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Disruption – ongoing and threatened - has impacted valuations of retailers and distributors. Our process focuses on assessing durability of the business franchise, range of outcomes, and downside protection when making investment decisions.

Valuations of retailers and distributors have been impacted, as disruption by Amazon and other e-commerce companies threatens to undermine their business models. Investors put both businesses in the same bucket – middle- men that are going to be disintermediated. The reality, however, is that retailers and distributors are very different businesses. Our objective in this article is to inform on how we are analyzing these targets of disruption, differentiating between the potential winners and losers, and making investment decisions.

Consistent Investment Process

We apply the same investment process that we have used over our twenty-two-year history to uncover opportunities for skewed outcomes with limited downside and the opportunity for significant upside. Key research questions include the following:

  • Are the issues temporary or permanent
  • Does the business have a sustainable competitive advantage
  • How susceptible is the business model to disruption
  • Can we quantify the issues
  • Is there downside protection

We’ll examine each industry to shed light on these questions and why we have found more investable opportunities in distributors than in retailers.

The Difference Between Retailers and Distributors

The greatest difference between these two businesses is that retail tends to be fragmented and inefficient, with many players providing the same products to a wide customer base. In many cases, their products are of a discretionary nature, and don’t require a high level of service to make the sale. Other than for a few business models, this makes retail ripe for disruption by a more efficient e-commerce business model such as Amazon. It’s notable that in developing countries such as China, the model for fulfilling customer needs is, to a great extent, skipping traditional brick-and-mortar retail in favor of e-commerce as the end-state.

On the other hand, distributors, which sell to businesses, specialize in niches where they can provide unique benefits to manufacturers and customers that are sophisticated and require high levels of service. They are also much further along in wringing inefficiencies out of their businesses. Merger activity has consolidated competitors in several categories, creating good industry structures where a small number of participants control most of the market. For example, the top three U.S. pharmaceutical distributors control 90% of the market, whereas one would be hard pressed to find a group of retailers that comes close to this domination of their category. For example, even the now-defunct Toys ‘R Us chain only represented approximately 17% of U.S. toy sales.

Evaluating Retail Business Models

Retailers compete across four criteria:

  • Value
  • Service
  • Assortment and
  • Convenience

The ability to offer a wide assortment of merchandise to the consumer has changed dramatically since the advent of e-commerce. One extreme example was the bookstore, which stocked a wide assortment of slow-moving titles, taking up valuable (and expensive) real estate. This concept was ripe for disruption by e-commerce. Hosting an “infinite aisle” online and shipping items from a centralized fulfillment center turned out to be lower cost and a better value proposition to the consumer. As a result, almost all brick-and-mortar bookstores have gone out of business, with perhaps only those offering fast-turning assortment and convenience (e.g., college or airport bookstores) surviving. Department and specialty stores are under similar pressures. They had been great for offering a wide assortment of products but are not the most efficient utilizers of retail space. Does this mean all retail categories are prone to disruption?

Cost of Fulfillment Provides Guidance

Examining the cost of fulfillment can help us answer this question by determining the most cost-efficient method of moving products from a supplier to a consumer’s home for various categories of goods.

As illustrated in Figure 1, the general rule-of-thumb is that bulky, low value, perishable, fast-moving items are cheaper to fulfill via stores than via e-commerce, whereas slow-moving, higher value, non-perishables are well suited for e-commerce. That may be why grocery has so far seen minimal impact from disruption as compared to categories such as books, apparel, and electronics (Figure 2), as groceries mainly sell fast-moving, perishable, and low value/ bulky items.




U.K. grocery also provides an example of a good industry structure where managements have implemented advanced strategies to meet consumer desires for new models of service. The industry is well-ordered, with the top five players controlling approximately 80% of the market. Amazon has had a distinct lack of success in the U.K. with its fresh food delivery offering, while Tesco, the industry leader, is driving a program of improving value to customers, and Sainsbuddy is getting ahead of the e-commerce onslaught by offering a click-and-collect model for its general merchandise assortment. In the U.S., Walmart is executing a strategy of utilizing its grocery business (55% of sales) to maintain customer traffic while repositioning its in-store general merchandise to a more unique, service-oriented selection.

