Millennium of change
As products begin to move through new channels, distributors may look to service contracts to make up for lost revenue
By John R. Johnson -- Industrial Distribution, 12/1/1999
The end of the century is less than a month away, and outside of a few anxieties about Y2K glitches, the big fear for distributors is what lies ahead for their businesses in the new millennium.Indeed, the final 10 years of the last century probably saw more change than the first 90 combined. And it's safe to say that the first three years of the new century may see more upheaval than we saw in the entire 90s.
Mergers, acquisitions and rollups altered the distribution landscape forever. The process scooped up well-known industry names by the dozen, and resulted in new industry players as well.
Integrated supply sped from its infancy into adulthood. It's now estimated that approximately 25 percent of all large company MRO purchases are linked to an integrated supply program.
The Internet, while still in its infancy, is quickly en route to teen idol status and will grow up even faster than integrated supply. And the 'Net is certain to rock distribution like nothing before. Just witness Forrester Research's report that business-to-business commerce will total $1.3 trillion by 2003. Just two years ago the question was will the 'Net change distribution? As we prepare to enter a new millennium, the question is now how will it affect distribution, and who will be left standing when the 'Net's role is fully determined. Many veteran distribution executives wonder the same thing.
Throw in competition from new channels, supply chain threats from logistics companies like FedEx and UPS, the new economy, the effects of environmental programs, a tougher than ever labor market, and new approaches to the supply chain, and business is sure to be a challenge in the new millennium.
Despite the gains that have been made by changes in the industry, what lies ahead for distribution is a big question mark. Will consolidation continue? Will there be a dozen $4 billion giants in the industry, and a bunch of small, niche-player independents?
Will the giants continue to get bigger, leaving the mid size players behind, with only the small distributors surviving in a niche role? Some go so far as to say that integrated supply is actually cannibalizing the distribution process. After all, isn't the goal of integrated supply really to find ways for the customer to buy less?
Then there is the recycling of products, which generally is resulting in less need for some of the MRO products that distributors make their living on. Take for example, the growing popularity of water-based solvents. They can be used safer and longer than other solvents, lessening demand. And as more parts are made from plastic instead of metal, the metal cutting industry sees less demand for everything from abrasives to cutting tools and lubricants.
Throw in the trend toward offshore manufacturing, and the future for distributors is cloudy. For example, the National Assn. of Purchasing Management said manufacturing was so robust in September that the sector is near full recovery from last year's Asia-induced retrenchment. Yet, at around the same time the NAPM report was released, many distributors were announcing that sales would continue to be soft. And at press time, the Industrial Distribution/ Baird stock index was at an all-time low.
"I'm seeing an absence of the correlation there used to be [between the fate of the economy and the health of distributors]," says an executive from one Top 100 firm. "If manufacturing went up, it used to be that it was a barometer for us. Here we are in this record expansion, but nonetheless, many distributor's results are lower because of these types of factors. There's been a confluence of so many factors which depress our customer's consumption of supplies, that the results in this industry can no longer be predicted by macro issues."
Clearly, distribution will be an entirely new breed of business a couple years from now. Just how? Integrated supply will continue to grow, and the bigger will continue to get bigger. That fact was demonstrated clearly by manufacturer WD-40 in its quarterly report released this fall. Five years ago, WD-40 had 12,500 "accounts" that sold its product. At the time, the top 100 made up less than 50 percent of WD-40's sales. Today, WD-40 has 5,000 accounts, and the top 30 of those make up almost half of the firm's sales.
"I really believe that distribution is in an evolution, and that while the U.S. is certainly the most sophisticated distributor market, that consolidation will just continue," said WD-40 president Gary O. Ridge. "We continue to see a consolidation of distribution in the U.S. and find our sales mix shifting more to the bigger accounts.
"If you think back 10 years ago, there was no such thing as an OrderZone or a Home Depot, both of which have grown tremendously. And look at WalMart. The biggest company in the world was nothing just 30 years ago."
Ironically, WalMart's success has been due to its ability to perfect the inventory process, something that will continue to impact distributors. However, industry analysts predict inventory will become less important in the long run, as logistics experts like FedEx and UPS move into the industrial distribution segment. Many believe those companies can remove five or six margin points from the shipping process overnight.
Therefore, the emphasis on providing technical services and customer support will become integral for distributors. As 1999 began to draw to a close, we began to see more distributors aligning themselves with that theory.
Vallen Corp., for example, is placing much more emphasis on providing services than products, and Bowman Distribution is making some of its sales personnel experts in handling environmental spills and hazardous waste.
