You Should Not Invest in Distributors – Here’s Why!

Lately, I was tasked to analyse a watch manufacturer listed in Hong Kong. The company was being acquired over by another peer in the industry. Before any analysis, I would ask myself a few top questions, who are the kind of players in the entire value chain and who makes the most money? My mind raced to a particular chart which I kept inside my investment learning folders.

Presenting to you, the Smile Curve. It is created by Stan Shih, the founder of Taiwan’s Acer.

Chaitravi’s Blog

While it is meant for electronics, it applies to apparel manufacturing too. I told my community that we have to be strategic in choosing the types of companies we invest.

“Not all businesses are made equal, some business is inherently more superior than the rest by its business model design.”

The Stan Shih tells us the margins are higher for branding/concept/sales/marketing.  The manufacturing and distributions companies do not make that much.

What is a distributor?

A distributor is a business that buys products from a manufacturer, warehouses it, then resells them to resellers or direct-to-consumers. Occasionally, distributors are even asked by the manufacturers to provide advertising dollars to promote the brand – collectively.

Using the Bloomberg provided by the library, I pulled out certain figures of watch distributors listed in Hong Kong and the brands under their management.

Extracted from Bloomberg

Excluding Stelux Holdings, all of them are distributors. You can see that there are several overlapping brands such as Omega, Tag Heuer, Tissot, and Rolex.

First problem

The cons of being a distributor are:

• No differentiation because you are selling items that can be sold by other distributors too.
• The need to maintain a physical retail store and there is a problem of being squeezed by rising labour/rental costs potentially.
• There is absolutely no pricing power and a company grows by distributing more brands or selling more. The lack of pricing power comes from a lack of differentiation.

The gross margins of watch distributors range from 15.6% to 27.4%. This represents the price differences between the wholesale price from manufacturers versus the retail price it sells to end consumers. More often than not, it is controlled by the manufacturers through a “suggested price” approach. If any of the distributors try to sell the products at a much lower price, it would hurt the brand image and other distributors’ ability to earn their profits too. Imagine, you have a distributor from a particular country who wants to earn a 10% gross margin, most customers would flock to them. This would put other distributors with higher cost structure out of business.

Since pricing power is absent, it is about lowering down your operating expenses such as rentals and manpower. For consumer products, it is critical to be in high-traffic. This brings the problem of high rental cost and running effective marketing strategies. It does not make sense to buy a company with low margins, it is a clear signal of stiff competition and high operating costs.

Second Problem

A distributor depends on the brand owner/manufacturer to release new products to grow its business. Let’s say,  a distributor is distributing products from Rolex only. If Rolex does not push out new products, the distributor’s profits are unlikely to grow. A distributor ties its fate with the brand owner too closely and it is very risky. On the other hand, if a distributor does not perform well, the brand owner can appoint better distributors in the country. The brand owner does not suffer as much as the distributor.

It is also known that brand owners use distributors as a way to test markets for their products commercial potential and viability. Once it is proven and profitable, the brand owners may opt to take back the distributorships upon expiry and run it themselves.

If a distributor purchases the inventory from the brand owner and it does not sell well, the risk lies with the distributor.

Either way, a distributor loses out.

Examples

Let us turn to F J Benjamin (SGX:F10), a Singapore distributor and brand management. It distributes brands such as Givenchy, Guess, La Senza, Marc Jacobs, Superdry, and Tom Ford.

Its FY2017 gross margins are around 46.4% which is fantastic. After deducting staff, rental and advertising, the business is left with 12.7%. This is rather decent. I do believe a distributor needs to earn more than >35% gross margins otherwise it would not have much left after deducting the necessary business costs.

How about Dickson Concepts (SEHK:0113)?

On 17 February 2009, Polo Ralph Lauren decides to take over the entire wholesale and retail distribution in South Asia from its licensee, Dickson Concepts. This caused their topline revenue to decline about 11% from FY2009 to FY2011.

From FY2015 to FY2016, Dickson Concepts suffered another setback. Its revenue dropped by 16.2%. In FY2015, American brand Brooks Brothers decided to end the Greater China license. Brooks Brothers felt that Dickson Concepts was leading them in the wrong direction.

Distributors with Scale or Own Brands

Like a reader pointed out, distribution can be a lucrative business if it has the scale. For models like Amazon or JD.com, they’ve lost huge money in the earlier days as they’re obtaining scale. Once the certain scale is achieved, the bargaining power starts to shift and the distributor is able to spread logistics costs per item to even a wider quantity of items.

Essentially, when we look at Costco or Walmart, they are retail distributors as well. They purchase huge inventories and resell them at a markup (gross margins). Over the years, as they have grown in volume, these companies were able to extract lower prices from their suppliers. After realizing what sells and what does not, a smarter distributor would attempt to create their own private brands as well.

Singapore’s Sheng Siong, a supermarket operator, has their own private brands such as Happy Family, Powerplus, Softess, and Tasty Bites. It gives them the wholesale margins.

Conclusion

At the core of any business, it must have the ability to control its own fate. It must be able to dictate its pricing power and stimulate demand for the brand. When the lifeline of a business is dependent on the brand owner, I do think it is a very risky business to invest.

Everything goes back to the value chain. Ask ourselves, which company earns the most money? It is not the distributor, it is the brand owner.

Invest smart, invest in businesses that are differentiated. When the business model is broken/challenged, it is tough to make money and compound wealth.