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.
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.
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.
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
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.