Morningstar Magazine - April/May 2018 - 68

Investors

they're project-based. They have to bid these
things out. I don't see why Amazon would
try to replicate that business only to earn margins
that are that low.
Outside of digital competition, what issues do the
companies on your coverage list face today?

Bernard: The market is looking at gross margins,
almost to a fault. If you're seeing pricing
pressure, obviously you're cutting your prices, and
if you're not able to cut the costs from your
suppliers, you're going to see that come down.
The problem is that gross margins are going
down for basically everyone that we cover. That
caused people to fear that it is because Amazon
is really disrupting distributors. But the reason
gross margins are going down is that the

for example, since they cut their pricing,
they've actually been growing tons with the
midsize customer.

merger would be interesting. That would really
increase their market share, and there'd be pretty
decent synergies.

You have to watch the sales, and you have
to be cognizant of the gross margin, but
I'm looking more at the operating margin.
Everything that I'm seeing so far suggests that
while there's some pricing pressure out
there, it's not disastrous for these businesses.

As for current opportunities, back in early summer
five of the six industrial distributors I cover
were in 4-star territory. People were nervous about
Amazon. But as the year progressed, the
market started to realize that these firms have
enough competitive advantages to continue
to thrive. Grainger's and Fastenal's stocks have
recovered. But Anixter and WESCO still
look like opportunities to us. It might be because
they are small cap, and they don't get the
same attention. Even if our thesis on Amazon is
wrong, and they end up taking share from Grainger
and Fastenal, we're pretty confident that
they are not going to come after Anixter or WESCO.

And one thing to remember, too, is that all
these companies serve industrial end markets, and
a lot of the activity's been depressed. Once
we start seeing a recovery-and volumes start to
tick up-I think you'll start to see that the
earnings power comes back.

Amazon is going to grow, but there's
a big enough pie for everyone to grow
and be happy.
Brian Bernard

distributors that have economies of scale are
serving national accounts, and those are
lower-margin. Larger customers have greater
buying power, so if you're growing those
larger accounts faster, that's going to hurt your
gross margin.
Fastenal's vending and on-site businesses
are lower gross margin, but they can leverage their
fixed costs better. So, the operating margins are
about in line, and it's less capital-intensive,
so they can grow their returns on invested capital.
We're watching what's going on with organic
sales growth. They should all be growing. And all
of them are, but if one's not, then you'd worry
that perhaps someone is taking share from
them, and that's not been the case. With Grainger,

68

Morningstar April/May 2018

What trends are you watching?

Bernard: I think you're going to see a lot more
consolidation in this very fragmented industry.
The leaders are going to either take share
organically or end up acquiring the mom and pops.
A lot of these smaller distributors might have
a special product or be in a region a larger
distributor is not in. And industry consolidation
should help with pricing.

Going back to Anixter and WESCO, there's been
pricing pressure there for years, because there are
over 10,000 electrical distribution businesses
in the United States. Margins have been around
2% to 3% just because the industry has
always been fragmented. Consolidation would
help. This is just speculation, but a WESCO/Anixter

Are there broader lessons that apply to other sectors
or industries?

Bernard: Some medical distributors, for example,
face a lot of pressure, those that supply
surgical gloves and bedpans and that type of thing.
These are not specialized products, and they're
selling to customers that are facing tremendous
cost pressure. If they have the capital, they
might want to acquire more specialized products
or beef up their service portfolio. You need
to have some product specialization or serve some
kind of niche. You need to show your customer
that even if someone out there can sell at a
cheaper price, you can bring in services that at the
end of the day lower the cost of ownership.
If you're a distributor, you want to make sure that
you build that type of business model. K
Laura Lallos is the managing editor of Morningstar magazine.



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