Manufacturer-Owned Distribution: Justifying The Ownership Of Captive Channels

 
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Introduction

The relevance and rationale surrounding manufacturer-owned

distribution channels has always been of interest within Frank Lynn

& Associates' executive network?and the topic

regularly evokes engaging discussions within our ongoing workshop

series. While few manufacturing executives will admit it, the

ongoing level of interest in the subject is directly related to the

lack of control they feel they exert over the operations of their

independent distribution channels. Manufacturing executives,

accustomed to the high level of managerial control exerted in

sourcing, logistics, and production, are often sobered by their

lack of direct control over independent market-facing

resources.

"If only we could get our distribution channels to . .

." (insert your largest market-facing problem here) ". .

. we could optimize our entire sales and marketing motion and

provide complete integration with (insert your current operating

platform here?SAP, Oracle, PeopleSoft, etc.) and the rest

of our internal operations!"

If this battle cry sounds familiar, it's likely that

you've heard the follow-up argument?one that almost

always includes support for acquiring formerly independent

distributors and rolling them up into a best-in-class,

manufacturer-owned distribution enterprise. Such discussions

typically describe an enterprise that would be "run like a

real business", "operated on a single business

platform", "provide a business model demonstration for

the industry," be "accretive to our earnings," and

ultimately function "in the best interests of the

manufacturer."

Such talk sounds impressive around the water cooler, but do

these arguments provide manufacturers any real justification to

acquire their distributors? To develop some perspectives on the

issue, Frank Lynn & Associates analyzed a sample of

manufacturer-owned distribution enterprises across a number of

industries?assessing the initial and ongoing

justifications for ownership, the underlying economic model, and

the alternatives open to manufacturers before and after the

acquisition(s). While we have divided the arguments into three

categories?economic, operational, and

strategic?most successful acquisition plans incorporate

an expansive view that encompasses justifications from all three

perspectives.

Economic Justification for Manufacturer-Owned Distribution

Channels

Economic analyses, if supported by sufficient current state /

future state scenarios and internal hurdle rates reflective of risk

levels, can provide sufficient "stand alone"

justification for distribution acquisition decisions. Frank Lynn

& Associates' research, however, finds that pure economic

arguments supporting the ownership of distribution are relatively

uncommon. Simply put, the business models that support typical

manufacturing and distribution concerns are quite different from

the perspective of virtually every financial measure. In most

cases, economic analyses and justifications are used to understand

the financial "downside" that accompanies an

operationally- or strategically-justified decision to acquire

distribution.

The economics associated with distribution

businesses?as they would be run by the manufacturer's

organization?are expected to be accretive to earnings and

do not conflict with any financial covenants. Such justifications

are quite rare, particularly because distribution businesses

typically operate on much slimmer gross margin and EBITDA lines

than manufacturers. Within manufacturing firms that own captive

distribution channels, the disparity between the financials

inherent in the two business models is a frequent topic of

discussion among shareholders and the analyst community. Wall

Street loves to complain about manufacturers who tie up assets in

operations that drag down overall earnings.

Some of the strongest economic arguments are found in industries

where a preponderance of value?across the entire raw

material-to-customer value chain?is created in the

distribution channel. Such scenarios are typical in industries that

rely to a great extent on the ongoing sale of consumable products

and on-site services, primarily because the revenue model is

weighted in favor of post-sale activities. Companies competing in

this "razor / razor blade" market typically pursue a

business model that leverages the lifetime value of an account, and

as such, use value chain analyses to justify the move into captive

distribution. In these industries, manufacturer new product

development decisions are evaluated from the perspective of value

capture over the entire life of the product, incorporating

manufacturer and distributor income from services, consumables, and

aftermarket parts into the overall decision making process. In many

cases, distributor margin over the life of the product is several

times greater than the margin reaped by the manufacturer in...

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