United States: Manufacturer-Owned Distribution: Justifying The Ownership Of Captive Channels

Introduction

The relevance and rationale surrounding manufacturer-owned distribution channels has always been of interest within Frank Lynn & Associates' executive network—and the topic regularly evokes engaging discussions within our ongoing workshop series. While few manufacturing executives will admit it, the ongoing level of interest in the subject is directly related to the lack of control they feel they exert over the operations of their independent distribution channels. Manufacturing executives, accustomed to the high level of managerial control exerted in sourcing, logistics, and production, are often sobered by their lack of direct control over independent market-facing resources.

"If only we could get our distribution channels to . . ." (insert your largest market-facing problem here) ". . . we could optimize our entire sales and marketing motion and provide complete integration with (insert your current operating platform here—SAP, Oracle, PeopleSoft, etc.) and the rest of our internal operations!"

If this battle cry sounds familiar, it's likely that you've heard the follow-up argument—one that almost always includes support for acquiring formerly independent distributors and rolling them up into a best-in-class, manufacturer-owned distribution enterprise. Such discussions typically describe an enterprise that would be "run like a real business", "operated on a single business platform", "provide a business model demonstration for the industry," be "accretive to our earnings," and ultimately function "in the best interests of the manufacturer."

Such talk sounds impressive around the water cooler, but do these arguments provide manufacturers any real justification to acquire their distributors? To develop some perspectives on the issue, Frank Lynn & Associates analyzed a sample of manufacturer-owned distribution enterprises across a number of industries—assessing the initial and ongoing justifications for ownership, the underlying economic model, and the alternatives open to manufacturers before and after the acquisition(s). While we have divided the arguments into three categories—economic, operational, and strategic—most successful acquisition plans incorporate an expansive view that encompasses justifications from all three perspectives.

Economic Justification for Manufacturer-Owned Distribution Channels

Economic analyses, if supported by sufficient current state / future state scenarios and internal hurdle rates reflective of risk levels, can provide sufficient "stand alone" justification for distribution acquisition decisions. Frank Lynn & Associates' research, however, finds that pure economic arguments supporting the ownership of distribution are relatively uncommon. Simply put, the business models that support typical manufacturing and distribution concerns are quite different from the perspective of virtually every financial measure. In most cases, economic analyses and justifications are used to understand the financial "downside" that accompanies an operationally- or strategically-justified decision to acquire distribution.

The economics associated with distribution businesses—as they would be run by the manufacturer's organization—are expected to be accretive to earnings and do not conflict with any financial covenants. Such justifications are quite rare, particularly because distribution businesses typically operate on much slimmer gross margin and EBITDA lines than manufacturers. Within manufacturing firms that own captive distribution channels, the disparity between the financials inherent in the two business models is a frequent topic of discussion among shareholders and the analyst community. Wall Street loves to complain about manufacturers who tie up assets in operations that drag down overall earnings.

Some of the strongest economic arguments are found in industries where a preponderance of value—across the entire raw material-to-customer value chain—is created in the distribution channel. Such scenarios are typical in industries that rely to a great extent on the ongoing sale of consumable products and on-site services, primarily because the revenue model is weighted in favor of post-sale activities. Companies competing in this "razor / razor blade" market typically pursue a business model that leverages the lifetime value of an account, and as such, use value chain analyses to justify the move into captive distribution. In these industries, manufacturer new product development decisions are evaluated from the perspective of value capture over the entire life of the product, incorporating manufacturer and distributor income from services, consumables, and aftermarket parts into the overall decision making process. In many cases, distributor margin over the life of the product is several times greater than the margin reaped by the manufacturer in the initial product sale.

Another compelling economic case can be made when the financials of the distribution business are co-mingled with the financials of the manufacturing business. In this scenario, the corporation chooses to cross-subsidize one operational structure with the profits taken in the other, blending the overall financial statements for the two businesses into a single geographic profit and loss statement. Cross-subsidization allows profits to be taken at the manufacturing profit center while the distribution entity is operated at or close to break-even status. While subsidies typically imply economic sub-optimization, such structures can offer strategic advantages for manufacturers seeking to grow market share, gain a foothold in a particular geography or market, or prevent their competitors from understanding the core economics of their operations. Because such financial structures are opaque to the marketplace, they are largely frowned upon by the investment community. As such, they are more common in privately owned enterprises and geographic divisions of international firms.

