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Middlemen in the Crosshairs

Industrial distributors stand up to digital competition.

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. 

Brian Bernard, CFA, CPA, is an equity analyst with Morningstar Research Services.

How have leading industrial distributors gained their edge? 

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 vendor-managed 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.

How have the larger distributors embraced e-commerce? Are they competing with Amazon on that front?

Bernard:
By no means have they had their head in the sand. Grainger.com is the 11th-largest e-commerce site in North America. They have robust websites, and they’ll say that their e-commerce is more than a website, that it includes their vending machines on site. They are synced to customer systems, and they can track volume through that.

But you found that Grainger is more susceptible to digital competition than some of the other companies you cover.

 Bernard:
Grainger doesn’t serve a market niche like the others do. Fastenal is big with fasteners. With HD Supply   , their bread and butter is serving multifamily, hospitality, and healthcare markets. MSC Industrial Direct  (MSM) has a niche in U.S. metalworking, and Anixter International   and WESCO International  (WCC) are project-based, technical wire-and-cable specialists.

If you look at Grainger’s product mix, some things are specialized, but they sell a lot of janitorial supplies, safety supplies, things like that. This is what’s called MRO—maintenance, repair, and operations spend. That’s the type of thing that is going to face the most pressure from Amazon and online competition. They don’t serve a niche, which we found really protects other incumbents.

But they still have competitive advantages with large customers that value their services in the vendor-managed inventory. Some analysts out there are still very bearish and think that Amazon is going to take these guys down. I don’t see that happening.

The thing with Grainger is that their pricing had always been very high relative to the other distributors. Earlier this year, they cut all their prices for all their customers. They needed to do that to remain competitive. Their larger customers for the most part will stick with Grainger, but these customers aren’t dumb. Grainger set a precedent, and I don’t see why these customers, even if they have no intention of leaving Grainger, couldn’t point to Amazon and say, “I like your service, but these guys are 20% cheaper. I want at least half of that, otherwise I’m going to walk.” You’re going to see these renegotiations more often, which is again going to put some pricing pressure on them.

But at the end of the day, the services do still offer some kind of pricing power. Margins will probably never go back to where they were, but right now they’re at 11%. While I don’t expect Grainger to get back to operating of margins of 13% or more, I think 11% to 12% margins are defensible.

Do you see Amazon building out services such as inventory management?

Bernard:
It depends on the solution. You could argue that they’re already starting to do vending machines with the Amazon Lockers— it’s not quite the same, but not that far off. But Grainger and Fastenal have employees at customers’ sites. Fastenal’s on-site program is basically a Fastenal store within the customer facility, and that service is growing very quickly. For Amazon to do that, it’d have to invest in head count and train and maybe carry more inventory than they normally would. Do they really want to have that investment?

Amazon is winning small businesses because they don’t really require that kind of service. And small customers are more profitable than the larger customers. It makes the most sense for Amazon to take share from smaller businesses with their existing model. There’s plenty of market share to capture there, and it’s higher-margin. My guess is that is where they’re going to go.

What are Fastenal’s advantages?

Bernard:
Fastenal has that niche in fasteners. Now, that’s only 35% to 40% of sales; the rest are coming from that less-specialized MRO type, such as janitorial and safety supplies. But they’re the largest in North America with fasteners. Nobody does it better. The thing with fasteners—and this explains why they built their distribution network—is that they are low value for a lot of weight. They are expensive to ship, so over the years, Fastenal has built a distribution network that a lot of people don’t appreciate. They have 2,400 stores. If you don’t know much about Fastenal and you see what Amazon’s doing, you look at these stores, and wonder if they will need to close because of online pressure. But these stores are not really used for foot traffic like a traditional retailer. Only 15% of sales are from people walking in the door. The rest of it is that last mile to support customers in their facilities. And Amazon is just starting to build out locations for that last mile.

So, that’s the advantage. Grainger doesn’t have anything like that. Grainger has vending machines, but Fastenal is basically building little stores on the customer site. Nobody else can do that, probably, because they don’t have that distribution network.

Obviously, Fastenal is a tremendous company. Their margins are the best among the industrial distributors that we cover. While there’s probably going to be pricing pressure on the, say, 60% of sales that are not fasteners, I think that they have enough going for them that they can overcome that.

Why is Anixter at low risk from digital competition?

