Private Equity Still Likes Distribution

The lead story in Monday’s NAW Smartbrief highlighted a recent Wall Street Journal article looking at drug wholesaler McKesson (MCK) as a possible takeover target. (See In McKesson, Some Foresee 'Value' Lesson.)

Despite the slowdown in M&A activity that I predicted in June, wholesale distribution will remain attractive to financial buyers. The prospects for a McKesson buyout highlight why private equity likes our industry.

Here’s a key quote from the WSJ article: “Rick Schnall, a senior executive of buyout firm Clayton, Dubilier & Rice, said McKesson has one of the best managements in the health-care business. He said "many private-equity firms would love to figure out a way" to buy it, though he said it is unlikely that such big deals will take place until difficulties in the credit markets pass.”

For those who don’t know, CD&R is a top-tier buyout fund that has been very successful with distribution businesses. They are currently invested in large distributors of electrical supplies (Rexel), lab supplies (VWR), food (US Foodservice), and building supplies (HD Supply). Click here to see a selection from their current portfolio. CD&R is one of the funds that I discuss in Chapter Five of Facing the Forces of Change®: Lead the Way in the Supply Chain.

I’ve been thinking about a drug wholesaler go-private buyout transaction for some time. As I see it, McKesson is the most logical buyout target among the Big 3 drug wholesalers due to its business mix, current operating platform, and age of the management team. McKesson has two distinct business segments – they are a drug distributor as well as the largest healthcare information technology company.

A buyout would provide a platform for a transformational restructuring and open up some intriguing domestic and international acquisition opportunities. Cardinal Health (CAH) is even more diverse but is in the midst of its own restructuring under new CEO Kerry Clark. AmerisourceBergen (ABC) is more narrowly focused on distribution but has a less centralized logistics platform, limiting its ability to serve large retail chains. McKesson’s acquisition of OTN improves the company's leverage with customers in the fast growing specialty distribution business.

McKesson also has very little debt due to the fee-for-service transformation that cut required wholesaler inventory levels in half. In fact, McKesson’s Net Debt-to-EBIDTA ratio was actually negative (!) based on second quarter financials, making the company especially attractive to private equity. (Net Debt = Short Term Debt + Long Term Debt – Cash & Cash Equivalents, so the numerator in this ratio is negative.) Keep in mind that a financial buyer is effectively purchasing the cash flow generated by a business and may finance the purchase by borrowing against the assets and future cash flows of the acquired company.

The drug wholesaling business has many risks, including ever-more powerful retail customers who squeeze margins and threaten to buy directly. Nonetheless, McKesson operates in a wholesale distribution line of trade that is insulated from global competition, just like other popular target industries for private equity such as facilities maintenance, construction supplies, and building materials. McKesson’s enterprise value is $17.1 billion, which is plausibly affordable once the credit markets settle down.

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Trust and Channel Data Sharing

“I don’t trust my suppliers with my data.”

This is the most common response from distributors when I tell them about the data sharing prediction from the new Facing the Forces of Change®: Lead the Way in the Supply Chain book. The research found that suppliers will get more visibility into actual customer demand because wholesaler-distributors will share more point-of-sale data.

Getting over the trust hurdle requires more than just faith in a supplier. I increasingly believe that wholesaler-distributors should only share point-of-sale data with supplier organizations that have rigorous internal security policies for data management.

Don’t Pass Me By

Trust worries fall into three basic categories:

1. “Suppliers will use the data to sell directly to my customers.”


2. “Suppliers will use the data to move my sales to another distributor.”


3. “When the channel manager changes jobs, he’ll take the data to a competitor.”

Personally, I believe that the first concern is overblown. Most customers (especially smaller ones) still prefer to buy via wholesale distribution. Few suppliers can meet the needs of high-service customers.

The latter two concerns have much more merit. The majority of wholesaler-distributors are privately held companies that have been operating in their markets for many years and often multiple generations. Most wholesale distribution executives have seen channel managers come and go. Based on the comments I’m getting, many have personally experienced the abuse of data by a supplier or by a particular individual at a supplier.

Making Collaboration Work

Collaborating with supply chain partners (from the latest Industrial Distribution magazine) highlights all of the key issues.

The article describes the point-of-sale data sharing between building materials distributor CH Briggs and 3M Corp, one of its major suppliers. (Observant readers will notice that I profile C.H. Briggs’ experience on page 45 of Lead the Way in the Supply Chain.)

Julia Klein, CEO of C.H. Briggs, points out the value of trust in her company’s 30 year relationship with 3M “When we were first asked [to provide POS data] we were hesitant, asking, 'Are you going to go around us? Are you going to sell direct?' They've never threatened to do it, they've never had a mistake they've had to apologize for, so we're comfortable in sharing that information with them.”

