This Distributor Is a Bargain
12/14/2011 9:35 am EST
Generally speaking, it’s costly for producers and customers to interact with each other.
Imagine an industry with five producers and five customers, with all the producers selling to all the customers. If there were no distributors, each customer would establish a relationship with each producer, totaling 25 relationships. These relationships must be nurtured, which consumes resources and time.
If we insert a distributor into the middle, we now only have ten relationships if each customer and producer deals only with the distributor. Scale this up to an industry with thousands of products, customers, and producers, and it’s easy to see the value a middleman brings to the table.
Distributors often have a few other points in their favor. For one, they are typically capital-light and generate high free cash flows through an economic cycle. Also, they don’t suffer from a lot of technology or business model risk. In a fast-changing economy, longevity should count for a lot to investors. Finally, past a certain critical mass, many distributors benefit from at least two sources of economic moats: network effects and scale, which reinforce each other.
This can be a pretty potent combination. Industrial and electrical distributors—companies like Anixter (AXE), Grainger (GWW), Fastenal (FAST), and MSC Industrial (MSM)—distribute industrial supplies: tools, electronic equipment, wires, cables, screws, lubricants, and basically anything that’s required to build or fabricate something. These firms are a vital part of our industrial supply chain, serving millions of businesses, both in America and abroad.
Because the customer base is so large and heterogeneous, they often carry mammoth product lineups. Anixter, for example, has about 450,000 unique products in stock, selling to over 100,000 customers. A heavyweight like Grainger carries twice as many products and serves several million customers.
This dispersion of products and customers is a big point in the distributors’ favor. For example, a machine tool maker with 100,000 small customers would find it impracticable to build a direct-sale presence to each of these customers. On the other hand, if you were a small general contractor, buying from several hundred suppliers, it would also be uneconomical for you to contact each of these firms directly.
There are a few big reasons that the industry remains highly fragmented:
- One, price transparency can be poor across thousands of different products, making it difficult to use price to steal customers.
- Two, many of the products sold by distributors are critical to a small company’s operations. For example, the lack of a simple fastener can shut down a million-dollar machine. Therefore, once a customer is satisfied with a distributor’s products and service, they often don’t want to take the risk of switching to a new provider.
- Lastly, many customer accounts are quite small, making it not worthwhile to devote significant selling resources to steal them.
Even after consolidating for the past decade, industrial and electrical distribution remains extremely fragmented. Depending on whom you ask, the top ten players control perhaps 20% to 30% of the market. This is a testament to how sticky some of the customer relationships are in the business. On the other hand, this suggests that the growth runway for the largest companies is very, very long.|pagebreak|
Unfortunately, Anixter is not the best distributor we can buy. That honor belongs to Grainger, MSC Industrial, and Fastenal, which all earn gigantic margins and returns on capital.
I don’t think Anixter will ever become as good as them. For one, its customer base tends to be larger enterprises and contractors, and its products are not quite as mission-critical, leading to weaker pricing power.
Moreover, Anixter hasn’t embraced information technology and warehouse automation as avidly, which has led to poorer productive gains over the past decade. That said, it does have two big saving graces that I think make it an attractive investment.
First, just as there is a gulf of difference between these companies’ margins, there is a massive difference in valuation. For example, Fastenal trades for a vertigo-inducing 34 times 2011 estimated earnings. Grainger trades for 20 times, and MSC positively looks like a bargain at 17 times. In contrast, Anixter only trades for 11 times. I don’t think Anixter deserves to trade for such a massive discount.
Second, Anixter regularly returns capital to shareholders. For example, the company has paid two large special dividends in recent years, including $3.25 per share in 2010. It’s also been a steady buyer of its own shares, about 5% of outstanding shares this year. Lastly, the company has some interesting opportunities to organically expand its presence in emerging markets, which make up about 11% of its revenues but are growing twice as fast as the rest of the company. As these fledgling distribution networks gain scale and market share, there should be some room for margin expansion.