Operational Justification for Manufacturer-Owned Distribution Channels

Operational justifications for manufacturer-owned distribution are typically rooted in the apparent inefficiency of relatively small, undercapitalized distribution businesses. Most assume that an injection of "big-company" operating processes—including enterprise systems, continual improvement processes, and well defined human resources practices will result in dramatic productivity and financial improvements within the distribution enterprise. Taking a look at the typical distribution operation, it's easy to see why anyone with a manufacturing world-view would have this impression.

Inside a typical distributor, employees play multiple roles. The branch manager is also the sales lead, director of HR, warehouse manager, and chief of quality control. There is little standardization of sales or forecasting activities, and the most successful inside and outside sales resources are secretive about their sales motions—which can include informal "last look" bid agreements and other arrangements that would not pass muster in a Sarbanes-Oxley audit. Operations are run using a combination of Post-It" Notes, clipboards, and the bare minimum in operational systems. Homegrown systems based on QuickBooks" or green-screen mainframe-based applications frequently prevail. Finally, customers are often sold without regard for their credit profile, simply because they are known in the community and have maintained solid accounts in the past.

Given visibility into the relatively informal operational model of the typical distributor, manufacturing executives see disarray. They don't recognize that distributors are profitable because of their ad-hoc operational style—not in spite of it. Manufacturer modifications to existing distributor processes rarely yield significant improvements in overall productivity, simply because the existing processes had been honed over the years—often adapting to the unique skills and personalities within the business. Also, the application of big-company systems, risk profiles, and hierarchy can cause the highly adaptive and efficient distribution business to become slow and unprofitable.

The most effective operational arguments in support of manufacturers' acquisition of distribution focus on the forward integration of manufacturers' existing business processes—and not on the local-level micro management of distribution operations. Such elements typically revolve around "big ticket" areas where scale economies and true operational prowess results in improved value chain productivity.

A common operational line of reasoning revolves around the benefits associated with compelling a captive distribution channel to buy "in house" products. In various process industries, where shut downs and product changeovers result in tremendous inefficiencies, some manufacturers have turned to captive distribution as one way to improve production forecasting and reduce the variability of their production throughput. In these situations, captive distribution is forced to buy all (or a majority) of a specific product category from in-house sources, allowing the manufacturer to rely on a guaranteed, base-level of production. Such assurances improve productivity, reduce the cost of goods sold at the plant level, and provide assurances to the customers of the given distributor that they will have access to product should industry capacity become limited. This argument is most effective when a single product category represents a majority of distributors' sales, and when the product category is relatively generic.

Another typical operational justification focuses on removing costs from the value chain and exploiting the savings to gain share or improve system profitability. Typically found in product categories where transportation and / or carry costs represent a significant portion of the final customer price, manufacturers seek to reap market benefit through the overall reduction of logistics expense. Manufacturers pursuing forward integration on these auspices will typically acquire distributors in a given region, consolidate inventories to a single point and leave market-facing operations more or less intact.

A final operational argument involves improving the availability of the manufacturers' product in the field. If independent distributors' business model or capitalization levels preclude them from maintaining sufficient inventories of products on hand, manufacturers may be justified in acquiring distributors to rectify the situation. This type of scenario is most often seen in product categories where very broad and shallow inventories of unique products are required—such as in aftermarket repair parts. Manufacturers pursuing this strategy, however, are often best served through the provision of consignment inventories, which offer many of the same benefits without the operating burden associated with distributor acquisition.

Strategic Justifications for Manufacturer-Owned Distribution Channels

Strategic arguments are the most common justification for manufacturer owned distribution. Frank Lynn & Associates has divided these ownership justifications into two categories—defensive and offensive strategies.