Bernard:
Both Anixter and WESCO, which is a very similar company, have a completely different business model. Fastenal and Grainger are providing inventory needed by customers for day-to-day activity. Anixter and WESCO are more project-based. They’re selling network and security products, and products that a public utility company would be using.

If you’re building a data center, Anixter is going to provide the wire and cable, a lot of the network gear. But these things can take months to years to complete, and Anixter is basically a consultant; they provide a lot of technical expertise. Before a customer even buys, they can come out to their Glenview, Ill., testing lab— which is UL-certified; nobody else has a testing lab that’s UL-certified—and test their products.

Amazon’s not going to go down that path. Even if they wanted to invest in the head count and the technical expertise to compete, it’s not worth it, because Anixter’s and WESCO’s operating margins are 4% to 5%. That’s because they’re project-based. They have to bid these things out. I don’t see why Amazon would try to replicate that business only to earn margins that are that low.

Outside of digital competition, what issues do the companies on your coverage list face today?

Bernard: The market is looking at gross margins, almost to a fault. If you’re seeing pricing pressure, obviously you’re cutting your prices, and if you’re not able to cut the costs from your suppliers, you’re going to see that come down. The problem is that gross margins are going down for basically everyone that we cover. That caused people to fear that it is because Amazon is really disrupting distributors. But the reason gross margins are going down is that the distributors that have economies of scale are serving national accounts, and those are lower-margin. Larger customers have greater buying power, so if you’re growing those larger accounts faster, that’s going to hurt your gross margin.

Fastenal’s vending and on-site businesses are lower gross margin, but they can leverage their fixed costs better. So, the operating margins are about in line, and it’s less capital-intensive, so they can grow their returns on invested capital. We’re watching what’s going on with organic sales growth. They should all be growing. And all of them are, but if one’s not, then you’d worry that perhaps someone is taking share from them, and that’s not been the case. With Grainger, for example, since they cut their pricing, they’ve actually been growing tons with the midsize customer.

You have to watch the sales, and you have to be cognizant of the gross margin, but I’m looking more at the operating margin. Everything that I’m seeing so far suggests that while there’s some pricing pressure out there, it’s not disastrous for these businesses.

And one thing to remember, too, is that all these companies serve industrial end markets, and a lot of the activity’s been depressed. Once we start seeing a recovery—and volumes start to tick up—I think you’ll start to see that the earnings power comes back.

What trends are you watching?

Bernard:
I think you’re going to see a lot more consolidation in this very fragmented industry. The leaders are going to either take share organically or end up acquiring the mom and pops. A lot of these smaller distributors might have a special product or be in a region a larger distributor is not in. And industry consolidation should help with pricing.

Going back to Anixter and WESCO, there’s been pricing pressure there for years, because there are over 10,000 electrical distribution businesses in the United States. Margins have been around 2% to 3% just because the industry has always been fragmented. Consolidation would help. This is just speculation, but a WESCO/Anixter merger would be interesting. That would really increase their market share, and there’d be pretty decent synergies.

As for current opportunities, back in early summer five of the six industrial distributors I cover were in 4-star territory. People were nervous about Amazon. But as the year progressed, the market started to realize that these firms have enough competitive advantages to continue to thrive. Grainger’s and Fastenal’s stocks have recovered. But Anixter and WESCO still look like opportunities to us. It might be because they are small cap, and they don’t get the same attention. Even if our thesis on Amazon is wrong, and they end up taking share from Grainger and Fastenal, we’re pretty confident that they are not going to come after Anixter or WESCO.

Are there broader lessons that apply to other sectors or industries?
  
Bernard:
Some medical distributors, for example, face a lot of pressure, those that supply surgical gloves and bedpans and that type of thing. These are not specialized products, and they’re selling to customers that are facing tremendous cost pressure. If they have the capital, they might want to acquire more specialized products or beef up their service portfolio. You need to have some product specialization or serve some kind of niche. You need to show your customer that even if someone out there can sell at a cheaper price, you can bring in services that at the end of the day lower the cost of ownership. If you’re a distributor, you want to make sure that you build that type of business model. 

[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.

This article originally appeared in the April/May 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.


Brian Bernard, CFA, CPA, is an equity analyst with Morningstar Research Services.
Brian Bernard, CFA, CPA, is an equity analyst with Morningstar Research Services.
Brian Bernard, CFA, CPA, is an equity analyst with Morningstar Research Services.

Laura Lallos has a position in the following securities mentioned above: AMZN. Find out about Morningstar’s editorial policies.