The Case for Consolidation: Two-Step Distribution
Builders have consolidated, dominating many of the major metros. This dynamic is one of the many reasons why LBM dealers have followed suit, consolidating at an extremely rapid pace over the past decade. Some mention national deals with builders as an advantage. Others cite economies of scale (although I am not really sure whether this is a reality). To me, the primary advantage that the large LBM consolidators have in supplying this customer segment is lower customer concentrations. Think about how differently decisions are made at the independent dealer where a few customers (or even one in some cases) make up over 25% of the business vs. the LBM consolidator, where the largest customer might make up 1% of total sales. The mindset is night and day.
Now consider the life of a two-stepper/wholesale distributor to the LBM dealer channel. Their customers are consolidating, too—US LBM, Builders FirstSource, Stock/BMC, 84 Lumber, etc., can easily make up more than 10% of revenues, respectively. These large customers have the sophistication, balance sheets and volume to demand things such as extended terms and can cut deals directly with manufacturers. In this scenario, profit margins shrink on these customers, the business gets riskier, and working capital—a key component of any distributor—suffers. Anchor Peabody research has discovered that many wholesale distributors would have been better off liquidating their businesses and investing it in the stock market rather than continuing to drive such low returns on assets.
Unfortunately, the vendors—the building products manufacturers—pose what is perhaps an even bigger problem for these businesses. An illustrative story is that of a large wholesaler that built a solid business distributing a leading brand of windows and doors. This distributor stopped selling other product lines to focus on this brand, in exchange for an exclusive right to distribute the brand in a major trade area. Several years later, the window/door manufacturer terminated its contract with the wholesaler. As the rumor goes, the decades-long relationship was ended without warning to the wholesaler.
I share this story not to debate who was right or wrong—this is ancient history at this point, but rather to point out the landscape can shift at a moment’s notice and for reasons completely out of our control.
Such is life with vendor concentrations. The fight for the few key brands which are difference-makers with dealers will get fiercer. If successful in attaining one of these brands, the brand becomes a larger part of the business. Most products also have life cycles, so a higher margin product which is doing well today may be commoditized tomorrow. Regarding the latter, the recent ascensions of cement board siding and PVC trim comes to mind (granted all products are not created equal). Let’s also not forget some segments of manufacturing are consolidating, too.
What are two-steppers to do? How do they create adequate returns for their shareholders for the risk they are taking? One option is to consider consolidating. Get bigger. Today, there is no doubting the importance of the role two-step distribution plays in the channel. Manufacturers and LBM dealers need the two-step wholesaler; they provide a valuable service, education and inventory component to their customers.
Consolidating is an opportunity to make their businesses even more important, perhaps becoming the best or only choice for manufacturers selling products down-channel and the best or only choice for solving LBM dealer’s problems—giving the consolidator a differential advantage over smaller independents. Further, there is a real opportunity to consolidate what is a fragmented segment
of building products. Economies of scale are there to be had. There will be cost-savings, and world-class managers can create and share best practices with acquired businesses.
Certain market leaders have embarked on this journey, but more can be done. Bigger is not always better but it sure seems safer given the current circumstances. LBM one-step dealer M&A announcements have grabbed headlines of late, but don’t be shocked to see our wholesale-distributor comrades cause the most disruption over the next 24 months.