Morningstar Magazine - April/May 2018 - 66

Investors

Middlemen in the Crosshairs
Industrial distributors stand up
to digital competition.

SECTOR RAP

Laura Lallos

Online wholesalers such as Amazon.com
AMZN are entering the business-to-business
distribution market, bringing increased
price transparency. Their growing market presence
will change customers' expectations, and
many incumbent distributors must adapt to remain
competitive. In a recent Industrials Observer,1
Morningstar equity analyst Brian Bernard
explained how the leading industrial distributors
can compete in the digital age. I spoke with
Bernard about his research on Jan. 31; our
conversation has been edited for length and clarity.
Laura Lallos: How have leading industrial distributors
gained their edge?
Brian Bernard, CFA, CPA,
is an equity analyst
with Morningstar Research
Services.

Bernard: Two factors helped the distributors that
we cover become the largest and most dominant
in the space. The first is economies of scale.
Industrial distribution is a fragmented market, with
a lot of mom and pops out there. These guys,
relative to those competitors, are very large and
have a cost advantage; they are able to leverage
fixed costs over a larger sales base.

Also, I think people forget that scale can really
help with customer retention. A lot of their
customers have factories across the United States,

across the world, and they want distributors
that can service them everywhere they are. You're
starting to see customers shifting their
spending to distributors that can do that, such
as W. W. Grainger GWW and Fastenal FAST.
The other factor is the services that they provide.
That can be something as simple as custom
packaging, or complex such as vendor-managed
inventory, where a representative from the
distributor comes into their customers' facilities
and manages their inventory for them.
That's the type of thing that smaller competitors
aren't able to do.
That gives some pricing power, because
they can say, "Maybe I'm a little bit higher on my
price here. But I can also give you these
services, and if we do the math, I can offer you
a lower cost of ownership, because I can
cut costs in your inventory management processes
and such."
Again, that helps with customer retention.
If you have a distributor that maybe doesn't have
the best pricing but is giving you ballpark
pricing and you really like their service and you
value it, are you going to switch? Probably not.
One more thing: A lot of distributors we cover
have private-label brands, too, which have
higher margins. That helps the pricing power and
the customer retention if their customers value
that brand.
But now these entrenched distributors have
competition from the likes of Amazon.com and other

digital marketplaces. Is this a disruption like we're
seeing in retail?

Bernard: Amazon Business has really just
started to come into play recently. They don't say
much about the business, but it hit $1 billion
in sales, and their customer base is growing
quickly. Amazon can replicate the economies of
scale for sure, maybe even better than the
larger distributors that we cover. But they don't
have anything near that level of service.
They can't even do customized packaging, for
example, and they certainly don't have vendormanaged inventory.

Now, is that something that they could
eventually do? Certainly. But remember, this
market is very fragmented. Grainger is
one of the biggest players, and they only have
6% market share in the U.S. They only
have 2% market share with smaller customers.
When I look at some of the data that Amazon
provides, it looks like they're growing with
smaller customers, those that care more about
price than service. For a lot of the distributors
that we cover, that's not really where they
play. For Grainger, 80% of sales are coming from
large customers.
Amazon is going to grow, but there's a big
enough pie for everyone to grow and be happy.
I think the only impact that you're going
to see on the incumbent distributors is some
degree of pricing pressure, because anyone can
go to Amazon and see those prices and
go back to Grainger and Fastenal and try to
negotiate. Even if I have no intention of switching
because I like their service, I can at least
pressure them on that. So, I think you're going
to see some margin pressure, but you're
not going to see these guys really losing
market share.
The mom and pops are going to lose market
share, though, because for the most part they have
not embraced e-commerce trends as much
as they probably should have. Without that,
without the service capabilities, without the scale,
they're going to be losing share.

1 Bernard B., et al. 2017. "Industrials Observer: Middlemen in the Crosshairs: Which B2B Distributors Will Survive (and Thrive) in the Digital Age?" Dec. 14.

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