While retail is disrupted, distributors carry on

As e-commerce threatens to undermine the business models of retailers and distributors, successfully identifying the most promising value opportunities depends on understanding the key differences between these two segments of the market.    

Valuations of retailers and distributors have suffered as Amazon and other e-commerce companies have transformed or threatened to transform these market segments. As this valuation pressure reveals, investors frequently put retailers and distributors in the same bucket—middlemen that will eventually be disintermediated. However, we think it’s a big mistake to lump both types of businesses together. Many traditional retailers may indeed be doomed, but we see opportunities outweighing the risks among the most discerning companies engaged in distribution.    

The canary in the coal mine of e-commerce disruption was the chain brick-and-mortar bookstore, which today is a highly endangered species.

As e-commerce proved, the downfall of bookstores turned out to be books, as the now defunct chains, such as Borders and Waldenbooks, stocked a library-like assortment of slow-moving inventory, which in quantity carries costly real estate implications. Hosting an infinite aisle online and shipping items from centralized fulfillment centers turned out to carry lower costs and offer a better value proposition to the consumer.

As a result, most of today’s surviving physical bookstores maintain a narrower focus and limit their shelves to faster-turning inventory—such as that found in college bookstores and airport-based bookstores—as well as specialty bookshops, which by definition will never offer meaningful competition to the giants of e-commerce. 

The logic of inventory and space that spelled the demise of the big chain bookstore applies to a variety of retail categories, including home goods stores, clothing stores, and other retail shops commonly found at the mall.

The question seems to be where e-commerce disruption stops. As we examine the cost of fulfillment—or moving goods from suppliers to consumers—across various categories, we find this helps us determine the limits of e-commerce.

Our rule of thumb is that bulkier, lower-value, more perishable, more regulated, and faster-moving items are generally cheaper to fulfill in stores than by e-commerce. Grocery stores, for example, have so far proven resilient to inroads made by e-commerce ventures—although this continues to evolve, as the example of Amazon and Whole Foods has made clear. By contrast, slower-moving, higher-value, nonperishable items, such as books, apparel, and electronics, are more expensive to fulfill, making these categories more vulnerable to e-commerce disruption.    

The primary assets of retailers include their inventory, properties, and intangibles, which include their brand. Property is sometimes considered an important asset because it’s perceived as providing downside protection, but owning real estate may not be the ballast it appears to be. Monetizing real estate can have onerous tax consequences and put a retailer’s operating business at risk: The retailer may receive a one-time payment, but the sale may also trigger a lease obligation, a hidden risk in that leases are a fixed obligation that don't appear on the balance sheet.

Brands, on the other hand, can be a source of differentiation and protection, although the value of a brand can be hard to estimate. In our research, we find we must evaluate brands on a case-by-case basis.    

In contrast to retailers, distributors provide a value proposition to manufacturers and customers in several different ways. In the strongest cases, they offer a combination of:

• Product knowledge
• Regulatory expertise
• Physical availability and convenience
• Inventory management and capital efficiency

Given a sufficiently robust combination of these factors, the intrinsic value of distributors in a variety of markets, from construction and technology to the pharmaceuticals, aerospace, office supply, and automotive industries, can remain robust in an environment increasingly defined by e-commerce.    

An example is evident among pharmaceutical distributors, which tend to have highly efficient distribution networks and the ability to comply with complex state and federal regulations. The largest pharmaceutical distributors in the United States—of which there are very few—move pharmaceuticals from hundreds of manufacturing plants around the world to tens of thousands of U.S. pharmacies. These companies offer a meaningful value proposition to their customers because of their massive purchasing power and highly efficient order aggregation and fulfillment network. Although an e-commerce company such as Amazon is a master at establishing scale, it has yet to demonstrate success in a highly regulated industry, let alone one that requires an exceedingly high level of order aggregation.

Distributors have other attributes that enhance their downside protection, including their ability to generate cash during a downturn—typically, by reducing inventories. In addition, they're insulated from obsolescence risk, as they can generally put back obsolete inventory to manufacturers.    

Retail businesses tend 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. With the exception of a few business models, this has made the retail sector ripe for e-commerce disruption.

This disruption continues today, demonstrating the fluid nature of business models that can be rethought and reshaped through a technological lens. In our research, we've identified only limited opportunities in retail, but numerous and diverse investment ideas among distribution-based businesses. As we evaluate both areas going forward, we'll continue to focus on strength of the business franchise, range of outcomes, and downside protection in making our investment decisions.    

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