At the same time, 3M appears to have above-average data security policies. 3M's director of channel management said: “We have a very intense security policy internally. It's on a need-to-know basis only. Employees with access have to take training on appropriate uses of the information.”

Trust then Verify

In my talks, I highlight the income statement and balance sheet benefits that channel data sharing can provide to wholesaler-distributors. But at the same time, wholesale distribution executives need to proactively manage the risks of sharing data.

For example, the EDI transaction set 867 (Product Transfer and Resale Report) is the foundation of point-of-sale channel data sharing. Wholesale distribution executives should manage and negotiate which specific fields get filled in along with the level of detail provided. At the same time, pay close attention to the data security policies of key suppliers.

"Trust then verify" was President Ronald Reagan's maxim for arms negotiations in the 1980s. The advice applies to today’s channel relationships, as well.

Finding Chinese Suppliers

I’ve been on the road for the past 6 weeks talking about my new Facing the Forces of Change®: Lead the Way in the Supply Chain book. It’s been a lot of fun for me, especially when I get questions from people who’ve been reading my books and articles for years – and even a few who have checked out this blog!

Over the next few weeks, I want to address some of the common questions that I hearing. Today I’ll address the controversial practice of global sourcing for private label products. The other controversial topic has been data sharing between wholesaler-distributors and their suppliers, which I’ll discuss week.

I have been surprised at how many wholesale distribution executives are looking into sourcing their own private label products. Apparently, many people still see opportunity among the risks.
A common question: How do I find a reliable supplier of private label products?

To be honest, I am not an expert in locating or evaluating potential suppliers. So check out How the Internet Changed Sourcing, an Industry Week article suggesting that U.S.-based buyers can now quickly generate a short list of potential suppliers using the Internet.

The author mentions three sites to look online for Chinese suppliers:

Alibaba

Made in China

Global Sources

While I can’t vouch for these sites, you should certainly look around on these sites as they are a fascinating peek into the world of global commerce. FYI, Alibaba is about to conduct the largest IPO (initial public offering) ever by a Chinese technology company. (See Alibaba.com Plans Up To US$1.33B HK IPO.) Yahoo owns 39% of Alibaba’s parent company.

Can anyone suggest any other good resources?

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P.S. Keep in mind that the falling dollar will reduce the attractiveness of Chinese imports while making American exports more attractive. Martin Feldstein, who chaired the Council of Economic Advisers under President Reagan, argues that the dollar’s fall will be good news for American competitiveness. (The article is quite unambiguous: A more competitive dollar is good for America.) Just one more unpredictable dynamic to monitor!

Creative Ways to Own the Customer

Mark Twain once said: “History doesn’t repeat itself, but it does rhyme.” Keep that quote in mind when thinking through the possible lessons from some recent acquisition activity in the health care space.

McKesson (MCK), one of the country’s biggest drug wholesalers, just announced a deal to buy Oncology Therapeutics Network (OTN) for $575 million. I don’t normally blog about specific transactions. However, this acquisition highlights a very interesting counter-trend for wholesaler-distributors concerned about disintermediation.

Here's the twist. OTN is a distributor that also owns Onmark, a large buying group for thousands of small accounts. Now, the buying group portion of the business will be under common ownership with McKesson, a major wholesaler-distributor.

Such forward integration makes it virtually impossible for a manufacture to bypass and sell directly to the customer -- because the distributor and the customer are the same company! Nevertheless, the customers of OTN/Onmark still operate as independent businesses. McKesson is not planning to operate physician offices or oncology clinics.

AmerisourceBergen (ABC), a competitor to McKesson, uses this strategy to great success. ION, the largest community oncology buying group, has a prime vendor distribution arrangement with Oncology Supply. Both organizations are part of AmerisourceBergen’s Specialty Group.

Learning from Other Industries

As I see it, the McKesson deal provides an intriguing opportunity to think about possibilities in your own line of trade. I know that customer buying groups exist in many wholesale distribution lines of trade. So I wonder: Are there any similar opportunities to establish a unique competitive advantage through forward integration?

There are interesting lessons and examples like this one all around the $4 trillion wholesale distribution industry. So I also want to tell you about an upcoming opportunity to learn about these examples -- the NAW Executive Summit.

I’ll be leading a panel discussion on customer focus featuring three wholesaler-distributors from three very different lines of trade. I hope that you can make the time to attend and get inspired by the creative strategies of wholesaler-distributors in other lines of trade.