During the past six months, I've had an opportunity to meet with senior executives at most of the 15 major integrators that dominate the integrated supply world. The purpose of these meetings was to enable me to assess the status of the integrated supply market and to gain some understanding of its future.

As usual, most of the integrators I interviewed were reluctant to provide hard data on the level of MRO spending they were responsible for managing during the economic downturn of 2001, 2002 and 2003. The general impression I gathered from these discussions, however, is that the industrial integrated supply market experienced somewhere between 0 and 5 percent growth per year during this three-year period. Many of the integrators pointed out that they continued to sign new contracts during the period, but any new business gains were largely offset by a decline in MRO activity from plants under existing contracts.

The almost unanimous assessment of the integrated supply market outlook from the integrators I spoke with is that they expect to see a 15 percent to 20 percent increase over 2003 levels in MRO spending under contract this year. Part of this increase will be due to an increase in MRO spending from plants under existing contracts. A number of integrators claimed, however, that they have so many new business opportunities that they are regularly turning down bid requests. The validity of these optimistic growth expectations was further reinforced by the recent announcement of IDG's second-quarter financial results, which indicated that revenues of their Flexible Procurement Solutions Division (which includes their integrated supply business) were up 22 percent over revenues in the first quarter, and up nearly 15 percent on a year-to-year quarterly basis.

Hard data on profitability levels was even more difficult to obtain, but my general conclusion is that new contracts were generating 6 percent to 10 percent pre-tax and pre-corporate charges profit levels. Several integrators suggested that they were seeing profit levels more than 10 percent on some of their new contracts.

In addition to the continuing growth of the integrated supply market, the other interesting finding revealed during my interviews is the change that has taken place during the past 10 years in both the business models of integrators and how integrators market and price their integrated supply services. When Frank Lynn & Associates first started tracking integrated supply in the mid-1990s, it was viewed by many distributors as just another way to sell their MRO products to large industrial plants. Pricing practices at that time were based on typical distributor markups, and the value proposition to end users was: "We can buy MRO products at lower prices than you can!" and/or "We can save you money by reducing your order-entry costs!"

Several years later, when we again looked at integrated supply, we saw a new business model emerging. Integrators were beginning to realize that there were major inefficiencies in the way end users managed their MRO procurement and plant inventory. By taking control of both these functions, integrators could generate huge cost savings for their customers. As a result, integrated supply contract terms moved to guaranteeing annual cost savings with "gain share" provisions if the integrator exceeded his cost savings objectives for the year. The move forced integrators to recruit and train personnel that would work in their customers' plants to oversee and manage integrators' inventory control and order procurement systems. At this point, product pricing to the end user was still on a traditional markup basis.

In 2002, we took our third look at the world of integrated supply and saw an entirely new business model beginning to emerge. Integrators were breaking away from their distributor roots and beginning to view themselves as an outsourcing business, where they functioned as contract MRO "buying agents" and inventory managers for their clients. This was a major paradigm shift for integrators. It meant that they were now operating a "services" business, and that they had to think and act as service providers. As a result, integrators began to drop their traditional distributor markup pricing models and started passing products through to the end user at the integrator's purchase price. Their pricing models changed to a "fee-for-services" approach, in which they charged end users service fees for inventory procurement and management activities, along with any special services they provided.

This shift is continuing, but it is more in concept than reality. I found virtually all of the integrators I met with "talking the talk" but not "walking the walk." Only a few integrators have learned how to effectively market and sell service offerings, and only one integrator I interviewed seems to have learned how to respond when end users ask for additional services— "We are happy to provide you with that additional service, and it will only cost you this amount!"

More importantly, integrators are just beginning to test the price elasticity of their service offerings. At some point, they will unlearn their old distributor habits of making profit on product markups and service giveaways. When they move to more effective marketing and pricing of their service offerings, I expect profit margins to increase significantly.

Beyond this move to an outsourcing "fee-for-services" business model, I believe there are two other significant changes on the horizon for integrators. The first of these changes is a further shift of their services business model to encompass information services. I expect this shift to largely displace integrators' reliance on revenue and profits from product procurement and management services. Some large end users I talked with felt that the value of the MRO data collection and information analysis that integrators have the potential to generate from their information systems may well exceed the cost savings generated from better product procurement and inventory management processes.

This transition to data collection and information analysis services will not only create a new revenue stream for integrators, but the pricing structure for these new services will present greater opportunities for integrators to increase their profit margins. Creating IT systems that can produce this type of information output and analysis, however, requires a major investment in IT—perhaps as much as $10 million to $20 million. A limited number of existing integrators will be in a position to make this level of investment. That will inevitably lead to consolidation, which will eventually produce a handful of very large integrators that will dominate the integrated supply market. Who those surviving integrators will be is not yet clear, but two or three integrators appear to be well down the path toward creating this new information services business model.

The second major change on the horizon for integrators is a by-product of the Sarbanes-Oxley Act that resulted in new Financial Accounting Standards Board regulations regarding the treatment of off-book financing of assets. Until these new regulations went into effect, there was a major financial incentive for end users to shift the ownership of MRO inventory to integrators. By moving the cost of a plant's MRO inventory from a balance sheet item to a P&L item—with service fees paid to integrators for the value of the plant's inventory that had been shifted to the integrator's books— plant management was able to reduce their balance sheet assets by millions of dollars. (This was a particularly attractive move for plant management if part of their bonus was affected by capital-in-use charges.) To protect themselves from the liability of owning the plant's MRO inventory, most integrators put a clause in their contracts that require the end user to buy back the integrator's MRO inventory in the event that their integrated supply contract is terminated.

The new accounting regulations limit the freedom that end users have in their treatment of off-book asset financing by requiring companies to carry this type of contractual obligation on their balance sheet as a contingent liability or a contractual obligation. Since integrators' fees for MRO inventory ownership are usually greater than the end user's cost of capital, there is no financial incentive for end users to shift the ownership of MRO inventory onto the books of the integrator.

Going forward, there is a strong likelihood that integrators will no longer take ownership of their customers' MRO inventory. Although there are differences of opinion in the accounting world as to what this change in inventory ownership will mean to integrators' business models, my view as a non-accountant is that, under these circumstances, integrators will now become procurement agents for their customers. If so, they will no longer be able to report the value of the inventory they manage on the customer's behalf as revenue; they will only be able to report the value of the service fees they receive as revenue.

If the above scenario plays out, it will result in a major change in integrators' financial statements—reported revenues will decline substantially (perhaps to one-sixth of their current levels); profitability will soar into double-digit levels; assets will decline substantially, as MRO inventory ownership transfers back to the end users; and return on assets will be outstanding. In short, integrators' business models will morph from one that closely parallels that of a distributor to one that will be reflective of other types of outsource service providers. I will let the reader speculate on what that will mean to distributors who currently own integrators.

To summarize my evaluation of the status of integrated supply:

• The integrated supply market appears to have resumed its approximate 15 percent to 20 percent per year growth rate after three years of considerably lower growth during the recent economic downturn.
• Profitability levels on new contracts are increasing and are beginning to reach low double-digit levels.
• Most large integrators have adopted the "fee-for-services" business model and are passing product through to the end user at the purchase price.
• Sophisticated IT data collection and information analysis capabilities may become the win/lose success factors for integrators in the near future.

There are major changes looming on the horizon that would continue to move integrators along the path towards an outsourcing services business model with lower revenues, much higher profit margins and very attractive returns on investment.

I do not expect integrated supply to disappear in the future, but I do expect these businesses to continue to move further and further from their distributor roots and become more of a "services" business.