November 27, 2011

Surviving the Industry Shakeout - Imperatives for MENA Distributors

Operational improvements may not be enough to save floundering business models; MENA’s distributors need to look to alternative means to retain profits.

The distributors of the Middle East are at a crossroads; after decades of steady growth, incoming competition from third-party logistics companies and moves by multinational corporations (MNCs) are making once-successful business models unravel. As a result, the distribution business is rapidly becoming less profitable and more risky, necessitating a turnaround in identities and strategies.

To date, distributors have addressed this challenge via operational improvements, such as cost-cutting, and by trying to add new MNCs to their rosters. These manoeuvres are of limited value, however, and will fall short of solving the distributers’ long-term problems. If they are to continue to enjoy success, they will need to change their identities and business models, via one of two strategic options as identified by Booz & Co experts; they can change their distribution mission, doing things like focusing on specific channels or unbundling services, or they can vertically integrate, adding greater profits that are available upstream in manufacturing, or downstream in retail.

“With profits falling and competitive threats rising, there is an urgent need for distributors to choose a new path and begin making the necessary changes to their strategy and operations,” said Gabriel Chahine, a partner with Booz & Company. “There are approximately 575 distributors operating in the Middle East, making the industry ripe for consolidation. While the incremental improvements that they have shown are useful, they are not sufficient to stay afloat in light of the increasingly crowded competitive landscape and protectionist legislation; distributors must determine whether their business model is at risk in the current environment, and whether it can continue to satisfy shareholders’ expectation in order to decide on the path forward.”

As mentioned above, there are two primary options that Booz & Company recommends to distributors. Option number one is to change and refocus the mission within distribution. By increasing the scope of what they do, distributors should consider six dimensions, which they can pursue either in isolation or in combination, depending on their assessment of their capabilities. These are:

  • Service focus: The distributor would unbundle some aspect of the value chain (for example, logistics or marketing), creating a best-in-class service that it would then offer to all principals in the market.
  • Channel focus: The distributor would retain scale using a channel focus, in which case it would provide a one-stop-shop service to particular channels. American company Sysco Corporation is an example of a distributor with a channel focus; it has become one of the preeminent food service distributors in the US. Similarly, a focus on traditional trade, such as the small corner stores that make up the majority of the retail landscape in MENA today, would be relevant for regional distribution.
  • Category focus: Moving into a category focus involves specialising in a product area where know-how is essential. A good example of this is McKesson Corporation; through its focus on healthcare, it has become the 15th largest company in the US.

These first three options require an adjustment to economic models, while the following three do not.

  • Midsized principal focus: Distributors would target a sub-segment of MNCs—the sweet spot being companies with enough revenue to have global aspirations but too little revenue to set up shop in every market. Qatar National Import and Export is a good example of using a midsized focus successfully in the region.
  • Geographic focus: This refers not to geographic expansion, but to concentrating on certain geographic areas. Those pursuing a geographic focus are an exception in that they generally don’t have to worry about scale; they just have to manage their accounts and businesses within the geographies they target.
  • Internal brand focus: With an internal brand focus, a distributor would identify local needs for everyday products that were going unmet, and find an outside manufacturer to produce market-appropriate versions of those products under the distributor’s own brand. Several MENA distributors have already gone in this direction as a way of ensuring their growth.

“Given the urgent need to refocus their mission, distributors will have to think about all of the options that will allow them to build scale quickly. Distributors that have already gained critical scale may opt to go it alone, whereas those that still need to create scale should consider partnerships and alliances with existing distributors, or with multinational companies,” commented Faisal Sheikh, Principal.

Option two is to enter another part of the value chain, in addition to distribution, and involves the most risk. This second strategic recommendation involves integrating vertically – either backward into manufacturing or forward, into retail—to lift distributors out of the middleman position and into those where they ‘own’ something sustainable.

