Morningstar Magazine - April/May 2018 - 67

How have the larger distributors embraced
e-commerce? Are they competing with Amazon
on that front?

Bernard: By no means have they had their
head in the sand. Grainger.com is the 11th-largest
e-commerce site in North America. They
have robust websites, and they'll say that their
e-commerce is more than a website, that it
includes their vending machines on site. They are
synced to customer systems, and they can
track volume through that.
But you found that Grainger is more susceptible to
digital competition than some of the other companies
you cover.

Bernard: Grainger doesn't serve a market
niche like the others do. Fastenal is big
with fasteners. With HD Supply HDS, their bread
and butter is serving multifamily, hospitality,
and healthcare markets. MSC Industrial Direct
MSM has a niche in U.S. metalworking,
and Anixter International AXE and WESCO
International WCC are project-based, technical
wire-and-cable specialists.

If you look at Grainger's product mix, some
things are specialized, but they sell a lot
of janitorial supplies, safety supplies, things
like that. This is what's called MRO-maintenance,
repair, and operations spend. That's the type
of thing that is going to face the most pressure
from Amazon and online competition. They
don't serve a niche, which we found really protects
other incumbents.
But they still have competitive advantages
with large customers that value their services
in the vendor-managed inventory. Some analysts
out there are still very bearish and think
that Amazon is going to take these guys down.
I don't see that happening.
The thing with Grainger is that their pricing
had always been very high relative to the other
distributors. Earlier this year, they cut all
their prices for all their customers. They needed
to do that to remain competitive. Their larger
customers for the most part will stick with Grainger,
but these customers aren't dumb. Grainger set
a precedent, and I don't see why these customers,
even if they have no intention of leaving Grainger,

couldn't point to Amazon and say, "I like your
service, but these guys are 20% cheaper.
I want at least half of that, otherwise I'm going
to walk." You're going to see these renegotiations
more often, which is again going to put some
pricing pressure on them.
But at the end of the day, the services do still
offer some kind of pricing power. Margins
will probably never go back to where they were,
but right now they're at 11%. While I don't expect
Grainger to get back to operating of margins of 13%
or more, I think 11% to 12% margins are defensible.
Do you see Amazon building out services such
as inventory management?

Bernard: It depends on the solution. You could
argue that they're already starting to do
vending machines with the Amazon Lockers-
it's not quite the same, but not that far
off. But Grainger and Fastenal have employees
at customers' sites. Fastenal's on-site
program is basically a Fastenal store within
the customer facility, and that service is growing
very quickly. For Amazon to do that, it'd have
to invest in head count and train and maybe carry
more inventory than they normally would.
Do they really want to have that investment?

Amazon is winning small businesses because
they don't really require that kind of service.
And small customers are more profitable than the
larger customers. It makes the most sense
for Amazon to take share from smaller businesses
with their existing model. There's plenty
of market share to capture there, and it's highermargin. My guess is that is where they're
going to go.
What are Fastenal's advantages?

Bernard: Fastenal has that niche in fasteners.
Now, that's only 35% to 40% of sales; the
rest are coming from that less-specialized MRO
type, such as janitorial and safety supplies.
But they're the largest in North America with
fasteners. Nobody does it better. The thing
with fasteners-and this explains why they built
their distribution network-is that they are
low value for a lot of weight. They are expensive
to ship, so over the years, Fastenal has built
a distribution network that a lot of people don't

appreciate. They have 2,400 stores. If you
don't know much about Fastenal and you see what
Amazon's doing, you look at these stores, and
wonder if they will need to close because of online
pressure. But these stores are not really used
for foot traffic like a traditional retailer. Only 15%
of sales are from people walking in the door.
The rest of it is that last mile to support customers
in their facilities. And Amazon is just starting
to build out locations for that last mile.
So, that's the advantage. Grainger doesn't have
anything like that. Grainger has vending
machines, but Fastenal is basically building little
stores on the customer site. Nobody else
can do that, probably, because they don't have
that distribution network.
Obviously, Fastenal is a tremendous company.
Their margins are the best among the industrial
distributors that we cover. While there's
probably going to be pricing pressure on the, say,
60% of sales that are not fasteners, I think
that they have enough going for them that they
can overcome that.
Why is Anixter at low risk from digital competition?

Bernard: Both Anixter and WESCO, which is
a very similar company, have a completely different
business model. Fastenal and Grainger are
providing inventory needed by customers for
day-to-day activity. Anixter and WESCO are more
project-based. They're selling network and
security products, and products that a public utility
company would be using.

If you're building a data center, Anixter is going
to provide the wire and cable, a lot of the
network gear. But these things can take months
to years to complete, and Anixter is basically
a consultant; they provide a lot of technical
expertise. Before a customer even buys, they can
come out to their Glenview, Ill., testing lab-
which is UL-certified; nobody else has a testing lab
that's UL-certified-and test their products.
Amazon's not going to go down that path.
Even if they wanted to invest in the head count
and the technical expertise to compete,
it's not worth it, because Anixter's and WESCO's
operating margins are 4% to 5%. That's because

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