Defensive strategies primarily center on protecting and preserving manufacturers' routes to market. Threats to distribution coverage arise when the ownership structure of a particular distributor is undefined, actively in transition, or when distributor functions have ceased due to financial or operational concerns. Manufacturers that rely on a small set of channels within a particular geography bear greater uncertainty regarding route-to-market risks. Where relevant, diversification of distribution coverage allows manufacturers to mitigate their route-to-market risk without pursuing distribution acquisition strategies.

Issues arising from ownership transition represent a majority of manufacturer concerns. Mitigation of these transition risks include proactive discussions with owners regarding transition planning, incorporating ownership authorization clauses into distribution agreements, and formal "action teams" that manage the acquisition and management (temporary or permanent) of distributorships in transition. Some manufacturers even provide informal networks of potential buyers—credible managers who understand the distribution business model and have the capital to acquire and operate a distributorship in transition. With active risk mitigation steps in place, manufacturer ownership of "in transition" distribution channels is typically a short-term, stop-gap measure until an appropriate independent ownership and management team is installed.

Longer-term ownership strategies are often required when manufacturers are faced with distributor transitions that are expected to result in a long-term route-to-market problem. Such issues tend to arise when the manufacturer's distributor is acquired by a distributor that is loyal to another manufacturer, or worse, when the manufacturer's distributor is acquired by a competing manufacturer. Given these scenarios, manufacturers without diversified distribution coverage are often compelled to acquire their distributors—often for the long term—to protect their routes to market.

Perhaps the best non-ownership mitigation option open to manufacturers in this situation is the deployment of an intensified end-user "pull" strategy within the geography in question. Such activities limit distributors' ability to switch out products and create a powerful economic incentive for distributors to offer the manufacturer's products in that market.

Offensive distribution ownership strategies primarily center on providing optimal coverage in markets where independent distributors are not present or where existing distributors are not willing to provide the level of coverage or service expected by the manufacturer. Because such strategies are, by definition, optional in nature, decision making regarding business structure and investments is typically supported by financial analyses that exceed the corporation's hurdle rate.

Creating distribution in a geography where none currently exists is typically a short-term ownership strategy. Manufacturers pursuing this option typically build the business, prove out the business model, and then sell the up-and-running structure to an independent owner. An exception to this rule is the creation of direct, over-the-Internet sales channels by manufacturers. Such outlets, when created, typically remain in manufacturer hands, providing strategic "universal" coverage and serving a critical role in reinforcing the manufacturers' suggested price, terms of sale, and post-sale benefits.

The process of acquiring existing distributors for the intentional purpose of modifying their coverage and service models is almost always considered a long-term acquisition strategy. Manufacturers seeking to change a distributor's business model must be prepared to invest in significant operational and process modifications—changes which can take years to refine, particularly within the tight economic constraints inherent in the distribution business model. Such changes, however, can provide significant marketplace differentiation—particularly in product categories where local service and support are key elements of customer satisfaction.

Rather than acquiring and modifying the business model of an existing distributor, some manufacturers create their own flagship distribution outlets, ostensibly to serve as a model for their existing independent distribution channels. Such captive channels typically serve as a test-bed for operational experimentation and often serve a dual function as an industry showroom, sales center, and brand marketing platform. Burdened by atypical costs associated with their corporate marketing role, many of these channels operate at a loss and are seen as cost centers within the corporation. As such, these channels are rarely operated on a large scale; they generally supplement existing distribution. While most captive flagship channels do not offer representative financial comparisons to the independent distribution community, they do allow manufacturers to establish a tangible set of objectives and expectations for their independent distributors—satisfying a key element of an offensive distribution ownership strategy.

Conclusion

While there are a number of qualified arguments in support of manufacturer-owned distribution, the relative rarity of this business structure on a national scale suggests that there are relatively few scenarios that offer true, large-scale justification. Overcoming the marked differences between the manufacturing and distribution business models remains the predominant hurdle—one that managers and shareholders are only willing to overlook in the most dire of defensive positions. It is Frank Lynn & Associates' general conclusion that manufacturers can better achieve their objectives through the exertion of greater control over independent, non-owned channels than they are in owning and controlling these channels directly. In the long run, programmatical, commercial, and contractual initiatives, aligned with the economic interests of independent distributors, are more efficient and effective marketplace control mechanisms than outright ownership.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.