"We've been on this journey for four years, moving internally to prepare ourselves," says Jim Thompson, president of Vallen Corp., who says that $33 million of his firm's sales (about nine percent) are derived from services. "We are accelerating that growth with some acquisitions, and we really believe that distributors need to move from a product paradigm to services and knowledge so that their importance in the supply chain increases. We think that's an important key to everybody's success."
According to industry guru Frank Lynn, principal of Frank Lynn & Associates, Vallen is way ahead of the curve. Lynn says his studies show that on average, one percent of distributors revenues come from services. That leaves lots of room to improve. Lynn points out that the switch to more service oriented revenue is a win-win. Distributors not only free up cash, but reap higher margins from service initiatives.
"It's an interesting concept, because if you look at a distributor whose inventory role goes down, they kick off a lot of cash," said Lynn. "If you're a $10 million distributor with $2 million worth of inventory, and you're inventory goes down to $250,000 ... it's like heaven. The only question is will distributors pay it off to themselves, or re-invest it into the business?
"We think distributors have got to add service revenue to survive. If you take away the inventory function, they can't survive on just product support activities. It's worth at best maybe 11 margin points."
Other industries -- notably computers -- are already heading in this direction. Computer resellers in many cases give away product at five percent margins just to get the accompanying service contract for the product. Many computer re-sellers, according to Lynn, derive 40 percent of their revenue from services, and are headed toward 60 percent.
"I could see that happening with industrial products like cutting tools and electrical controls," says Lynn. "It doesn't take a lot of service revenue to make up for what you lose in profit from not doing much inventorying anymore."
Lynn notes that his company is paying his travel agent thousands of dollars for services he used to get for free. Lynn says that airlines stopped offering travel agents steep discounts, and that manufacturers of MRO products could easily follow suit, more or less forcing distributors to a services-for-fees revenue structure. He also notes that a possible next step for distributors is offering service contracts over the phone, similar to those also offered by the computer industry.
That may not be such a bad thing. Typical service revenue has margins of approximately 20 percent, plus the savings gained from not inventorying product. "So you don't need a lot of revenue to offset the loss of 2.5 percent net profit on the inventory side," Lynn says. "So it's not as hard as distributors might think it is."
Vallen Corp.'s first quarter results provide proof of that. While overall distribution sales were down, overall gross profit margins on Vallen's distribution business improved, primarily because of its changing product and service mix.
"We think service should be 25 percent of the volume for a distributor," says Thompson, "which is likely to [represent] over 50 percent of earnings. Greater earnings will be derived from services than from core products. Customers are open to receiving service solutions. It can be a pretty long journey, but it's realistic."
1900-10
By 1900, more than $75 million of industrial supplies were sold to industry. Southern industry began to come to life with in the form of the lumber, textile, furniture, chemical, and paper and machinery industries. Fueling the growth were the South's industrial distributors, who provided supplies for industry. The Southern Supply & Machinery Dealers Assn., a forerunner to the Southern Industrial Distributors Assn., was formed in 1902.
1911-20
In 1911, with great fanfare, Mill Supplies Magazine, now Industrial Distribution, was launched, "Devoted to the interests of the jobbers and manufacturers of the mill, steam, mine and machinery supplies." Among other things, Mill Supplies reports that the per capita debt of New York City surged to $153.02, while Boston's was $114.50. Also, per capita consumption of whiskey rose to nearly two gallons.
1921-30
In an effort to settle their differences, distributors and manufacturers set sail on a four-day Peace Cruise aboard the SS Noronic. The Triple Convention had been cancelled the previous year due to disagreements. Executives vowed not to return until a working relationship could be formed. In 1929, Wall Street hit rock bottom. Despite the slogan "Distributors serve industry economically," distributors received only 35 percent of purchases.
1931-40
The Great Depression caused havoc, and by 1933 distributor sales were only 31.4 percent of what they were between 1923-25. Many supply houses died off, but an interesting phenomenon occurred. Since manufacturers could not afford to sell direct, distributors began to capture a favored position. In 1939, distributors again set sail for their annual convention, this time on the Monarch of Bermuda. Inventories were at rock bottom when Hitler invaded Poland in 1939.
1941-50
In December of 1941, Japan bombs Pearl Harbor, the official entry of the U.S. into the international fray. WWII puts pressure on distributors to meet increased need for products. In 1942, inventories were up 30 percent, and sales were up 75 percent over 1940. In 1943, Senator Harry Truman addresses the Triple Convention. Two years later, Truman takes office when President Roosevelt dies. Germany surrenders in 1945. In May 1949, the first issue of ID, formerly Mill Supplies, is published.
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