Many independent distribution companies wonder why their gross margin, net profit and attendant multiples are inferior to their $2 billion-plus sales, national-market, publicly held competitors. These competitors may have many structural advantages:
- They can raise capital in public markets.
- They have enormous scalability because of their size.
- They can afford and attract smart, experienced managers.
- They can source private label products.
- They can negotiate better purchasing prices.
I would argue that one of the primary advantages of larger competitors is their management focus and discipline on thinking and acting like an investor. This factor may be another, somewhat less obvious part of their success as the reasons listed above.
Our larger competitors run similar businesses. Their management decisions, like yours, are driven by marketing, product and operational considerations.
However, they add, with equal importance, looking at the business as an investment that should be generating superior returns, or the Private Equity Investor Framework. One way to accomplish that view is to focus on Additional Value Creation (AVC). AVC is a way of thinking about the disparate drivers of net profitability: What really contributes to your bottom line? How can you add value to your business by building margins more effectively and more sustainably? How do you add growth volume to your existing profitable business model?
This installment of my blog will examine the Additional Value Creation dimension of the Private Equity Investor Framework discussed in my previous blog post.
I have selected some of the most important drivers of Additional Value Creation that private equity investors consider:
- Growth with existing customers.
- Growth with new customers.
- Pricing strategy & elasticity, aka strategic pricing.
- Granular analytics of customer and/or product line profitability. An example is The Islands of Profit in a Sea of Red Ink approach from Jonathan Byrnes.
- Granular analytics of marketing strategy and execution.
- Buying smarter by using master distributors, maximizing rebates, purchasing negotiation and other distributors.
- Reducing non-core expenses/costs. Examples include using cloud IT, self-insurance, outsourcing and EDI.
- Inventory: turns, turns and turns.
- New market/product alliances and JVs, including collaboration, franchises and services.
- Acquisitions: arbitraging other firms’ less favorable performance.
Note that only a few of these drivers are product-centric. We are a product-centric channel, but there are more ways than product to add value and grow net profitability.
Distributors should think about net profits rather than gross profits when considering Additional Value Creation. Why? Gross margins give disproportionate weight to the impact of products. Looking at value creation with an eye on net profits broadens your viewpoint; it allows you to determine what might have the biggest impact on your bottom line.
No avenue to improved profitability is more valid than another. The Private Equity Investor Framework-driven manager considers every profitability improvement activity on its own merits.
Here’s an example of thinking beyond product in Additional Value Creation:
Many companies’ inventory turns are far from what they should be. Too many of us see our warehouses as long-term parking lots rather than switching yards. There are many valid reasons for low inventory turns, but for many of us it is because we are just too wedded to our physical product.
Think instead of your warehouse as stacks of dollar bills that should be creating additional value, rather than as boxes of product. Excess product that sits for eight months because you got free freight is not creating value. Staff time keeping track of items that don’t move, over and over again, does not create value.
How many distribution managers spend an inordinate amount of time beating up suppliers for better pricing because of the real or perceived attendant gross margin improvement, where investing equal or even less time and effort in strategic pricing would have a significantly higher net margin impact?
That’s what a Private Equity Investor Framework-driven manager does, and it’s how your largest competitors think and execute. And that is how you – regardless of where you are – from working on your exit plan, making your own acquisition or preparing the next generation for leadership—should act – like the investor that you are!
In my next blog post, I will discuss how and why you should think of your business as a portfolio.