Disruptive forces may have a big impact on the future performance of distributors. This article, the first in a three-part series, will identify some of the critical disrupters and their effect on distribution.
After years of evolutionary change, the wholesale distribution industry faces major disruption and a true inflection point. The disruptive forces impacting distributors across all lines of trade provide ample qualitative evidence for this. And quantitative evidence can be found in the erosion of the industry’s financial performance. The current inflection point will likely produce a marked division in future performance between visionary distributors willing and able to chart a new course for their business and those too constrained by orthodoxies to keep their business from declining.
In recognition of these dynamics, 22 executives from nine leading distributors recently gathered at Deloitte’s Greenhouse for a full-day workshop to examine the industry’s financial performance and disruptive forces, and then explore a framework for navigating the inflection point. In this three-part series, we will share some of the insights and perspectives from this workshop.
Each quarter, Deloitte analyzes the financial performance of distributors with publicly available financial statements. For an extended period of time across a number of key metrics and indicators, performance has been deteriorating. The umbrella metric Deloitte considers is return on operating capital (ROC), defined as:
This formula reveals how effectively a company is turning capital into profit.
Figure 1 displays average ROC since 2002 for the distributors included in Deloitte’s analysis. While some cyclicality is evident during the financial crisis, the chart shows a persistent negative trend over the past 10 years. The 8.3-percentage-point decline since 2006 represents a fundamental shift in industry performance that exposes and constrains weaker players, while also creating a breakaway opportunity for leaders.
Driving the decline from an income statement perspective is:
- Uninspiring year-over-year revenue growth, which has slipped from 16 percent in 2006 to 3 percent CAGR in more recent years, with a negative trend.
- A 40-basis-point erosion in gross margins due in part to the inability of distributors to get customers to compensate them for incremental services, inventory management, self-service capabilities and value added services.
- Flat SG&A productivity, reflecting ongoing investments in e-commerce, mobile, self-service, a better trained and informed sales force and other value added services without offsetting efficiencies in more traditional expense areas such as inside/outside sales.
When taken together the revenue, gross margin and SG&A factors have depressed distributor EBIT margins by a full percentage point since 2006. This is the primary reason industry ROC has declined 8 percentage points since 2006.
The industry’s financial performance represents a serious call to action for distribution executives. But navigating the industry inflection point and avoiding the fate of Kodak, Blockbuster, Lucent and Borders – among countless others that failed to navigate their own inflection points – requires a deep understanding of the forces in play and new thinking.
In distribution, orthodoxies are powerful forces that can and do have a detrimental effect on decision-making. Concerted effort and decisive action will be needed by executives to overcome their own
organization’s orthodoxies. Here are some common “truths” about distribution to consider – and challenge:
- We are a low-margin business.
- We need a large sales force.
- We are an asset-intensive business.
At the workshop, Deloitte engaged participants in a structured exercise to both acknowledge and challenge their orthodoxies.
The emergence of new competitors is one powerful sign that an industry has reached an inflection point. For distribution, this can be seen in AmazonSupply’s (now Amazon Business) 2012 launch and its rapid growth to $1 billion in revenues by 2016. Amazon is unbounded by orthodoxies; they simply don’t exist in the same reality of most distribution businesses.
Reflecting on your orthodoxies and understanding how they impact your decision-making can create new perspectives and open your eyes to new opportunities.
The sheer number, as well as the magnitude, of the factors impacting the industry presents a daunting, shifting landscape for distributors to navigate. Most distributors are not accustomed to the rapid emergence of new competitors leveraging completely new business models, swift advances in new technologies or seismic shifts in how customers want to interact and transact. Some perspective on these disruptions can help navigate the new market realities.
What makes digital a truly disruptive force is not the enabling technology, but the transformational shift in value creation that it is driving. Digitization is not only empowering distributors to make more informed decisions about what inventory to stock, how much and where to store it, but also what value proposition will resonate with each customer segment, what price to charge, which markets are growing, which segments value private label, which customers prefer face-to-face sales vs. self-service and which customers offer the strongest growth potential.
Digital is also driving greater transparency. Some distributors have thrived in market niches with a certain level of pricing and availability opaqueness. However, digital is enabling customers to more efficiently shop for items from various suppliers and for distributors to offer an endless aisle of products. As e-commerce, online marketplaces and other digital tools gain further acceptance and capabilities, they will further drive transparency, increase pressure on gross margins and commoditize some specialty products.
Distribution has always been highly competitive, but the number and variety of competitors has reached new heights. This increased competition includes traditional distributors expanding the breadth and depth of their offerings. For example, a growing number of foodservice distributors now also offer foodservice equipment, smallwares, safety products and technology solutions.
Beyond traditional competitors, B2C retailers are showing interest in B2B, particularly in building supplies and tool markets. These competitors can effectively leverage their purchasing power, store network and B2C experience to present a formidable source of competition for distributors.
