The Nuts and Bolts of Industrial Distributor Moats
Cost advantages and network effects work in their favor.
We believe the industrial distributors we cover have wide or narrow economic moats thanks to cost advantages and network effects. Distributors play a crucial role by connecting thousands of suppliers to millions of customers. Despite the common desire to eliminate middlemen, it would be highly inefficient for customers and suppliers to contract with one another directly. We estimate that sales by the industrial distribution industry have grown around 5.2% annually over the past 20 years--60 basis points faster than U.S. gross domestic product growth.
Highly Fragmented Market
The industrial distribution industry is highly fragmented. According to the U.S. Census Bureau, the average wholesale distributor has only 15 employees and less than $3 million of revenue. MSC Industrial estimates that the domestic industrial maintenance, repair, and operations market generates $140 billion of annual revenue. If we include original-equipment manufacturers, we believe the addressable market is much larger--on the order of $1 trillion in the United States, with an additional $1.3 trillion in Europe.
W.W. Grainger is the largest competitor in the MRO segment but still has just 5% market share. More than two thirds of the market is split among 150,000 small distributors. In such a fragmented market, having scale contributes to cost advantages and network effects that form the foundation of economic moats.
Broad Product Assortments
The average number of stock-keeping units at the distributors we cover approaches 1 million. Impressively, these firms have managed to nearly double the number of items offered over the past decade while holding inventory days relatively constant at 100-110. We attribute this to better capacity utilization. We believe industrial distributors have intentionally focused on inventory depth to satisfy customers' diverse product requirements and the need for quick delivery.
Vendor-managed inventory solutions enhance distributors' switching costs. Under this arrangement, a distributor assumes responsibility for ensuring that a customer's component bins and production supplies are always stocked at the customer's site. Industrial vending is a subset of vendor-managed inventory. Industrial vending increases employees' accountability by requiring them to swipe unique identification cards before they can gain access to supplies. Customers like this system because it cuts shrinkage and waste and can help identify when a piece of equipment may need to be repaired.
Deploying vending machines can reduce product consumption by as much as 30%. To ensure that vending machines do not translate into lower overall sales, industrial distributors often mandate that a customer's average monthly spending increase by consolidating purchasing with fewer vendors. This strategy has allowed the biggest advocates for the systems--MSC Industrial, Grainger, and Fastenal--to expand their wallet share at vending machine customers.
Value-Added Information and Services
Distributors can differentiate themselves by offering unique product knowledge or services. For example, MSC's expertise in metalworking is so extensive that customers routinely ask its salespeople to critique and make recommendations on their production processes. Fastenal stocks almost 600,000 kinds of fasteners. Its salespeople can discuss the different strength and coating characteristics as well as work with customers to create custom fasteners. Anixter, which is focused on electrical distribution, will assemble security systems to customers' specifications. The company also independently tests products to affirm or invalidate manufacturer claims.
Some distributors operate extensive networks of stores, most notably Fastenal. Stores provide a convenient point to interact with customers and deliver products quickly, which can enable distributors to charge higher prices. At the same time, customers are increasingly demanding e-commerce capabilities from distributors, including online product catalogs and ordering capabilities. Large distributors should be able to adapt their sales efforts to accommodate changing customer preferences.
Many industrial products suppliers offer rebates and incentives for meeting minimum quarterly and annual volume targets. The large distributors we cover tend to be market share leaders in their niches, and incentives can meaningfully contribute to operating margins. Larger distributors also tend to have more efficient logistics supply chains, including a higher degree of automation that reduces errors and improves the timeliness of deliveries.
Direct sourcing and private-label products can contribute to margins. Distributors that source products directly from manufacturers can bypass other middlemen and cut costs. Smaller distributors may be forced to buy from a master distributor or through a buying co-op with a less efficient supply chain. The distributors we follow have leveraged global direct sourcing to offer private-label products, which can improve customer loyalty and bargaining power with suppliers. At around 22%, Grainger derives the highest percentage of sales from private-label products.
Wide- and Narrow-Moat Industrial Distributors
W.W. Grainger (GWW)
Grainger is one of only two industrial distributors to earn our wide moat rating. It was an early leader in vendor-managed inventory, industrial vending, and e-commerce. It has unmatched scale and very strong private-label and direct-sourcing programs.
Fastenal is the other wide-moat distributor. The company differentiates itself with the largest store network in the industry as well as a strong industrial vending operation. The company has a highly efficient supply chain and a leading share of fastener sales.
MSC Industrial Direct (MSM)
MSC is smaller than Grainger and Fastenal, but we think it has a narrow moat and one of the more attractive valuations in the industry. MSC has an especially strong position in metalworking, where customers have high service requirements.
Wesco International (WCC)
Wesco is a leading distributor of electrical supplies, which entitles it to receive some of the most favorable discounts and incentives from manufacturers. The company has a strong presence in vendor-managed inventory and derives nearly 20% of sales from outside the U.S.
Anixter International (AXE)
We like Anixter's value-added services, such as assembling integrated security systems for customers and independently testing product performance. The company has a strong position in electrical supplies, security, cables and fasteners, and communications equipment.
HD Supply (HDS)
Formerly a division of Home Depot, HD Supply focuses on MRO, water, power infrastructure, and specialty construction. The company has weaker customer relationships and deals with more cyclical end markets than other distributors we cover.
Kwame Webb does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.