We believe the B2B distribution model is structurally advantaged and we’ve previously studied various distributors including Addtech, Fastenal, and POOL CORP. B2B ‘middlemen’ that supply a wide range of products from a fragmented set of suppliers to a fragmented customer base typically enjoy durable superior economics due to the critical value they create for either side of the value chain.

In Practise
In Practise

Distributors that offer critical, non-core services to both suppliers and customers create sticky relationships that are hard to break over time. At scale, distributors can not only serve customers with higher-value services, but also offer private label products that drive better economics. Although revenue is transactional, it’s often non-discretionary and recurring in nature which drives stable gross margins and reduces earnings volatility throughout the cycle.

This advantaged position in the value chain enables distributors to typically earn sustainable 20%+ ROIC. More importantly, distributors can often reinvest the FCF into acquisitions of smaller distributors to widen the range or enter new geographies. High-returns with reinvestment opportunities are vital ingredients for long-term compounding.

We plan to study as many publicly-listed B2B distributors we can find that share these attributes. Electrocomponents is potentially one of those businesses.

Founded in 1937 to supply spare radio parts, Electrocomponents (ECM) is a UK-listed industrial and electronics B2B distributor. The company has added various industrial products over time and now stocks 650,000 products from over 3,000 suppliers and serves 1.2m customers globally.

After briefly scanning ECM’s 20-year financial statements, one thing is immediately clear: the gross margin is in structural decline and far more volatile than FAST, POOL, or ADDTB.

Source: ECM 10-K, In Practise
Source: ECM 10-K, In Practise

We interviewed a Former President at Electrocomponents in the first of a series on the company to understand ECM’s model.

ECM is unique in that it supplies two different products: electronics and industrial components. These are almost two completely different businesses.

Source: ECM Corporate Presentation, 2018
Source: ECM Corporate Presentation, 2018

Being the link between a fragmented supply and demand side is one of the most attractive characteristics of the distributor business model. For electronic components, the industry continues to consolidate around dominant, global suppliers that have power in the value chain. The industrial side is far more fragmented with smaller, regional suppliers.

The sales process is also different: electronic products are sold to design engineers who integrate and build the Intel or Texas Instrument components into the final product whereas industrial components are typically MRO purchases by maintenance engineers for production upkeep or facility maintenance. Electronic customers are more focused on product design, industrial customers on availability and cost.

Historically, electronic suppliers relied on distributors to provide technical assistance to customers to integrate the component. The distributors’ product knowledge and access to the customer was also crucial for suppliers to plan the product pipeline and stay competitive

ECM would hire experienced and expensive field engineers to sell and implement electronics. This is high-value, high margin work but suppliers are slowly taking back ownership of servicing:

Over the last 15, 20 years, the big suppliers like TI and Intel have finally decided, we’ll take responsibility for the field application engineer function that distributors had spent a lot of money and time and generated a lot of extra margin from suppliers doing in the past. There’s been a bit of a turn; part of it is based on the fact that I don't think the distributors were successful in truly designing components for suppliers. We could talk all day about that. But I think the suppliers are speaking with their actions. They’re looking at what they’re paying distributors to help them design new products and design-in components. They’re not terribly happy with that and are now deciding to take that responsibility for themselves. That takes a fairly significant chunk of the margin opportunity away from distributors now, and it's just gone. - Former President at Electrocomponents

One potential reason for suppliers taking back ownership is because the application and value of the electronic components themselves is changing:

My sense is that the days of trying to create differentiation within the electronic component elements of a product are less than they were years ago. What I mean by that is the speed and capacity for processing are rigid, and a bit prescriptive, and the real magic in an electronic product happens in how the firmware is built and then the software on top of that to provide an application that then becomes unique. Speed and capacity, in terms of processing, have become a little less important. - Former President at Electrocomponents

In a connected, cloud-based world, electronic components are more commoditised and the value accrues to the firmware and software application layers on top. The value is more in the service, not the product component.

Suppliers understand they need to be closer to the application of the final product or run the risk of falling behind competitively. As technology improves, product life cycles decline, and the value chain shortens. Suppliers moving closer to the customer leads to the major risk of disintermediation for distributors.

It seems like the disintermediation risk in electronics is driving a portion of ECM's gross margin pressure:

You can see a typical component sale going off at a gross margin of high single digits, but if you can prove that you as a distributor were responsible for that customer designing in that particular part, that high single-digit then goes to 15, 16, 17, 18 points of margin. It's happening now. TI made that decision a couple of years ago. Intel has done it, and a bunch of other folks are doing it. Now, distributors have to find another way to make up for that. - Former President at Electrocomponents

As electronics moves from products to services, high-service distributors like ECM or Farnell, unlike volume-driven players like Arrow, need to find ways to add incremental value. The same thing has happened over the last decade for IT service companies such as Bechtle, a hardware and software reseller and Microsoft's largest European partner.

