Current State of the Market
It is now widely recognized that the IT market is going through a significant transition. Specifically, and what is seen by many as transformational, is the migration from the traditional on-premises to an off-premises model (“XaaS” and its many variants) that is well underway. While that is not news for anyone who is involved in the market, the full effects of this transition are still unclear as is the rate of customer adoption. What is not unclear is that the transition will occur. While there has been considerable analysis of the effect on the suppliers, partners, and customers, one segment that has not been discussed as fully is the effect on the distributors. Based on the traditional model the role of a distributor is as follows:
- Partner Management: The ecosystem of IT partners is significant. There are thousands of partners that resell various vendors hardware and software. Managing these partners requires considerable time and resources. One of the main roles for a traditional distributor is to assist in the management and recruitment of these partners.
- Logistical Support: For hardware, there is a significant logistical support role that is filled by the distributors. They are the ones that monitor and track product shipments, ensure that partners have the right products for their markets, and assist with returns and restocking.
- Financial Support: Finally the distributor provide some measure of financial support to the partners. Most of the smaller partners do not have the balance sheet strength required to be able to self-finance the net working capital for their operations. This service can be of value to large partners as well as it offers another line of credit to these partners as well. In this space, the distributor can provide some assistance.
However the migration to the alternate consumption models, including “XaaS” and cloud, is disrupting this models. For the distributors, this disruption will be felt first on the product-side of their business. For every customer that migrates to any XaaS or cloud offering, there will be a decline in their need for on-premises hardware and some infrastructure software. This is obvious for a customer that choses to use cloud based storage through an offering like Syncplicity from EMC, or compute through an offering like EC2 from Amazon. But it is also true for any customer that decides to deploy a cloud based offering like Salesforce.com or SucessFactors. Because the customer does not have to buy or upgrade the internal hardware to run a CRM or HCM solution. Based on this, it is clear that the role of the distributor is going to change as the demand for on-premises hardware and software continues to decline.
One of the problems that the distributors face in this transition is they are serving two masters, the suppliers and partners. They are the clue that holds this complex ecosystem together. Both have the same goal, to sell more solutions, they approach this from different angles. Partners want some autonomy so they can provide customers with a solution from a variety of suppliers, while suppliers want the partners to provide a solution that uses as much of their products or services as possible. This often leaves the distributors in the middle, serving two masters. Without the partners, they have no one to distribute product to, and without the suppliers they have no product to distribute.
Changes to the model
As the transition continues, everyone in the IT supply chain will be impacted. For some the impact will be less dramatic than for others. For example, the need for compute, storage and networking is not likely to decline in the coming years. As such the impact on the hardware vendors, in aggregate, is not expected to be very significant as they are expected to have fewer customers that consume more of their products. The competitive dynamic will be different and the sales approach and importance of each customer will increase, but from a macro perspective, the total need for product is not expected to decline. From a reseller perspective, the revenue opportunities from hardware sales is likely to decline as customer move to cloud based services, but because of the change in the consumption model, there will be opportunities for IT consulting and migration services to manage the transition. So, product margin can be replaced with services margin. However, for the distributors, the situation might be a bit more challenging if they do not/are not shifting their models as well.
Given these changes in the market, the distributor, who is caught serving two masters, needs to evolve their business model. One area for potential investment is services. Services have been and will continue to be very much in demand and Distributors offer services to varying degrees. The problem that the distributors will face in providing services is two-fold. In many cases, the distributor will be viewed as competing with their partners for services revenue. While channel conflicts, particularly between the partners and the suppliers, are nothing new in IT, in most cases the power balance between the partners in aggregate and the suppliers are relatively balanced. The partners need the suppliers as they can only get certain products from the suppliers, and the suppliers need the partners because they do not have the resources to build a fully direct sales model. But this is not true in the case of the distributors. In many cases partners and suppliers have a variety of distributors they can use to acquire and distribute products. So the competition with the partners is much more problematic for a distributor than it is for a supplier.
The second problem with providing services is crowded nature of the services market. The suppliers, the partners, and the distributors see this opportunity. As does GSIs, outsourcers, and managed services providers. Given the breadth of services market participants, it is challenging for a distributor to be able to come up with a niche or unique offering in the market. For new technologies, most partners look to the supplier to provide the initial consulting and integration skills as they developed the product and are in the best position to understand how to deploy it.
So while services may not be a panacea for distributors, there role in the IT ecosystem is not expected to go away. One potential opportunity for distribution is going to their core of offering financial services to their partners. Running and growing a profitable business with very thin margins is very difficult. Running and growing a business with thin margins that is transition from a CapEx to an OpEx spending model is bordering on impossible. The reason for this is the payment and revenue recognition changes. In the traditional market, revenue is recognized and collected shortly after the sale of the product. This is not true in a cloud of “XaaS” world. Revenue is recognized and collected over the life of the contract. This creates a cash flow problem for the partners as they incur all or most of the cost of sales before the contract is agreed to, but do not get paid for several months or years.
This can present an opportunity for the distributors. What the distributors have is strong relations and knowledge of the glue that holds the IT system together, the partners and the customers. If they can monetize this, there can be true differentiation for them. One possibility for monetization is to use their balance sheet to help the partners finance their deferred revenue. Given this is too is a highly competitive market, some competitors are well known but this opens up a set of new competitors, such as traditional banks. The advantage the distributors would have in the market, is a stronger level of knowledge of the customers and the technologies which, if leveraged correctly, could put the distributors in a better position evaluate the credit risk associated with some of the contracts. Further, the credit markets available to smaller partners are not as robust as they are for the large enterprise.
A New Tack on Old Business
There are limited (if any at this point) distributors catering to smaller startups. The main reason for this is smaller vendors often cannot afford the services of a major distributor. However, this does not mean that start-up’s could not benefit from some of the services that a distributor can offer. The challenge is scaling down the offerings to reduce the cost as smaller vendors do not need the full suite of comprehensive services offered by a distributor. Doing this will likely require the distributors to create or spin off a division that can be scaled to handle multiple smaller vendors. This could be a very interesting proposition to help increase distributor revenue, counter some of the losses from the existing big vendors, help the start-ups from the get go which would build customer loyalty that could be used to drive additional revenue as they grow. While these changes would not be easy, successfully pulling this off could potentially be a very significant game changer.
While the IT market is a mature market, it remains very dynamic. Advances in technology can change consumption models, open new markets and destroy existing markets far faster than in other mature markets. These features of the market make constant change and adjustment a requirement for any company operating in this industry. For the IT distributors, who are in the “middle of the middle” and as such serve two masters, the coming change is likely to require them to make more dramatic business model changes than some of the partners and suppliers. Fortunately, the distributors seeing the market shift moving to new IT consumption models because of the tremendous market attention and unmatched customer demand. While the jury is still out on what becomes of IT distribution, one thing is known is that while for now, their role is safe, the current model will become increasing non-viable in the coming years. Going forward, they must look out the future, perhaps put their toe in the water of new models.
Matt Healey, Director of Software & Services contributed to this Research Note