Distributors: improve your return on capital - Distribution - electronics industry distribution practices

Electronic News, July 22, 2002 by Rob Spiegel

Sales? Who cares about sales? Margins? Hey, what's wrong with low margins? Profits? Yep, that's everything. Stock experts reveal widespread agreement on the leading challenge facing distributors: If you're in business to create some green, just do it.

For the analyst community that watches every move of the publicly held electronic distributors, return on capital is the foremost concern. Other worries are mixed with disputed challenges including low margins, the no-growth market, tanked stock prices and the two-tower approach of distributing both components and computers. But the pressures of delivering a decent return on capital took top honors as the biggest hurdle facing distributors.

"Margins are not a problem, but return on capital is clearly an issue," said Clarke Walser, principal of Walser and Associates of Arlington Heights, Ill. "Return on capital stinks at distributors. I think there is no question they need to improve it. If you look at the last decade, return on capital has been under pressure for some while."

Analysts often labeled the return-on-capital challenge as a pricing problem as well as a reduction-in-overhead concern. "One of the top challenges is getting paid appropriately for the services they're providing without making their suppliers and customers nervous," said Rob Damron, executive VP and equity analyst at SWS Securities in Milwaukee. "Distributors have done a good job of validating their place in the channel, so I think they resecure from that standpoint, but if they don't get appropriate margins and return on capital, they'll die."

Brian Alexander, analyst at Raymond James & Associates in St. Petersburg, Fla., said part of the problem lies in the area of perceived value, which erodes pricing. "The first challenge [for distributors] is making sure they get compensated for the value they give their customers," Alexander said. "That's a matter of making sure their customers understand the value they deliver."

Walser said distributors are facing difficulty in making their case for better pricing. "The basic problem is that the industry has a lot of excess capacity and that capacity has to be bled off," Walser said. "The number of distributors has gone down, but the square footage of warehouse has gone up. And the industry is only doing two-thirds of the business that it was."

Though Walser said he is concerned about return on capital, he's not bothered by low-margin business. "I don't worry about margins. What's important is creating a profit. The distributors are honing their businesses to higher turnover in order to get that return on capital even if margins are down," Walser said. "But the return hasn't gone up fast enough to offset the decline in margins."

Damron agreed that low-margin business is just fine if a company can deliver it without employing too much capital. "The way to improve your return on capital with low-margin business is by reducing your investment in capital," Damron said. "If Avnet can take low-margin business but have little capital employed to produce that margin, then great." Damron noted that Arrow Electronics Inc. of Melville, N.Y., is taking a different tack. "I'm noticing that Arrow is choosing more the margin route. They got out of Gates [Electronics, a low-margin, midrange computer business Arrow sold last spring] and moved out of the low-margin processor business while Avnet is still embracing the low-margin processor business."

As for the disastrous stock prices that have distributors at 52-week lows, Alexander doesn't believe the valuations are really all that low. But he does think they're starting to look attractive. "I would not say the valuations are ridiculously low. I think they're reasonable," Alexander said. "But as an investor, I would lean more toward buying these stocks than selling them because they're trading at close to book value. But I don't get the feeling these stock are ridiculously cheap." Ultimately, he sees stock prices reflecting the companies' abilities to deliver. "The stock prices will take care of themselves if the distributors deliver on the other things."

Alexander also questioned the combination of component and computer distribution businesses common with the larger distributors. "Another challenge is to determine what business they want to be in and what business to exit based on improving return on capital," Alexander said. "How strategically important is each business? And should they be a pure electronic components distributor or should they be a midrange enterprise computer distributor? Do both of these businesses meet the return-on-capital goals they set out for themselves?" He noted that this challenge is particularly vivid at Pioneer-Standard Electronics Inc. of Cleveland because component and computer businesses have equal footing.

Walser isn't concerned about distributors carrying both computers and components. "Having a computer business and a component business is not a tough deal because there is not a big difference between the two," Walser said. He was more concerned when some of the smaller distributors began to test the waters of contract manufacturing since manufacturing is far from the skill set of distribution. But now that trend is dying, Walser said.