Digital is exerting a massive influence on the competitive landscape, as well, enabling companies to launch specialty models that focus on a particular customer segment or product category. Examples include Zoro Tools, Enco Tools, AtlantaLightBulbs.com, BuildDirect.com, WebstaurantStore and Supplies on the Fly.
Capturing new customer demand
Inflection points can have positive or negative effects. Potential positive implications are seen in the new industries being spawned by technology and business disruptions. Consider the private space business where newly formed companies such as SpaceX, Blue Origin and Virgin Galactic each represent significant potential for a wide range of distributor products and services such as industrial MRO, electrical switches, wire and gear, electronic components, and a wide range of chemicals. In foodservice, new go-to-market models are creating potential new customers (e.g., Blue Apron, Freshly) and expansion of food service offerings in convenience stores and the growth of food trucks. Additive manufacturing also represents an opportunity; one chemical distributor already announced it carries filament refills.
These examples are truly disruptive in that these industries simply didn’t exist a few years ago. They bring different business models and economics to traditional segments and exhibit rapid growth. Distributors of the future will likely need an ecosystem of connections to stay aware of developments and stay ahead of their competition.
An array of product innovations are reshaping distributor value chains, while at the same time creating unanticipated opportunities and challenges. For many electrical supplies distributors, the rapid adoption of LED lighting has created a paradigm shift in the sales discussion, from sockets and bulbs to total cost of ownership, compatibility and integration. In the process, LED technology has created an entirely new set of suppliers, a different go-to-market channel and is rapidly eroding the recurring revenue stream
associated with replacement bulbs. In the foodservice line of trade, growing consumer interest in locally sourced and organic produce and concerns about GMO have created challenges and opportunities.
Another innovation with the power to completely disrupt many lines of trade is additive manufacturing, or 3-D printing. The full suite of technologies involved in 3-D printing is complex and compelling. Materials such as metals, ceramics and even food ingredients can be used to create parts and products as diverse as electrical circuits, shoes, jet engine parts, personalized housewares and even steaks!
A market is growing for the supply of additive manufacturing machinery and equipment, the raw material inputs into production and the ongoing MRO needs associated with their use. AmazonSupply was an early entrant into this market, featuring 3-D printers and supplies on its site before evolving into Amazon Business.
According to a UPS study from 2015, 64 percent of industrial buyers say that they already buy direct from manufacturers (DFM) and 88 percent indicate they are likely to increase their DFM purchases. However, unlike the past when disintermediation was a gradually evolving and less important threat, today it is rapidly evolving and exerting significant pressure on many distributors, forcing them to higher levels of due diligence and introspection about their value proposition and go-to-market channels.
Today’s disintermediation threat is playing out in different ways across lines of trade. Some examples:
- In medical supplies, customers such as integrated health networks and integrated delivery networks are building scale and capacity to self-distribute, completely removing the distributor from the value chain.
- In LED lighting, manufacturers such as Cree Lighting are not only selling direct to end customers but also providing design services, financing and installation.
- In foodservice, the continuing growth of group purchasing organizations is reducing the distributor’s role, sometimes to drayage only. Overall GPO penetration in foodservice grew from 16 percent in 2009 to 21 percent in 2014, according to research from The Hale Group. Even more troubling is the growth in the street segment where many make their money.
Whether the distributor is completely removed from the transaction or just the price negotiation, the implications on performance are dramatic. Digital tools are in many cases accelerating this disruption, and demographic shifts indicate it will likely increase further. Distributors should develop long-term responses that leverage their capabilities and reflect their line of trade dynamics, according to the UPS study.
Consumerization of expectations
Distributors often emphasize that B2B commerce is very different from B2C. Figure 2 highlights some examples of these common differences.
However, expectations in B2B commerce are increasingly informed by developments and experiences in B2C. Expectations common in B2C, such as transparent pricing, a rich, tailored user experience and communities/social connections are rapidly permeating to B2B. B2B e-commerce customers now expect:
- Intuitive, easy-to-navigate ordering platforms, including mobile, that have high quality product images, in-stock information, measurements and specifications, faceted search and the ability to buy online with a variety of fulfillment options
- Transparent pricing with the ability to quickly compare price and availability using digital tools. Amazon enables B2B buyers to compare their negotiated price for specific items with that of other Amazon sellers, giving them the option buy at a price below their negotiated price.
- A consistent and persistent experience across channels and platforms. (For example, “Inside sales knows I’ve been on the website.”)
- Ratings, reviews and social network access via Twitter and YouTube. Already a handful of leading distributors survey customers about their willingness to recommend them to peers. The resulting Net Promoter Score and trends inform distributor marketing, promotion, sales and customer service decisions.
Distributors that cling to outdated perspectives on B2B engagement and experience will likely forego opportunities for fostering customer loyalty and miss incremental revenue growth. At a time when top-line revenue growth comes at a premium, this dynamic is not sustainable.
Part 2 of this series will introduce a framework for navigating the inflection points.