Downside Protection Limited

Retail has proven particularly challenging for identifying downside protection, as inventory, properties, and intangibles (including brand) are the main assets, and their values can be hard to estimate. Leases create hidden financial leverage and can also impede a retailer’s ability to rapidly restructure. In addition, owning real estate may not be the ballast that it appears to be. Monetizing real estate may not be possible (e.g., onerous tax consequences) and, even if it is, such a transaction may put the operating business at risk, as the retailer is receiving a one-time payment, but creates a lease obligation that adds debt- like fixed costs. On the other hand, some retailers’ brands can be a source of differentiation and protection, which we assess on a case-by-case basis.

Evaluating Distribution Business Models

Distributors provide a value proposition to both manufacturers and customers in several ways:

  • Product knowledge;
  • Regulatory expertise;
  • Physical availability and convenience; and
  • Inventory managemment / capital efficiency.

A combination of these factors can be a source of defense for incumbents. For example, in electrical supply distribution, contractors often have uncertain demands at job sites. Orders vary day-to-day, and purchase decisions are based primarily on speed and convenience. As such, a dense network and the ability to rapidly fulfill orders are key and can defend the business franchise. One such distributor is Anixter International, the world’s leading provider of cable and wiring for enterprise networking and security solutions. The company delivers high service, wide assortment, and global reach, selling in over 50 countries. Anixter’s data center clients, ranging from small businesses to global hyperscale facilities, focus their own effort on determining the best servers to purchase, but rely on Anixter to advise on racks, connectors, tiles, and other items. These may make up less than 5% of project spend but are most of the individual items purchased for a job.

Not all distributors fit this mold. Grainger, which sells a wide assortment of undifferentiated products to a variety of industries where little product expertise is required and price discovery is easy, has struggled.

Identifiable Downside Protection

We have been able to identify greater downside protection in distributors, where we believe a combination of attributes (service, proximity to customer, etc.) can provide resilience to the business franchise. Some also have other barriers to entry, such as pharmaceutical distributors, who have a highly efficient distribution network and also need to comply with complex state and federal regulations. For example, McKesson, the largest pharmaceutical distributor in the U.S., moves pharmaceuticals from hundreds of manufacturing plants around the world to tens of thousands of pharmacies in the U.S. It operates in a natural oligopoly with two other competitors and offers a meaningful value proposition due to its massive purchasing power and highly efficient order aggregation and fulfillment network. Although Amazon is a master at establishing scale, it has yet to demonstrate success in a highly regulated industry, let alone one which requires a level of order aggregation well beyond which Amazon has yet attempted.

Distributors have other attributes that enhance downside protection, including their ability to generate cash during a downturn, as they reduce inventories, and their insulation from obsolescence risk, as they typically can “put back” obsolete inventory to manufacturers.

Final Thoughts

The environment is fluid, and our research to-date has identified only limited opportunities in retail but has been more constructive in distribution. Retail investments in our portfolios are so far generally limited to businesses where grocery is either the primary or most significant business activity, whereas we own distributors in the construction, electrical, technology, pharmaceutical, aerospace, office supply, and automotive industries. Issues unrelated to disruption also enter the analysis, as with the potential impact of Brexit on the U.K. builders’ merchants. Our research is ongoing, and we will continue to focus on strength of the business franchise, range of outcomes, and downside protection in making our investment decisions.

As of March 31, 2018, a number of securities discussed in this article were owned in the following Pzena strategies: Tesco plc and Sainsbury plc – European, International, and Global Value; Walmart Inc. and McKesson Corporation - Global, U.S. Large Cap and U.S. Focused Value ; Anixter International - U.S. Mid Cap and U.S. Small Cap Value. The specific portfolio securities discussed herein were selected to illustrate our research process and not for performance. They do not represent all of the securities purchased or sold or recommended for our client accounts during the quarter, and it should not be assumed that investments in such securities were or will be profitable.



 

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The specific portfolio securities discussed in this article were selected for inclusion based on their ability to help you understand our investment process. They do not represent all of the securities purchased, sold or recommended for our client accounts during any particular period, and it should not be assumed that investments in such securities were, or will be, profitable.

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Notable portfolio holdings are discussed for illustrative purposes only.

The specific portfolio securities discussed in this presentation were selected for inclusion based on their ability to help you better understand our investment process. They do not represent all of the securities purchased or sold or recommended during the quarter. Holdings vary among client accounts as a result of different product strategies having been selected thereby. Holdings also may vary among client accounts as a result of opening dates, cash flows, tax strategies, etc. There is no assurance that any securities discussed herein remain in our portfolios at the time you receive this presentation or that securities sold have not been repurchased.

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