – but only by 4.2 percent. The decline in the gross margin percentage eroded a portion of the sales gain.
In aggregate, expenses as a percent of sales fell by 0.5 percent (Figure 6). Recent research indicates that the ability to control expenses is the single most important driver of profitability for distributors, even more important than the ability to maintain adequate sales growth. Given that, the expense improvements, while modest, are noteworthy.
However, this improvement was more than offset by the reduction in the gross margin percentage.
Despite popular mythology, neither inventory turnover nor days sales outstanding have a very large impact on profitability for distributors. They do, however, have a large impact on cash flow. Both ratios have to be viewed in that particular context.
Inventory turnover levels deteriorated across the board in 2014 (Figure 7), although none of the declines were large. Construction-oriented distributors experienced no change. When combined with the increases in sales and the decline in the gross margin percentage (an increase in the cost of goods sold percentage), the decline necessitated a jump in inventory investment.
For a typical firm, the changes are large enough to be concerning when combined with the sales growth. The increase in cost of goods sold is 5.6 percent because of the decline in the gross margin. The increase in inventory is 8.2 percent due to slower turns. The inventory increase has significant implications for any firm’s cash position.
Days Sales Outstanding
In aggregate, distributors experienced an increase in their days sales outstanding of 0.7 percent (Figure 8). This reflects the percentage increase in accounts receivable balances that the firm would require if sales remained constant. Most of the changes in performance reflect a necessity to invest more which causes a decline in the cash position of the firm.
This report focuses on two issues. First, how well did individual lines of trade do on key performance metrics in 2014? Second, to what extent did those metrics change by line of trade between 2013 and 2014?
It is not possible to put high-gross margin industries together with low-gross margin ones and come to a conclusion. Some statistics must be converted to a common denominator to make conclusions possible.
The procedure used here involves converting absolute metrics into percentage change metrics. The percentage change figures measure how much better or worse a specific industry performed. For example, if an industry with an average inventory turnover of 2 times experienced a 0.5 turn improvement, the percentage improvement in turnover was 25 percent (0.5/2 = 25 percent). An industry with 5 turns per year as a starting point with the same 0.5 turnover improvement would see a 10 percent improvement.