Last year, we interviewed a Former Bechtle Director on how the distribution model was changing:

In the early days, the reseller model was quite simple in that you received a margin from everything you sold. If you sold high volumes, you could negotiate back-end margins where the total volume over the year could give you an extra kick back. In 2008 we moved from a product and service to a service-only house, and cloud has lower margins. The model changed from a selling fee to a use or activation fee. Over a short period of time, I saw the falling margins on selling fees and the resellers who had built their business model on these reselling fees had a tough time. - Former Bechtle Director

As software shifted from on-premise to SaaS, resellers moved from volume to value-driven. This is what we wrote last year:

Resellers can no longer earn high margins from selling on-prem licenses. They are selling access to cloud-based services rather than physical licenses or equipment. The IT reselling game has shifted from being volume-driven to value-driven. Resellers have to evolve to add more value to the customer. This means having the correct talent with the technical understanding of a wide range of products that you can stitch together to create the enterprise technology stack for customers. - In Practise

SMB customers don’t want to buy and stitch multiple individual software solutions together themselves. They want to buy a full, modern enterprise tech stack that works seamlessly from day 1. To move from volume to value-driven, Bechtle needed a breadth of technical expertise internally to architect any stack the customer wanted. A deep understanding of the interdependency of IT products rather than independent knowledge of one vertical solution matters most.

Over the last decade, Bechtle has consistently acquired this technical expertise and re-trained its workforce to focus on adding value rather than focus on volume. Bechtle's deep understanding of designing and implementing tech stacks for SMBs builds sticky relationships with customers. The last thing a SMB will do is risk changing the IT infrastructure it runs on without Bechtle being at hand.

Bechtle has navigated this challenge extremely well and both gross and operating margins have expanded. Also, as the supplier’s revenue has moved from lumpy to recurring, the company now enjoys higher recurring revenue and a higher valuation multiple.

ECM has recognised its uncompetitiveness in electronics and plans to add more suppliers but it seems the core problem is a human one. Like Bechtle, ECM needs to recruit, pay, and train great engineers that can implement complex electronics better than the supplier itself. This seems like a very different business to industrial distribution.

However, as ECM moves into industrial value-added services with IESA and Synovos, it could be possible to combine value-added services across both electronics and industrial:

Regardless of where you sell your industrial products, there's a good chance some electronics are going on somewhere there. That's what we found in many of the customers. We tried to find a way to cross-sell and make sure that our sales folks, as they were walking in and the routing was to go left to the industrial guys, we were working very hard to make sure that they acknowledged whether there was a right turn to get to electronics, electro engineers, and where electronics were being developed. Because a lot of times, they just walk right past it because they're not focused on that element. Very rarely did customers not have both some kind of a mechanical thing going on and an electronic thing going on. - Former President at Electrocomponents

Elecrocomponent’s challenge in electronics highlights just how good the industrial distribution business is. This was ECM’s CEO in 2018:

We have numerous strengths in this [industrial] market, including the strength of our supplier relationships and our sales force but one of our key differentiators is our leadership in digital. We have an outstanding team when it comes to digital and we are working to build a digital culture. One of the barriers to entry in this business is, for those people that do a lot of offline business, is just the cost it takes to build the digital business where we spend more than GBP 70 million a year in OpEx to maintain our digital business. It is a high cost in barrier to entry, but once you are there, it becomes more of an ongoing machine, we have continued to reinvest and grow that business. - Lindsley Ruth, Electrocomponents CEO, 2018

Not only is ECM up against smaller, weaker regional industrial distributors, but the products themselves are not as complex as electronics. This is one reason why POOL and FAST have such durable competitive advantages: over 50% of FAST’s revenue is fasteners and safety products and 60% of POOL’s is non-discretionary chemicals and pumps.

There is relatively less risk of technological improvement in either product that would put FAST or POOL at risk of losing power in the value chain. If anything, each business is becoming more entrenched as FAST literally moves onsite with the customer and POOL gets closer to retail.

So where does this leave ECM?

In 2015, Lindsley Ruth joined as CEO and has revamped the business by simplifying the org structure, cutting excessive costs, and completed the first acquisition in 19 years. Over the last three years, ECM has acquired IESA and Synovos, two value-added MRO service companies. ECM's gross margin has stabilised and operating margins are back to 10%. Lindsley believes this is ‘not good enough’ and is aiming for mid-teen EBIT margins.

Could ECM spin out the electronics business?

It’s unclear whether ECM benefits from running both businesses internally. It’s also challenging to train a workforce that can provide value-added services on the industrial MRO side and also integrate complex electronics products. The evolution of electronics components and increased supplier power seems to lead electronics and industrial distribution even further apart.

Spinning out electronics could lead to more pain; losing ~20%+ of revenue would deleverage the whole business and pressure margins even further. However, it would refocus ECM on the industrial business which enjoys a more favorable industry structure and superior offering relative to competitors.

We will be releasing more content on ECM and other listed B2B distributors; if there are any specific distributors you’d like us to cover in this space, please reach out.