In The Public Eye

by Larry White - Interlynx
Systems, LLC

When working with manufacturers and their distributor partners, I often encounter an immediate disconnect between the two groups. Three primary reasons are normally cited:

  • Manufacturers normally work on a shorter term basis while their distributors are more likely to have a longer term business approach
  • Manufacturers fail to clarify the roles of their various channel partners, creating confusion and conflict (real or perceived)
  • Manufacturers often use inconsistent decision-making guidelines when making channel decisions.
Of the three reasons noted above, the short-term approach that most publicly traded manufacturers undertake is least understood by the distribution network.

The reason for a short-term focus
The road to understanding a manufacturer's short-term focus can be traced back to Wall Street. In today's financial environment, stock appreciation is an absolute must for publicly traded companies. And, since stock appreciation is intrinsically tied to financial performance, manufacturers become a slave to the short-term financial gyrations of Wall Street.

Before you make the mistake of assuming the average person does not get involved in short-term stock pressure, think again. Pension and mutual fund managers, who very likely manage your retirement portfolio, are key drivers of stock selection based on financial performance.

To gain Wall Street's favor, companies must drive consistent and improving financial performance, demonstrate management competency, and have a believable story for long-term potential. In addition, publicly traded manufacturers must compare favorably against their peers.

Normally, an analyst community is responsible for tracking the manufacturer. When evaluating a company, analysts look for the company to drive balanced earnings. In other words, companies must demonstrate earnings growth through both revenue and productivity growth, and, in the case of acquisitive growth, successful integration of the acquired business.

Analysts that track a stock normally make public estimates of a company's earnings per share (EPS) far in advance of a company's publicly reported results. Wall Street traders use these estimate as guidance for making trading decisions.

Incentives that drive manufacturing management
It is critical for distributors to understand that publicly traded principals are driven to meet the analysts' quarterly EPS estimates. Woe to the manufacturer that underperforms the estimate. It is not uncommon for a manufacturer to suffer 10 percent drops in stock and market valuation if it misses EPS estimates.

In order to assure that manufacturers make their numbers, companies use financial incentives to drive performance behavior within their management ranks. The single biggest incentive used by manufacturers are stock options. Stock options drive a focus on stock appreciation by rewarding executives for stock appreciation. The way a stock option works is as follows:

Executives receive the right to buy 10,000 shares of stock for $40 per share. Over a period of time, assume the stock price rises to $50 per share. The executive can exercise the options and take the profit gain of $10 per share ($50 minus $40), multiplied by 10,000 shares. This nets the manager a $100,000 stock option payout. This is in addition to other salary and bonus payments.

At the very highest levels of a manufacturer, an executive can accumulate hundreds of thousands of options, making options the single biggest compensation component.

Understanding the significant potential from the options, it's easy to see why a manufacturer strives to hit its numbers and the devastating effect that missing them can have on EPS and stock valuation. Objectives of mid-level managers and below are normally aligned to driving the financial performance.

The other critical thing to understand is that managers who consistently miss their numbers become short timers.

Impact on distributors
There are clearly pros and cons to the phenomena described above. Those that advocate stock valuation argue that the approach drives accountability, a constant focus on productivity and an obsession with revenue growth.

The downside of this approach is felt by the distributor community in the form of short-term decision making. Some of the more controversial decisions include inventory loading at the end of the quarter, pulling in future orders to ship - with or without the distributor's permission - or the most serious, adding more distribution on the promise of a large initial stock order.

It's easy to see how a reckless management team can create a tremendous amount of short-term damage to distributor relations.

What every distributor must know

The exercise above is not optional. Any distributor's manufacturing partner that does not deliver quarter-over-quarter EPS improvement will jeopardize its stock and business valuation.

Companies with significantly low business valuation could ultimately become targets for acquisition, and the acquiring company will ultimately drive a focus on stock valuation. There is no escaping the requirement.

So, if delivering quarter-over-quarter performance is a given, a prudent distributor will learn its role in influencing its principal's earning performance. The simplest way to impact a manufacturer's financial impact is to understand its financial statements - the income statement and balance sheet.

Distributors can affect three areas of a principal's income statement. The single biggest impact item to drive financial performance is top-line growth - revenue! Consequently, manufacturer's will do all they can to drive the sale perfomance of the sales network. Keep in mind, with or without their distributors, manufacturers must find ways to grow their business.

The manufacturer's balance sheet is also a key financial document to understand. The critical items a distributor can affect are inventory and receivables. A publicly traded company generally wants to reduce inventory levels, convert receivables to cash and push out payables.

Distributors need to understand that carrying inventory for the manufacturer can be a wise approach to building a business relationship. However, not only does it offload inventory from the manufacturer, but because the manufacturer strives to drive down inventories, in spite of best intentions, the manufacturer's service levels will normally suffer. Manufacturers won't stop tinkering with their inventory levels; eventually, a distributor with a low inventory buffer will run the risk of excessive lead times to their customer.

The imperative for growth
To restate, with or without distributors, manufacturers must finds ways to grow their sales. Normally, manufacturers try to drive growth in three ways - product, presence and hit rate.

A manufacturer can add new products (or services) to its portfolio to drive new revenue streams. A distributor that helps develop and promote a manufacturer's new products will help a manufacturer drive top-line growth.

A manufacturer can expand its market presence by finding new customers and markets to drive new revenue streams. A distributor that actively prospects for new accounts (while maintaining existing customers) will help a manufacturer drive top-line growth.

Finally, a manufacturer can improve its sales performance by helping improve distributor sales effectiveness. A distributor that invests in talent, trains its staff and effectively manages its sales team will drive sales for the manufacturer.

While less significant than revenue growth, other areas on the income statement a distributor can affect include the gross margin and selling expense lines. Gross margin is driven primarily through price realization. Distributors that sell on features and provide solutions are more likely to capture more margin, not only for the manufacturer, but for the distributor as well. Finally, selling expense is affected positively when a manufacturer has distributors that do the selling, so the manufacturer doesn't have to.

Planning and action items
Most manufacturers engage in an annual planning session with their distributor partners. These sessions are an excellent opportunity for both the manufacturer and distributor to work out their growth plans for the coming year, identify significant events and craft a revenue projection. A good action plan includes the following:

Mutual Action Plans - Annual:

  • Review of contact information
  • Policy review
  • New products
  • Target accounts
  • Training and promotional plans
  • Line card review
  • Competitive review
  • Revenue projection
  • Creation of focused attack plan
The revenue projection should be mutually derived rather than the manufacturer pushing its numbers down on the distributor. A clear list of both growth drivers and erosion drivers with detailed actions for each is critical. Too many times, plans are speculative and do not reflect the realities of the opportunities and challenges in the distributors' market.

Review the plan monthly to assure that commitments are being driven, identify shortfalls and create back-up plans that can help bridge shortfalls. Suggested review topics include:

Review of Monthly Activities:

  • Significant issue review
  • Revenue and quote review
  • Target account statistics
  • Lead statistics
  • Action items review
  • Promotional
  • New Products
  • Training schedules
  • Updates to personnel
  • Update action list and forecast
While a distributor may view these sessions as intrusive, a prudent distributor recognizes these sessions can create an opportunity for two-way communication and mutual commitment. A manufacturer should be held to account for meeting its commitments as well. Product launch dates, training and joint calls are all examples of manufacturer commitments that are imperatives for meeting growth goals.

The good news
The good news in understanding publicly traded suppliers is that the very same issues apply to a distributor's customers. A distributor that can help its publicly traded partners improve their numbers is more likely to be considered a valuable partner.