More tangibly, vertical integration offers the chance to enhance profits. For every $1 profit in the MENA pharmaceutical industry, for example, manufacturers get 55 cents, retailers get 30 cents, and distributors get only 15 cents; the figures are even lower for distributors in the food and beverage industry (8% for distributors). By becoming involved in other parts of the value chain, distributors’ profits would be given a significant boost.

Distributors that integrate forward into retail can make use of their knowledge of inventory planning, warehouse management and logistics network optimisation to gain efficiencies. Likewise, distributors that integrate backward, into manufacturing, start off with some advantages, such as an existing distribution scale to allow them to quickly penetrate markets with products from their own assembly lines. Their marginal cost of distribution is typically quite low—they already own the delivery trucks, the regional warehouses, and the heating and cooling systems. In addition, if they start manufacturing products, companies that operate as distributors can get prominent placement for those products in stores, because they already have deep relationships with retailers.

“Reinvention is possible, as is proved by examples that exist successfully in the marketplace. But there is a high risk of failure when trying to integrate new capabilities, therefore some distributors may consider this second strategy a bridge too far,” said Chahine. “No matter which additional part of the value chain a distributor decides to enter, there will be gaps to fill. Distributors are typically not well-versed in figuring out the optimal location and formats of stores—two essential components of retail success. They are not adept at using consumer insights to determine what should be on the shelf or how to price it.”

If they go into manufacturing, distributors will find just as many gaps. Typically, they will need to add a research and development capability, a raw materials sourcing capability, and a production capability, because running a manufacturing plant is a highly specialized skill. Although a distributor may already have some of the requisite capabilities in-house, it won’t have them all, as one of the region’s pharmaceutical distributors realised when it set out to manufacture generic versions of prescriptions.

The Basamh Group is a regional example of backward integration; a few decades ago, this now almost 80-year old Saudi Arabian trading company started manufacturing its own food products under the brand name Goody. Axiom Telecom furnishes an example of forward integration; having started out as a distributor of mobile devices, it is now a highly successful retailer of mobile phones with more than 900 outlets in the region.

“Although the stage is set for consolidation and it is likely to be intense, most MENA distributors can’t, and don’t need to, transform their businesses overnight,” said Sheikh. “They need to accept that the market is changing and to start thinking about how they can adapt to keep up, while determining how quickly they need to embark upon a new path to ensure continued profits.”

To do this, they must determine the extent of the risk to their existing business model; 

  • Do the distributors’ principals have multiple distributors in the market? 

Principals with more than one distributor have a readymade alternative to turn to, making it a higher risk that the principal will leave.

  • Has the distributor lost any of its key principals in the past?

This sort of loss sticks in the mind of management and shareholders, increasing the perception of risk.

  • Is the majority of the distributor’s revenue derived from just a few principals?

Being too dependent on a handful of customers is never safe; if relationships with principals end, distributors often have a hard time covering their fixed costs.

Once the extent of risk is ascertained, they must then determine whether their existing business model can continue to meet shareholders’ expectations, through asking the following questions;

  • What is the return on invested capital (ROIC) for the business?

A declining ROIC reduces the value of shareholders’ equity and creates a situation in which shareholders may be better off putting their money in the bank.

  • In the case of family-run distributors, to what extent is the shareholder base expected to increase?

New generations create an imperative for more profits. Without a healthy and increasing ROIC, the business will have trouble meeting its obligations.

“For some distributors, the answers to these questions will highlight significant near-term challenges—these are the ones that should consider diversifying most aggressively, by moving into new parts of the value chain or making strategic bets through initiatives like equity stakes in joint ventures,” added Sheikh. “However, no-one can afford to be complacent; companies should, at the very least, take some preliminary steps to prepare themselves to adopt a new dimension as distributors.”

Not every distributor is in the most perilous position of being dependent on and having all its assets built around a single principal, but many are too dependent on revenue streams that, after decades of steady growth, are suddenly looking vulnerable. There is a need for bold, strategic action. The right strategy will depend on the distributor’s assets and capabilities, as well as the risks it is facing—however, the most important decision of which path to take cannot be delayed.