Wholesale Distribution is a meat and potatoes industry. There’s not much fancy about it and, yet, modern economies can’t function without it. It is an economic staple; that’s why approximately a quarter of the U.S. GDP is in distribution firms.
But Wholesale Distribution is not near as financially healthy and economically viable as it could be. An increasing number of non-traditional businesses are getting into the distribution space. With each passing year, wholesalers find competitors that come from outside the industry. Our research points to a business that, despite its size, has slowly decreased as a percent of the GDP since the late 1990’s. Outside research finds that many distributors are not achieving real organic growth and cite non-traditional competitors as a cause. And, while we’ve written about the sector decline for the last several years, the multitude of consultants, schools of distribution, and outside experts can’t seem to stanch the loss.
The purpose of this blog installment is to offer a different perspective on the sector’s decline; the need for distributors to manage value along with profit.
Profit and Value: Similar ends, different starts and different time periods
The World of Profit
Profitability is concerned with the now or the short term which is generally defined as anything less than a year. The measures of profit are well known to most distributors and stem from the income statement. Sales, margin dollars, margin percent, operating expenses and earnings are the common terms used with current numbers and financial ratios. Monthly and quarterly reports along with common growth efforts of sales, acquisitions, large orders, and whatever else drive the top line or margin dollars are constant topics.
Distributors are, more than less, masters of profit. They have to be in a thin margin business where 2% to 3% return on sales is common. The need to drive top-line orders, keep top vendors in play, protect margins, and constantly regulate operating expenses and the credit line are everyday events that demand to be done well. Some distributors drive profit better than others, but generally speaking, all successful distributors have a reasonable handle on short term profits.
Exhibit 1 gives an overview of the “World of Profit” and major components that we find in wholesale distribution. Along with the focus on the short term, the profit directive is supported by distributor education, research and publications focused on optimization and management of short-term cost. A quick look at the NAW’s top selling books finds, arguably, that eight of the top sellers are dedicated to profit or the short term. In our opinion, Innovate by Dirk Beveridge and Facing the Forces of Change are more dedicated to the long-term future. The rest of the best seller list with a possible pardon to The Future of Selling , are dedicated to today’s issues.
Selling has always been a profit driven, now proposition; at least the product/application selling done by most distribution sales forces. The future of selling, in our purview, lies in the ability of the distributor to craft solutions for customer issues. The solutions are of three types: 1) Supply chain and material handling, 2) Production floor, production processes, and non-direct materials related to production and 3) Product and service solutions for the customer’s customer.
We’re not targeting the top industry book sales. We believe the titles and their popularity are indicative of a profit focus and not as much of a value perspective. It illustrates the industry’s bent toward extracting profit from a mature platform where the ability to differentiate becomes less, year by year. However, the near term focus and profit directive are, at this day and time, more of a problem than a solution. Our research clearly points to the majority of distributors getting beaten for organic growth by those who focus on long term value. Hence there is a real need to focus on the subjects of value creation and generation.
The Value Perspective and Why it Wins
As a concept, value is simple to understand and, for many, hard to measure. From an academic perspective, value is defined as Free Cash Flow (Operating Profit-Working Capital)/Weighted Cost of Capital. Value is, for all intents and purposes, differentiated from profit by the time frame. Value efforts are longer-term than profit initiatives. They are the products and services offered by the distributor that demonstrably differentiate the company from the competition. Value efforts can be measured for their return on investment. They find their genesis in new services and new products that the competition doesn’t offer. They require a keen understanding of what the customer’s pain points are and what the customer is trying to accomplish. They go well beyond simply trying to fill an order. Value’s handmaidens are marketing, market research, new product and service development, and a well-funded IT effort and operating platform to support new value streams. Exhibit 2 is an overview of the components of value.
In the exhibit, the time frame of value is identified as a year or year(s) out. Please note that there are plenty of products and services that generate value that are performed in the now. However, we refer to these as profit initiatives as most are mature and well-known. The overall objective for these efforts is to optimize them by adding technology and getting the cost out. Our concern with value creation and generation are future income streams that are more profitable than today’s products and services. Hence value is concerned with what the customer wants or would want if they knew about it; customer needs are the things the customer knows about and accepts as they are a part of the current day — everyday.
Value creation is a net new product or service that has not been offered. Value generation is the ongoing growth of successful creative ventures. Value creation is anything but a sure investment. For instance, most new products have somewhere between a 1 in 5 to 1 in 8 success rate. The figures are little better for new services. The leading edge of value efforts require qualified marketing professional(s) and monies for market research. Financial return analyses from simple ROI calculations to more complex discounted cash flows are part of value measurement.
There are two processes to value creation for products and services: 1) Stage Gate and 2) Agile. The processes are different but both have been proven in corporations around the world. Wholesalers who don’t have or use these processes, likely have much less efficient and less effective value creation efforts than those who have mastered them.
The value approach wins, almost all the time, over the profit perspective. It honors the role of technology, thought, and an intimate knowledge of the customer to make their work easier, higher quality, and more successful.
Research and Thoughts on Value
Value is not some fuzzy logic subject. McKinsey, the global consultancy, has done value research for the past two decades. Their book, Value: The Four Conerstones of Corporate Finance,[i] is a recommended read. The research clearly finds that new products and services to existing customers generate higher value than acquisitions or optimization work. Our work in wholesaler value finds that wholesalers who have a successful new product and new service process have higher profits and greater organic growth than those who focus on short term profitability or acquisition.
Value also can be demonstrated in using technology to give the customer a more meaningful buying experience and business relationship. This is evident, to us, in the gap between the billion dollar distribution firms and the mid-tier wholesalers (100MM to 500MM) where the investment in e-commerce and technology is quite different. Our recent research on Big Data or sku content more than 100,000 units finds that most Billion dollar firms have PIM (Product Information Management) software and are growing at organic rates of 5% or more. Most mid-tier wholesalers don’t have the software, have significantly less organic growth, and have significantly less sku content.[ii] Big Data is a value generating service for customers. It allows them to shop at one firm, with accurate content, and cut back on the number of purchase orders.
As wholesale distribution enters its third and fourth generation(s), it will be increasingly challenged by outside entrants or large public firms that drive customer value with new products, new services, and talent that can create and generate value. Unless these privately-held firms change their perspective from a profit outlook to one of value, they will be forced into a low-value commodity platform where incremental profits and high returns are difficult to secure. As their return on sales declines, so will their share price and the result will be a firm that sells for less, often much less, than it could have had value been a focus over profit.
[i] Koller, T., Huyett, B., Dobbs, R. Value: The Four Cornerstones of Corporate Finance, Wiley, 2010.