Convergence and Distribution

By and large, people don’t really like middlemen. There’s a popular view that middlemen contribute very little but inflate prices to create profits for themselves. But to an economist, a middleman needs to be contributing something valuable, or they will be cut out of the process. This is certainly true of FP distributors: they set prices, promote products, work with retailers, handle imports, hold inventory, ship product to retailers, and take care of servicing, repairs and returns. These guys contribute enormously to the market – often for a fairly paltry return – and I suspect that convergence is going to make a life a lot harder for them, at least for the ones that survive. In today’s post, we’ll look at why distributors exist in the first place and how convergence threatens that.

The first question to consider is why most brands have independent firms for distribution rather than handling everything internally (like Montblanc do). For a brand to give up some of its profits to another company, there must be some benefit that outweighs the lost profits; I suspect that the major drivers of this are economies of scale and local expertise.

For a single brand, particularly those that don’t sell a huge volume of product – think Visconti or Nakaya – it can be pretty expensive to set up a distribution operation. In addition to staff, you need an office, branding, and there’s lots of travel out to meet and build relationships with the retailers. The cost of all this needs to be passed in the form of higher prices. Alternatively, independent distributors can carry multiple brands and spread out the same costs over a much larger volume of product; that means they can do the same work but cheaper. Even with a profit margin added to their costs, a brand can save serious amounts of money by outsourcing distribution.

Local expertise is also important, though it’s much harder to value. Anyone can access a list of FP retailers in a particular region, but a good distributor will know each retailer’s business and their idiosyncrasies: the sorts of products they sell, how quickly different products move, their financial situation and the terms they prefer. This kind of expertise is the basis of a good commercial relationship and allows the two businesses to work together more easily. A distributor carrying several brands will have more frequent contact with each retailer and a broader understanding of their business. If you only sold Visconti to a retailer, you’d know something about their high-end customers but you’d have no idea about their low-end customers, perhaps you wouldn’t even know if they were an important part of the business or not. On the other hand, if you distributed Lamy, Nakaya, and Visconti to that retailer, you’d have a much better idea of what the retailer’s business is all about. And this understanding translates into a better sales approach, because a distributor can focus on the products and features that are relevant to the retailer’s customers, hopefully increasing sales and making everyone happier. A single, annual visit from a brand’s sales rep is unlikely to have the same depth or relevance, particularly if that rep covers an entire country or region.

These factors combine to mean that outsourced distribution is both cheaper and more effective than internal distribution, but that arrangement is challenged as markets converge. As discussed in our last post, the ability to have different prices in different regions allows for brands to maximise their revenue globally, but – crucially – depends on preventing buyers in one region from accessing lower prices in another region. When buyers can do this, sales volume is inevitably going to shift over to the market with the lowest price, and brands will fail to maximise revenue. This means a new pricing strategy is necessary for brands to maximise revenues in a converged market, approximating a single, global price for buyers everywhere (adjusted for factors such as freight and local taxes); it also means the ability to buy something cheaper online – the arbitrage window – disappears. In some markets, there might be very little change; other markets could see quite large price adjustments, as cheap products go upmarket or upmarket products become a lot more competitive.

Distributors choose a price based on their own cost structure and the price sensitivity of their local buyers (perhaps with some guidance from brand HQ); when a brand chooses the price, it eliminates the distributor’s ability to choose what is optimal for their business. Outside a certain range, a pen is either too expensive (and the distributor sells too few units to cover their costs) or too cheap (and the distributor sells a lot of product, but at too low a price to cover costs) for the distributor to carry, and they either drop the product – or the brand entirely.

For some peripheral markets, such as Australia, this is the exact scenario I expect to play out in the coming years. Distributors – some of them already part-time operations and struggling to get by – will simply not be able to make the business work. As they go, brands will be forced to exit particular markets completely or to handle distribution internally; as we see global prices converge, Australian prices will start to fall or the products will simply disappear from the shelves of local retailers. It’s hard to say which it will be.

For larger markets, such as the EU and United States, we can expect there will be some reorganisation of the wholesale market: some distributors will consolidate or close down, while some brands will bring these operations in-house. It’s hard to predict the effects here with any real accuracy, as it depends on the magnitude of price changes, but it’s certain that some distributors would close and this would have flow-on effects for retailers and consumers. Retailers would lose their local agents, those value-creating relationships, and much of the support that entails. On the other hand, they would gain a direct relationship with a brand and have more ability for their feedback to reach product designers, as well as access to a full product range.

For consumers, there would be a definite price impact: some products would become more expensive and others would become cheaper. The arbitrage window would certainly close and it’s possible that local servicing/repairs would be moved offshore or outsourced to local agents (who, like distributors, would handle work from a variety of brands). On the other hand, brands would be closer to consumers and this should lead to more responsiveness, better product design and refinements (as we currently see with Twsbi).

It’s hard to say if convergence would be a good or a bad thing overall for most brands, retailers, and buyers: it seems like it will largely be a mixture of both. For distributors, though, it will mean that their job gets harder and less rewarding, and that will push many to close. That’s unfortunate but the actual work of sales and distribution will still need to be done, and that will keep many FP specialists employed. The next few years should certainly be an interesting period for the industry, one full of transformation, opportunity, and challenge.