Distribution Adjusts Its Business Model in China

Even after decades of doing business in China, the supply chain is still busily ironing out some kinks.

Electronics distributors, which serve both component makers and customers in the region, have reasons to advance their business toward Western models. The channel can operate at its maximum efficiency by leveraging inventory volume, unifying service offerings, serving common suppliers, and managing high-volume, low-mix customers. But the channel has been hesitant to impose its Western-developed business models in Asia.

In addition to respecting foreign cultures, distributors have found one size doesn't fit all.

The reseller market in China is highly fragmented, made up of numerous distributors that carry a limited number of product lines. Starting in the 1980s, US-based distributors began an acquisition binge that has largely consolidated the global electronics supplier base and the service offerings to many international customers. In the US, regional distributors became national distributors. Those nationals duplicated the model in the EU and moved toward the Pacific Rim.

The electronics industry's two largest distributors, Arrow Electronics Inc. (NYSE: ARW) and Avnet Inc. (NYSE: AVT), have invested significantly in China. Arrow first moved into the Asia-Pacific market through its acquisition of CAL Group (Hong Kong) in 1993. Avnet acquired WKK Semiconductors, Hong Kong, in 1995. The distributors have since cobbled together a number of acquisitions that have strengthened their presence in the region. Avnet's China acquisitions include Eurotone Electric Limited, Vanda Group, and Sunrise Technology Ltd.; Arrow's includes Excel Tech, Inc. and Eteq Components Pte Ltd.

Relative to other acquisitions, the China acquisitions were small. Strategically, distributors benefited in several ways. Suppliers in China have traditionally sold through multiple, small specialists that carry a few lines. Acquisitions united many of these suppliers -- and customers, whenever possible -- under one roof.

Electronics OEMs initially used indigenous distributors as they expanded into China. By using the ready distribution network, OEMs were able to reduce time-to-market, Albert Puhay, chairman and CEO of Singapore-based Excelpoint Systems Ltd., told me in an interview earlier this year. But that expansion also brought new distribution competitors into the market.

"Having grown rapidly over the years, the population of distributors has grown by leaps and bounds since the late 1990s," Puhay said. To survive, many distributors resorted to pricing competition to keep market share. According to Puhay, principals and customers now have to grapple with many administrative problems due to dealing with too many distributors, especially in areas of inventory and price management.

Price competition has been a particular headache for US-based distributors. Western distribution practices largely prevent two distributors that carry the same product line from undercutting one another on price. This isn't the norm in Asia. Additionally, there's a disconnect between an OEM product design and manufacturing of the product.

Distributors will often assist their customers with designs so they can capture volume component orders when manufacturing moves overseas. However, both distributors and customers have difficulty enforcing this program because orders pass through many layers before reaching the factory floor. It isn't unusual for a customer to place an order with a competing distributor once manufacturing begins in China.

The onus is on distributors and suppliers to rectify that particular situation. In the meantime, OEMs have learned over the years that managing fewer suppliers increases cost efficiency. OEMs are already looking to consolidate their supply chains.

Smaller distributors may be forced out of the market, or will opt to partner with bigger firms to survive, says Excelpoint's Puhay. "This consolidation is poised to change the distribution landscape, and today, size matters. While we may see a smaller population of distributors in the future, it will also mean that there will be more orderliness in the market, and distribution will ultimately evolve into a more professional business.

This trend will accelerate as business in China starts to mature. In their most recent conference calls with analysts, Arrow and Avnet said that while Asia continues to outgrow other markets, the pace has slowed. Distributors typically rely on their higher-margin businesses in the West to offset low-margin engagements in Asia-Pacific, which didn't happen in the third quarter of 2012.

It's also unlikely the channel will see prices firm up in Asia. More likely, distributors will continue to increase their presence in Asia-Pacific by expanding market share, which means more merger and acquisition.