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Why distributors? More specifically, why electronics distributors? Why have these intermediaries in the markets at all?
Yes, obviously, someone somewhere has to have pieces of kit on a shelf somewhere for when a customer wants to make an order. Someone has to crate it up and ship it off too: but why do we still have distributors as independent companies performing these functions? It's the sort of thing we might have expected to see being disintermediated away over the years as communications became cheaper, as information became ever easier to keep track and as delivery itself became both easier and cheaper.
It's entirely possible to think of ways in which that gap between the manufacturer and the final retailer should have closed, killing the space in which distribution is done. Wal-Mart's logistics system is reputed to have done just that. Wal-Mart systems know that someone's just bought an extra jar of veggie pasta sauce and it's not long before this is aggregated with other store information to tell the manufacturers of said pasta sauce to get busy shipping some more: or indeed making it.
However, this gap hasn't shrunk. In large part the industry still works on manufacturer to distributor to retailer or VAR/reseller. Some firms have gone direct, Dell being an obvious example, but this hasn't become the standard across the industry despite what might seem to be obvious benefits of such a model.
There are reasonable financial reasons why this extra step might not be worthwhile as well: depreciation of value being one of them. It rather shocked me when I first heard it said that electronics are about as perishable as chocolate. While they are sitting on a shelf their value (as an average, of course) goes down by some 1 per cent a week, or 50 odd per cent a year. This means an extra step – where the goods hang about in a warehouse gathering dust – seems like something people would like to cut out. And certainly, it would be brave people who take on the risk of being the ones watching the expensive stock depreciate.
So I've done a little bit of digging around in the accounts of the industry to see what I might be able to find. Please do understand that I am looking at this as an economist would: not at all from the industry point of view. You might well know how distributors make your life easier (or more difficult) in the business, but I'm interested in the existence of the very sector. Simply, do electronics distributors add value to the economy in the way that an economist thinks about that?
Economists are funny birds and tend to think of things quite differently from engineers or even accountants. Most importantly an economist is always (or damn well should be) aware of opportunity costs: the cost of doing something is not in fact solely the amount of money you have spent doing it. It's really giving up all of the other things that you could have done with that money. That last £4 on a Friday night can be spent on another pint, or a burger to lesson the hangover from the pints you've already downed. The cost of the pint is the loss of the burger, the cost of the burger the loss of that last pint. Weird, but someone's got to think this way.
Which means that when we think about adding value we don't in fact look at the margins that a business is making. They're interesting but not really relevant to our question. A margin of 1 per cent is obviously smaller than one of 10 per cent: but whether you've got a viable business there depends more on your fixed costs and the volume that you're getting that margin on than it does on the size of the margin. A hedge fund making 2 per cent on a few billion when overheads are 1 per cent is going better than someone with a 30 per cent margin on £1m with £400k of overheads.
So operating at thin margins might be something a business worries about: thin margins leave less room for mistakes for a start. But that's not what an economist would worry about.
Similarly, profits are important to all sorts of people. A loss is indeed the universe's way of telling you to be doing something different. But simply making a profit isn't enough, because of this opportunity/cost thing that economists like to bang on about.
Yes, a profit is a start, it's a move in the right direction. However, capital has a cost and capital has to be employed within a business. So what an economist wants to see is that a company is making a profit over and above that cost of capital. Only then can it be said to be adding value to the economy as a whole. For if it isn't, then perhaps the business should be closed down, the capital deployed to do something else that does in fact earn that average cost of capital: something pretty close to the average return to capital in that economy in fact. Accountants and business people ought to be concerned with this number too, but they tend not to be quite as much as they should be.
All we need now is a guess at that cost of capital, some distribution company accounts and we can have a look. A reasonable guess is 8 per cent. That's what companies often use to judge internal rates of return on projects at least and we might as well use that same return to measure companies as a whole. There are reasons (like current low interest rates) to think that this is a high hurdle to use, but we have to use something so why not?
Take Acal as an example. It has a total equity of £50m-odd, upon which in 2010 it made a lovely loss, while in 2011 it made £1m. By our yardstick it doesn't matter what its margins were, nor even its profits. We care about whether profits are greater or lesser than an 8 per cent return on total capital employed. For Acal, that would be £4m and clearly it failed. However, two years' results isn't really enough to judge such a thing. And one company isn't enough to judge an entire sector either.
Avnet, on the other hand, shows the following returns over the past five years: over 10 per cent; over 10 per cent; whacking loss; over 10 per cent; and then another 10 per cent. So it is by our particular measure adding value; it is earning more than its cost of capital.
If we look at Arrow over the past five years we see: well over 10 per cent; whacking loss; 4 per cent; 15 per cent; and then 16 per cent.
Ingram Micro gives us this intriguing little snippet: “Full year return on invested capital was 10.4 per cent, exceeding our weighted average cost of capital of 9 per cent.”
Which is very nice and gives us an idea that our near arbitrary 8 per cent cost of capital isn't far off. However, “invested” capital is not the same as total capital. If you have a chunk of capital that you don't know what to do with and are keeping in the bank at 1 per cent then your total return on total capital can fall below that cost of capital. And to be fair to Ingram, it has only failed our 8 per cent test twice in the last five years.
Northamber (PDF): Ooops! Using a slightly different set of numbers (but which ought to be the same as percentages) net earnings per net equity both per share, seems to have had returns over the past five years of: 3.6 per cent; 1.5 per cent; 0.2 per cent; 0.6 per cent; and minus 0.4 per cent. So it didn't really manage that return over the cost of capital that makes an economist beam with pride.
But just looking at individual companies isn't going to tell us whether the whole sector is adding economic value or not. Some companies might just not be doing very well in the face of competition while others are doing just fine. What we'd really like to to see the average return on capital for the whole sector. Which, through the magic of low friends in low places I can provide – if only for this most recent year.
For the 36 companies which my low friend considers to be the electronics distribution sector, this gives us a return on capital of 24 per cent. This is well above either our arbitrary 8 per cent or Ingram's admitted weighted average cost of capital of 9 per cent.
At this point the economist entirely loses interest in the subject under discussion. Why a certain activity is adding value to the economy is completely uninteresting: we know that people do all sorts of weird things and the very reason that we don't try to plan an economy is because no one centrally can work out why they do what they do or what value they gain from having done so.
We can, as we have done, work out that the activity itself is adding value: profits in a competitive market are higher than the cost of capital. This boils down to the fact that someone, somewhere, is willing to pay more for these services than they cost to provide. This is the very definition of adding value. Excellent, well done and that's all we care about.
Unless you'd all like to tell me why it is that distributors add value to you? ®
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